The Value at Risk

How Reliable is The January Barometer?

2010-01-30T19:37:00.000-05:00

With 2010's first month of trading in the record books, the perennial references to "The January Barometer" are being espoused ad nauseum, and throughout a variety of media outlets. In a January 29th WSJ article - "January Proves Tough for Stocks" - the venerable newspaper makes the following statement:

"History suggests that a weak January performance is a worrisome sign for the rest of the year...In years when the Dow has risen in the first month of the year, the median rise for the rest of the year is 10.4%. In years when the Dow has fallen, the median rise for the next 11 months is just 0.28%"

Feeling dissatisfied with the statistical methodology (Given January % Return > 0, median return) used above, I set out to apply a regression analysis to the data. I pulled data on the S&P 500 for every year from 1952 to 2009, setting each year's January % Return as the explanatory (X) variable, and the subsequent full year % Return as the response (Y) variable. The results are plotted below to provide a visual:

In the event that a strong relationship between X and Y existed, the plot above would display at least some modicum of linearity. This isn't quite the case. In fact, the r-squared value for this data is 0.1012, meaning that only 10.12% of the variation in Y (entire year's stock market return) is explained by X (return in January). However, I realize that regression analysis of this nature is not very resistant to outlying/extreme values; that is, a few extreme observations have the potential to significantly affect the portion of Y's variation that is attributable to X. For this reason, I arranged January's % returns into quartiles, calculated the inter-quartile range (IQR), and deleted any observations that fell greater than 1.5*IQR from either the first or third quartile. Interestingly, only two observations throughout a 57 year period passed the above test for being considered "extreme" - the S&P 500's return during January 2001 and January 2009. I deleted both observations, and recalculated below:

After removing the two extreme values, the new r-squared value is 0.1544 ( 15.44% of Y explained by X) - a near 50% improvement, but still well below any reasonable threshold which might prove the predictive value of January.

In conclusion, I will not be using January's stock market decline as a basis for any prediction concerning the full year performance of the S&P 500. That determination is better made - in my opinion - by recognizing that not all recoveries are created equally, via close monitoring of the mortgage market's response to the Federal Reserve's exit from it's mortgage backed security purchase program, and by examining the structural implications of sustained double digit (real) unemployment.

*long several S&P 500 stocks

Quantitative Assessment of House Price Distributions

2010-01-23T21:46:00.000-05:00

This weekend, as I found myself inundated in quantitative finance problem sets, I decided it might be worthwhile to apply some quant methods to real estate. After all, we're in the midst of a recession whose numerous causes - and/or exacerbating factors - include a multi-year decline in median home prices across virtually every geographical market. Furthermore, a larger proportion of Americans own a home than own equity securities. My experiment began with market selection; I wanted to compare two housing markets within relative geographical proximity. I also wanted the comparison to be between markets that have suffered comparably during the recession, and are perceived as good long-term housing bets for reasons such as population and demographic trends, weather etc. After brief deliberation, I decided that tonight's matchup would be between Atlanta and Charlotte.

To begin, I pulled data from the S&P Case-Shiller Home Price Index (monthly) from January 2000 to October 2009. I then converted the index value to a periodic rate of return for each month, using the natural log function. That data was then summarized in histogram format below:

The two distributions are somewhat similar at first glance, although Atlanta appears more skewed to the left. Atlanta's most frequently observed interval (bin) of return is also a bit higher than Charlotte's. However, in this instance I'm most interested in providing an investor with a general idea concerning the risk associated with a house purchase in each of these markets. To do so, I computed the mean and standard deviation for each city's returns. Furthermore, I calculated the (theoretical of course) probability that a given month's return would be less than zero for each market:

The Conclusion: Although the monthly return could conceivably be higher for an Atlanta house, there is a 45.75% probability that a given month's return will be less than zero - negative that is. In Charlotte, that figure is only 39.54%. Furthermore, it's important to note that the Atlanta data is characterized by a fatter left tail; that is, Atlanta has experienced multiple months of >2% price declines, while Charlotte's returns all fall above -2%.

Clearly, there are many variables that influence house prices, not all of which are even subject to attempted forecasting. However, I would venture to say that the method above provides a reasonable illustration of the relative risk associated with a real estate investment in the two subject markets.

*no positions in either Charlotte or Atlanta real estate. I am licensed to sell real estate in NC however.

Health Insurers and the Medical Loss Ratio

2009-12-29T14:57:00.001-05:00

As Washington continues to micro-manage various industries via royal decree, it is becoming increasingly evident that Congress is afflicted by some combination of the following conditions:

Ignorance of industry specific business models
An inability to read financial statements
Willful disregard of #'s 1 and 2
Delusions of grandeur

Now, I will readily admit that the near collapse of the financial system is evidence in and of itself that the pre-crisis regulatory framework was flawed. However, the solution to ineffective regulation is not the passing of more ineffective regulation. In other words, Congress seems to assume that capitalism's regulatory guard rails simply weren't strong enough, as opposed to questioning whether those rails were even in the proper location.

The latest Congressional foray into the ineffective regulation of business is contained within H.R. 3962 (the Health Care bill). Apparently, the likes of Harry Reid and Maxine Waters have secretly been working towards a masters degree in actuarial statistics, and have subsequently determined that the health insurance industry can make coverage more affordable by throwing all actuarial assumptions out the window. This strange brand of ill-informed meddling has culminated in Section 102 of H.R. 3962, in the form of a mandate that health insurer's medical loss ratio never dip below 85%. The medical loss ratio is calculated as medical benefits paid divided by premiums received. Now, all questions regarding the ability of Congress to properly determine a reasonable medical loss ratio aside, I'll turn to an analysis of where this ratio has trended over time. Below is a chart comparing the medical loss ratio's of United HealthCare (UNH), Aetna (AET), Wellpoint (WLP), Humana (HUM) and Coventry Health Care (CVH). Data is based on the 9 most recently reported quarterly results for the above mentioned firms:

The evidence above would suggest that the health insurance industry's major players are already operating at a medical loss ratio of between 80-85%. So why make a point of regulating this metric? I certainly don't purport to know the absolute truth on this one, but one could theorize that Congress intends to start at 85%, and slowly creep up into the 90's. Nevertheless, we can assume that these firms will need to take steps towards putting themselves comfortably within the 85% medical loss ratio mandate. The most likely compliance scenario will involve management's assessment of operating expenses. A little "trimming the fat" analysis if you will. To get an idea of where operating expenses stand relative to premiums at these large firms, I've prepared the analysis below.

As you can see above, medical costs and operating expenses combined have come close to - or in most cases exceeded - premiums received by the major health insurance companies. Therefore, health insurance firms are not able to turn a profit from premium revenue alone. Profitability, it seems, is achieved by two other sources of revenue: fees and investment income. Because investment income is unreliable in many circumstances, and the premiums charged to individuals will henceforth be regulated in arbitrary fashion, I can only see two ways that health insurers will respond:

Reduce operating expense via layoffs and off-shoring where possible
Increasing fees that Congress didn't remember to regulate

If I could make a recommendation to the industry, it would be to arbitrarily "invent" new fees. Maybe introduce another stage to the application process that would require payment of additional fees. To introduce a little bit of irony to the situation, the industry could pretend that it now faces burdensome ratio compliance costs, and must assess a few cents worth of compliance fee upon every claim. Remember: Focus on the Fees.

*no positions

3COM Corporation: Poised to Profitably Emerge From Downturn

2009-12-23T18:20:00.001-05:00

Although some companies in the technology sector - especially those firms that benefit from semiconductor demand - appear to be pulling out of the recession, 3COM Corp's (COMS) fiscal second quarter results show that even tech is experiencing a rocky and uneven recovery. Although net income for the period rose 55% from a year ago to $20M , today's report indicates that extraordinary items played an over sized role in the bottom line growth. 3COM, a firm that recently agreed to be acquired by Hewlett-Packard (HPQ), might appear to be suffering from performance declines:

What I'd point out though, is that from 2004 to the beginning of the recession in December 2007, 3COM fairly consistently operated in the red. Sales appear to have reached a plateau mid-2006. However, one could argue that 3COM is in the midst of a turnaround that has occurred during and despite the global recession. Evidence exists that 3COM has significantly reduced its cost structure and improved efficiency. For example, gross profit margins have consistently improved since 2004:

Furthermore, the company appears to have become substantially more liquid - as measured by a ratio of cash to current liabilities - since the onset of the recession:

It remains to be seen just how HP will choose to integrate 3COM's operations into the existing organization; however, it appears that 3COM is well positioned for strong earnings growth in the coming quarters. With the resources of HP behind it, I look for the Company to successfully secure new sources of revenue, and to continue to streamline operations.

*no positions in any securities mentioned in this article

XTO Energy: Liquidity and Solvency Analysis

2009-12-21T16:39:00.000-05:00

Anyone who has been even remotely cognizant of financial market events over the past week should be aware that Exxon (XOM) has agreed to purchase XTO Energy (XTO) in an all stock deal worth $31B (or $41B, depending upon whether you choose to categorize debt assumption as a direct cost to Exxon). At first glance, the deal looks like a pure-play home run bet on the natural gas industry. After all, XTO's revenue has risen from less than $400M in 1999, to over $8B over the trailing twelve month period. Net Income has risen from $46M to $2B over the same time period.

The question though, is whether XTO has managed to achieve this level of growth with a debt level that is manageable in the long term. I'll begin an attempt to answer this question by looking at XTO's debt maturity profile, as stated in its most recent 10-Q. All figures are in $MM:

The schedule above lets us know that XTO has several billion dollars worth of debt maturing in the next 6 years; however, it may be more instructive to observe just how this debt has affected the firm's balance sheet. To do so, I prepared a 10 year look at XTO's debt to equity ratio:

The trend displayed by the chart above is encouraging; XTO's debt-to-equity ratio has declined throughout the past decade, and the company is now financed by roughly a 1 to 1 mixture of debt and equity. Yet another way of examining XTO's use of leverage is to take a look at its Times Interest Earned (TIE) ratio, which measures EBIT as a multiple of interest expense:

In 2006, XTO's TIE ratio peaked at just over 14X, meaning that the company reported earnings before interest and taxes that could have covered its annual interest expense 14 times. That multiple has since decreased to ~6X, as interest has comprised an ever larger share of XTO's EBIT. A possible explanation for this trend lies in TIE's numerator: EBIT. A rapidly growing company like XTO will have large amounts of depletion expense that will adversely affect EBIT, but not cash flow. To see whether this idea holds water, I'll look at operating cash flow as a multiple of interest expense:

Once again, we see this measure trending downwards. Obviously, 3 data points doesn't create an irreversible trend. However, its worth noting from a standpoint of how XTO's financial performance is likely to affect Exxon in the coming years. Of course, Exxon may be able to refinance XTO's debt at a far lower weighted average cost of capital.

Next, I think that XTO's liquidity should be examined using the current and quick ratio's:

Although you'd generally like to see both of these ratios at a level above 1, its worth noting that over the past decade, XTO's current and quick ratios have stayed within a relatively stable band (1.4-0.8). If you look at XTO's balance sheet, you'll notice a relatively large current asset labeled "Derivative Fair Value". According to XTO management, these derivatives are cash flow hedges used to protect the company from major price swings in the natural gas market. Ultimately, the hedges should be viewed as a prudent move that allows XTO to focus on the acquisition, exploitation etc of new properties, and ignore short term noise in the price of natural gas.

In the end, XTO has to be considered a pretty remarkable growth story. There's clearly a strong performance oriented culture at the company that has allowed it to expand as rapidly as it has. My feeling is that post-merger, Exxon would do best by allowing the XTO culture to remain in place, at least in its core business operations. Exxon's true contribution to the marriage will be in the economies of scale created by the combined venture; perhaps XOM should handle the financing and hedging activities that XTO requires, and simply place some guard rails on the acquisition strategy. XTO is definitely structured for growth; the problem is, it needs to be managed properly, and with manageable levels of debt.

My last comment on the XOM-XTO merger is it represents the potential for a brilliant strategy. Exxon has poured too much money into share buybacks over the past decade, probably because hostile foreign government run oil companies have kept Exxon from exploiting their natural resources. The XTO purchase though, could provide a useful outlet for XOM's excess cash. If XTO's acquisitions can be funded through Exxon's internally generated cash flow, and the debt agglomeration trend can be halted, then Exxon could wind up being the largest owner of natural gas property in the country - and the US has plenty of natural gas.

*no positions

Basic Principles of Revenue Recognition

2009-12-12T12:38:00.000-05:00

Common sense would indicate to most people that the issue of revenue recognition shouldn't even be an issue; after all, a sale has either occurred or it hasn't right? The problem is, due to the multitude and variety of transactions that occur in the modern economy, it isn't always clear when a firm may record a given sales dollar. For instance, when several pieces of software are sold in a bundle, and a right of return exists for any of the individual bundled components, then at what point can the company reasonable assert that the sale is final? To look for guidance on this issue, we have to consult with dual sets of regulatory guidance, originating from the FASB and SEC.

The FASB guidelines for revenue recognition involve two primary criteria, both of which must be met in order for the sale to be legitimate and reportable as revenue:

The revenue must be realized or realizable
The revenue must be earned; that is, the company has performed it's duties under the terms of the sales agreement.

The general picture here is that the FASB has developed a relatively straightforward, common sense set of criteria for assessing when a sale...is a sale. The company must both have the cash - or be reasonably sure that it can collect the cash - and has actually delivered its product or service. The guidance doesn't stop there though; the SEC, via Staff Accounting Bulletin (SAB) 101, has issued four additional pieces of guidance in clarification of the principles of revenue recognition:

Persuasive evidence that a sales agreement/arrangement exists must be present. The SEC appears to believe that this principle is very important in relation to arrangements that customarily require a written sales agreement between the buyer and seller, specifically as it relates to the timing of product delivery and execution of a sales agreement. If product delivery and sales agreement execution fall in different fiscal periods, revenue can only be recognized in the later accounting period (during which both have been completed).
Delivery has occurred or services have been rendered. The SEC seems to be interested in the passage of title and assumption of risks associated with the delivered product. A consignment store may have received delivery of a product, but it hasn't assumed title, or any of the risk associated with owning the product. As such, revenue can not be recognized until the consignment product has been paid for.
The seller's price to the buyer is fixed or determinable. The SEC's primary focus with regards to this rule has to do with "side agreements" that may have attached themselves to the primary sales arrangement. Sometimes, the practical effect of these side agreements is to transform a sale into a demonstration period or otherwise incomplete sale. In such cases, the associated revenues may not be recognized. The SEC further explains that when the right of return is structured so that the dollar value of returnable product declines according to a fixed schedule over time, the associated revenue must be recognized according to that schedule.
Collectibility is reasonably assured. This requirement is not explicitly addressed in SAB 101, however the general principles outlined in the bulletin can be applied towards its understanding. If the transaction is customary, historic data indicates a reasonable expectation of collectibility, and no external factors which might affect the transaction have significantly changed, then we can probably infer that the requirement has been satisfied. There are some obvious factors that could hinder the assurance of collectibility, such as bankruptcy proceedings or major litigation.

Because the SEC has issued these guidelines, they must be followed in addition to the FASB/GAAP requirements. As business practices evolve, its likely that the issue of revenue recognition will continue to be clarified and revised accordingly. Nevertheless, investors should be aware that not all revenue is created equally, and is subject to restatement, especially during times of economic turmoil.

Financial Statement Effects of Intercorporate Investments

2009-12-06T00:24:00.000-05:00

For a wide variety of reasons, one company will often make an equity investment in another company. We could be simply talking about the parking of excess capital, or there could be strategic reasons such as a bid to gain control of a supplier or other important segment of the supply chain. These investments show up on corporate financial statements in a variety of ways, depending largely upon the size of the investment, and the ability of the investor to control the investee.

In terms of a relatively insignificant, non-controlling (<20%) stake in another firms equity, the financial statement effect will depend largely upon whether management classifies the investment as Available-for-Sale (AFS), or Trading (T) . The difference here really comes down to the intent of management; if management considers the investment a "buy and hold" kind of scenario, and generally won't sell unless the price is right, the investment is AFS. Securities classified as Trading are acquired with the intent to sell in a short period of time. This difference is extremely important due to the way GAAP requires companies to report unrealized gains (losses) from investments in the income statement. Market value changes of AFS securities flow to the Accumulated Other Comprehensive Income (AOCI) section of stockholders equity. Current period income and retained earnings are not affected. Market value fluctuations in Trading securities on the other hand, are counted as investment income (or loss) on the income statement, as well as an increase (decrease) of retained earnings. Dividends received in conjunction with both classifications are treated as other income on the current period income statement. Lastly, in both instances, these marketable securities are reported on the balance sheet at fair market value (FMV).

When the equity investment is such that the investor is able to exert significant control (between 20% and 50% stake) over the investee firm, the rules change just a bit. Accountants refer to the financial statement treatment of these investments as the Equity Method. First of all, market value fluctuations affect neither the income statement or balance sheet. Dividends received are treated as a reduction in the investment basis. Additionally, the investor recognizes investment income - and concomitant increase in retained earnings - from its stake that is proportional to the stake held in the investee.For example:

On February 2nd, Company A purchases $2,000,000, or a 40% stake, in the equity securities of Company B. Let's say this corresponds to 400,000 of Company B's 1,000,000 outstanding shares. On March 31st, Company B pays a $1/share dividend to all common shareholders. On December 31st, Company B reports $5,000,000 of net income. The accounting for these events, from Company A's perspective, is as follows:

2/2
Investment in Company B    $2,000,000
Cash                                                                          $2,000,000

3/31
Cash                                                         $400,000
   Investment in Company B $400,000

12/31
Investment in Company B $2,000,000
               Investment Income                                             $2,000,000

At the end of the year, Company A will report it's investment in Company on its balance sheet at $3,600,000 ($2,000,000 - $400,000 + $2,000,000)

Given that investments in marketable securities comprise a significant portion of most firm's balance sheets, and can have a significant impact on stockholders equity and retained earnings, its important to monitor them. You should read up on the footnotes associated with these investments, and monitor the way management changes its AFS or T classifications over time. Also, be wary of the income related to unrealized gains on trading securities; financial market volatility can significantly impact these numbers between each reporting period.

Will Earnings Eventually Support the Stock Market Rally?

2009-12-02T17:01:00.000-05:00

Since closing at 676.53 on March 9th, 2009, the S&P has rallied some 63.7% to its current level of ~1108. Some market pundits attribute this meteoric rise to the Fed's unprecedented market intervention(s), which has created massive amounts of liquidity. Other skeptics call it another round of irrational exuberance; a short-lived bull market within a cyclical (or secular?) bear market. Still others say this rally is for real, that the equity markets typically look 6-9 months into the future, and that only the fools are still on the sidelines.

Granted, stocks have become relatively non-cheap, at least in terms of the multiples of reported earnings which they're trading. The real question behind this debate however, is "Whether corporate earnings will catch up to, and eventually support, the current stock market's trading range". Before I attempt to answer that question, I'd like to first frame the argument in terms of the psychological basis from which each side is attempting to further its argument.

The first point I need to make is that this economy IS recovering. However, the rising tide is not lifting all boats. I wouldn't want to be D.R Horton right now, but I wouldn't mind being Intel. Most of all, I would not want to be a small business; they have effectively been denied access to nearly all sources of credit, they aren't large enough to throw their weight around with suppliers, and oh yea, health insurance premiums are about to go up. Given this set of facts, its easy to see why nearly every small business owner in this country is quite pessimistic at this moment. Furthermore, small businesses don't use - or even understand for that matter - GAAP accounting. Their focus is on cash in v. cash out, i.e small business income statements are usually just two lines: sales and costs. Therefore, profit boosting concepts like LIFO liquidations and unrealized gains on trading securities are somewhat foreign, effectively obfuscating their perception of recent corporate profit increases. Psychologically, they are mad; the government bailed out big business and didn't throw them a crumb. Watching the stock market rise on a daily basis simply angers many small business owners.

On the flip side, big business reacted quickly and viciously to the Great Recession; they laid people off in the thousands and shuttered profitable plants/mills just to achieve higher asset utilization rates. The result was the temporary occurrence of costly restructuring charges. The largest of these are probably behind us though, meaning that bottom lines will be juiced in the coming quarters. The next advantage available to big business is global scale; there may be little US based sales growth in the months ahead, but developing markets continue to grow. Given this set of facts, many large corporations that operate in a handful of industries have reason to be cautiously optimistic.

Don't think for a minute that the current stock market bulls v bears argument isn't completely driven by this psychological and economic dichotomy. Bulls typically cite the earnings cycle, proposing that the following sequence of events will lead to an earnings - and an economic - rebound:

Corporation's cut costs
Productivity Increases
Profits begin to increase
Inventories are replenished
Capital Expenditures are made
Hiring resumes
Consumption rebounds

In contrast, the bears are either in denial that corporate profits will increase, or (the more sophisticated ones) would say that once inventories are replenished, firms will hold onto cash and the capital expenditures will never materialize. From my perspective, the resumption of hiring looks to be the major impediment to a recovery. When hiring does resume, it will be at the largest, healthiest multi-national corporations. Furthermore, those hired first will the most educated and most able to add value to the firm. Housing and construction may never return to pre-recession employment (absolute) numbers, and manufacturing jobs will continue to be lost to a combination of technology and China. This doesn't bode well for the consumer as a whole, whom I expect to behave anemically for another 3-7 years.

That all being said, the answer to the title to of this post is something to the effect of "some of them". It's up to individual investors to figure out which firms have the global scale and management capacity to go out and find (take?) new sources of revenue, whether it be via acquisitions or expansion into new markets. Beware of dead business models.

Components of RNOA: Margin and Turnover

2009-12-01T16:42:00.000-05:00

Previously, I touched on the importance of Return on Net Operating Assets (RNOA), specifically with respect to my view that it's foolish to examine a firm's ROE without an idea as to the relative contributions of operating and nonoperating returns. I'd like to examine RNOA a bit further, and place some emphasis on it's dual components of margin and turnover. Just to refresh, the original formula for Operating Return is:

RNOA = Net Operating Profit After Taxes / Average Net Operating Assets

In order to illustrate the margin and turnover components, I'll create a new, equivalent equation:

RNOA = (Net Operating Profit Margin / Sales) X (Sales / Net Operating Asset Turnover)

Therefore:

RNOA = Net Operating Profit Margin (NOPM) X Net Operating Asset Turnover (NOAT)

Truthfully, I don't blame you if this still doesn't make a whole lot of sense. So, let's look at this using some real numbers from the largest employer in the world/retail titan..WalMart (WMT).

Above I've included every part of an equation necessary to understand RNOA's components of NOPM and NOAT. Keep in mind that WalMart's RNOA was originally calculated using NOPAT/RNOA, or $15,637/$109,987 to yield 14.22%. To calculate Net Operating Profit Margin (NOPM) I took NOPAT of $15,637 and divided it by 2009 revenue of $401,244. The resulting 3.9% seems rather feeble for such a monster like WalMart; it means that for every dollar of sales revenue, WalMart is only earning 3.9 cents of after tax operating profit. Remember though that the margin is somewhat useless in the absence of turnover figures. To calculate Net Operating Asset Turnover (NOAT), I took 2009 revenue of $401,244 (millions by the way, crazy right) and divided it by Average Net Operating Assets of $109,987. The resulting NOAT is 3.65. Now multiply 3.9 (NOPM) by 3.65 (NOAT); the result should look familiar - 14.2%. Walmart's figures highlight an important concerning the relationship between margins and asset turnover. A high margin firm won't necessarily earn healthy returns for shareholders; it all depends on the turnover they are able to achieve given that level of margin.

I included WalMart's 20.63% ROE just to illustrate that the company is earning a very healthy operating return component of 69% (14.22RNOA / 20.63ROE). Interestingly, the company doesn't highlight this ratio in its financial presentations. Rather, they use a modified return on investment (ROI) formula that takes operating income as its starting point, and adds back in some non-cash adjustments for depreciation and amortization to arrive at the numerator. In the denominator, WalMart creates an average operating assets figure, similar to NOA except that operating liabilities are not netted out of the equation. Although investors should keep an eye on these metrics that are recommended by management, don't forget that they are non-GAAP and are probably suggested for a reason.

*no positions

Beyond ROE: Return on Net Operating Assets (RNOA)

2009-11-30T11:26:00.000-05:00

Many investors rely on Return-on-Equity (ROE) to gauge a firm's ability to generate profit from each dollar of equity; a somewhat fundamental determination when assessing the attractiveness of owning a piece of that equity. The problem is, ROE is calculated as net income divided by average stockholders equity, meaning that you have no idea the extent to which leverage played a role in the returns generated for shareholders. In the aftermath of the credit bubble, it should be apparent that not all returns are created equally. For instance, had you been an investor in Merrill Lynch around say, 2006, you may have been lulled into complacency by the firms ridiculous returns-on-equity; oblivious unfortunately to the fact that MER's performance was merely the result of massive amounts of leverage. Fortunately, through calculation of a firm's Return on Net Operating Assets (RNOA), we can isolate the portion of ROE attributable to the operations of the business (the portion that matters).

The general concept behind RNOA is that ROE= Operating Return + Nonoperating Return. As I've said, investors should focus on the operating portion of return, which is calculated as follows:
Operating Return (RNOA) = Net Operating Profit After Taxes (NOPAT) / Average Net Operating Assets (NOA)

The calculation of RNOA requires you be able to differentiate between the operating, and nonoperating items on both the balance sheet and income statement. This should be somewhat easier to do with the income statement, just because although GAAP doesn't require it, most companies will break out their operating results on their financial statements. Management tends to be judged based on the firms operating results, so this shouldn't be surprising. I'll refer to Dell's most recent full year results to illustrate the RNOA calculation.

Step 1: Calculate NOPAT
For FY '09, Dell logged pretax income of $3324M, and income tax expense of $846M, resulting in an effective tax rate of 25.45% (846/3324). Dell posted operating income of $3190M; therefore, applying the 25.45% tax rate, we can state that Dell's NOPAT is $2378M ($3190 X (1-.2545) ).

Step 2: Calculate average net operating assets (NOA)
First of all, Net Operating Assets = Operating Assets - Operating Liabilities. The components of each category are listed below.
Operating Assets
Cash/Cash Equivalents
Accounts Receivable
Inventories
Prepaid expenses
Other Current Assets
Property, plant and equipment (net)
Capitalized lease assets
Natural Resources
Equity method investments (unless unrelated to the core business)
Goodwill and other intangible assets
Deferred income tax assets (current and long term portions)

Other long term assets

Operating Liabilities
Accounts Payable
Accrued Liabilities
Deferred income tax liabilities (current and long term portions)

Pension and other post-employment obligations

Dell's 2009 and 2008 NOA are $6488M and $7501M, respectively. The average of these two numbers is $6995M. Therefore:

RNOA = NOPAT / NOA
= $2378 / $6995
=34%

This compares with a 2009 ROE of:
ROE= Net Income / Avg Stockholders Equity
= $2478M / $4003M
=61.9%

A conclusion which can be drawn from these results is that only 55% of Dell's ROE (34/61.9) is attributable to operations. I'd generally like to see a higher ratio of operating to nonoperating return; however, Dell's 34% RNOA is substantially higher than the 10% average RNOA for publicly traded companies. A further examination into Dell reveals that it's debt-to-equity ratio (total liabilities divided by total stockholders equity) is 5.2, meaning that for every dollar of equity, dell has $5.20 worth of debt. This high debt to equity ratio partially explains the juiced ROE number, and should probably be monitored by investors.

*no positions

Vertical Analysis of Financial Statements: Coca-Cola v Pepsi

2009-11-27T18:57:00.001-05:00

Due to the complexity of corporate financial statements, the prospect of deciphering meaningful insight can be a daunting task. Furthermore, the ratios deployed by professional analysts are numerous, effectively creating a thousand piece jigsaw puzzle whose composition perpetually and frequently fluctuates. Luckily, for those of you who lack either the time or mental stamina to perform calculations such as the disaggregation of the components of return on net operating assets (RNOA), a relatively effective process exists known as Vertical Analysis. The premise of Vertical Analysis is to create common-size financial statements, where all balance sheet and income statement items are converted into percentage terms for purposes of comparison.Using vertical analysis, comparisons can be made between firms regardless of size. This approach is especially useful when determining the relative financial health of competing firms within the same industry. Financial metrics display a large degree of variability across industries; however, within a given industry, competitors should be fairly aligned in terms of funding sources (debt v equity), liquidity, asset turnovers etc. Below is a vertical analysis I prepared using the FY '08 balance sheets from Pepsico (PEP) and Coca-Cola (KO).
Vertical Analysis of Financial Statements - Pepsi v Coke

From here, it's fairly easy to scan through Coke and Pepsi's relative balance sheet percentages(page 2 of pdf) , making some fairly useful generalizations. The first thing I noticed from this comparison is that Pepsi and Coca-Cola have a nearly identical composition of current v long term assets (30/70). However, Cash/Cash Equivalents represents 11.7% of Coke's assets, but only 5.7% of Pepsi's. It appears that Pepsi makes up the difference in it's proportion of (net) receivables to assets (13% v 7.6%); this could just be a timing issue, but it could also mean that Pepsi has become more aggressive in terms of the conditions by which it will offer credit to customers. The next observation I'd make has to do with differences between the two company's capital structures. Pepsi's debt/equity split percentage is 66.2/33.8, whereas Coca-Cola's capital structure is comprised of 49.5% debt and 50.5% equity. Interestingly though, Pepsi's short term debt only represents 1% of the right side of the balance sheet, whereas Coca-Cola comes in at 16.1%. This could just be an indication that Coke relies more heavily on commercial paper to fund it's short term operations; it could also mean that Coke has a significant amount of long term debt coming due in the months ahead. Coca-Cola's 2008 10-K should contain footnote disclosures describing the nature of these short term obligations. In this sense, the vertical analysis above serves as an informative starting point from which to diagnose any potential issues the firm might have down the road. Additionally, vertical analysis can expedite the analysis process by narrowing down which footnotes you, as an investor, should be concerned with.

*no positions

Fed Flushes $1.7B Worth of Taxpayer Funds Down the Toilet

2009-11-20T15:46:00.000-05:00

Last week, under the cover of darkness and in an extraordinary show of Government incompetence, the FDIC seized United Commercial Bank. The problem is that Mingsheng, a Chinese bank, had already approached the Fed about a potential acquisition of UCB. Mingsheng, which had already invested $129M into UCB, was presumably trying to salvage some portion of it's investment. Unfortunately, Mingsheng's application was destined to whither away on a bureaucrats desk, as various branches of the federal government bumbled about in an attempt to resolve the problems at UCB - oblivious it seems to the cost effective solution right before their eyes. They (Mingsheng) were not the only investors though; last year the Treasury injected $298M into UCB as part of the now infamous TARP program. Furthermore, the FDIC estimates that the UCB failure will cost it's Deposit Insurance Fund $1.4B. The DCF is theoretically funded through premia leveled on the banking industry; however, we all know that this cost gets passed onto consumers in the form of higher overdraft, ATM, inactivity etc. fees. Therefore, the Treasury/Fed/FDIC - acting in disorganized concert - managed to flush $1.7B worth of taxpayer money down the toilet.

This is truly an embarrassment.

Diluted EPS and the Capital Structure

2009-11-18T16:01:00.006-05:00

Although the financial media's reporting centers almost entirely on a corporation's reported basic earnings-per-share (EPS), most analysts have historically paid attention to a different line on the income statement: Diluted Earnings per Share. Diluted EPS takes into account the potential dilutive effect that would ensue if holders of the firms preferred stock and bonds were to convert their stake into common equity. This possibility theoretically exists whenever investors purchases securities that include a conversion option. Usually there is some sort of market based trigger point, but ultimately those details will be contained on the face of the preferred stock certificate, or in the bond covenants. For the sake of simplicity, let's say that Company X earned $1000 in a given quarter, and there are 1000 shares outstanding, resulting in quarterly Basic EPS of $1/share. However, let's assume that Company X has also financed itself via 500 shares of convertible preferred stock which give holders the right to convert each preferred share into 2 shares of common equity. Assuming that all preferred holders exercised that option, Company X would record 2000 outstanding shares of common stock, and would only have earned 50 cents/share for the same quarter. This hypothetical example is rather extreme for the purposes of making a point; below is a chart showing Basic v Diluted EPS during the most recently reported quarter for 7 large firms:
Corporations must disclose both basic and diluted EPS on the income statement, however the actual calculation is below for those who must know:

Diluted EPS = (Net Income - Preferred Dividends) / (Weighted Average # of Common Shares Outstanding + Additional Shares Due to Dilutive Securities)

Arithmetically, we can see that the dilutive effect increases the denominator, reducing the amount of net income available to each shareholder. In many firms with simple capital structures, the basic and diluted EPS numbers will be identical. However, firms that utilize more complex financing instruments generally have more potential for dilutive equity conversions.

Going forward, I would expect Diluted EPS to continue to gain significance, especially with regards to analysis of financial corporations. As banks struggle to refinance trillions of dollars worth of debt, the use of convertible options should become more popular for a couple of reasons. First, a conversion option represents value to the investor and additional capital for the borrower. Second, if the conversion option is tied to a regulatory trigger like TCE ratios, then the borrower is essentially selling an automatic equity boosting instrument for times of market distress. If things play out like I anticipate regarding convertible debt, the gap between basic and diluted EPS will grow further. Equity investors need to monitor these developments to insure that they are not diluted into oblivion.

*no positions

Contingent Convertible Bond Ruminations

2009-11-13T15:41:00.002-05:00

The latest idea to revolve around the task of inoculating the global financial system involves a financial instrument known as the contingent convertible bond. Overall, I'm somewhat pleased that the discussions surrounding financial reform have begun to deviate from the bonus-recipient-witch hunt mentality which has dominated the Obama Administration's rhetoric to date. Furthermore, it's encouraging to see the private sector begin to formulate it's own prescriptions; opposed to of course government solutions which amount to nothing more than throwing (other people's) cash at the situation, appointing czars of every shape and form, and hoping the problem solves itself.

Contingent convertibles are a nifty bit of financial innovation (isn't that supposed to be synonymous with evil and destructive?) that takes regular convertible bonds and adds a twist. The process would play out something like this:

Investors give cash to banks, and in return, they receive contingent convertible bonds.
Investors receive regular coupon payments, just like with any other bond.
If and only if the bank's capital ratio falls below a certain threshold determined by the bond contract, the instrument will convert into equity.

Part of the draw for contingent convertibles is that the conversion clause is not based upon observable market prices. In that sense, even the most concerted efforts by short-sellers can not trigger the conversion. Conceptually, assuming these instruments comprised a significant enough portion of global banks' capital structures, they would act as automatic stabilizers during periods of economic distress, bolstering banks' capital ratios without the need for TARP-like government interventions. As an aside, will widespread use of contingent convertibles be evidence of the Europeanization of financial markets? We all know how much the Europeans love their automatic stabilizers.

To briefly play devil's advocate, I could see the establishment of contingent convertibles causing a wholesale shift in the way bank stocks are valued. Capital ratios would be monitored very closely in order to develop a probability of equity conversion; this could cause bank stocks to prematurely fall in anticipation of a massive equity dilution. I could also see bank stocks' losing all of their appeal in terms of a dividend investment. That might not be an issue now, what with 1 cent dividends imposed by the Treasury; however, I have to assume that by say 2015, banks will once again be paying healthy dividends. The problem is from the banks standpoint, the debt to equity conversion will amount to the elimination of a contractual obligation to make semi-annual interest payments, and replace it with the extremely optional payment of a dividend. If I were investing in a bank's contingent convertibles from a current income perspective, I would prefer that the potential conversion be structured so that I received some class of preferential stock whereby a dividend comparable to the coupon rate was guaranteed. Nevertheless, the discussions surrounding contingent convertibles is a net positive in my book; we'll just have to wait and see if this new "movement" has the legs necessary to become a widespread reality.

Analyzing Leases On and Off the Balance Sheet

2009-11-12T15:28:00.007-05:00

In the midst of the criticism that's been leveled towards financial innovation of all shapes and sizes, one form of financial instrument in particular has managed to travel under the radar: leases. Although leases have never been accused of wreaking financial destruction, they do serve as a convenient means of off-balance sheet financing.

The first thing to know about leases as they pertain to financial statements is that there are two main categories: Operating Leases and Capital Leases. The closer a lease is to an actual purchase agreement, the more likely it is that the lease should be classified as Capital. There are however four conditions which, if any are met, automatically render the agreement a Capital Lease. They are:

The lease agreement contains a provision whereby, at the end of the lease term, title to the leased asset is transferred from the lessor to the lessee.
The lease agreement provides the lessee an option to purchase the leased asset at bargain terms (like $1 for instance)
The term of the lease agreement constitutes a period of time which is greater than or equal to 75% of the leased assets useful/economic life.
The present value of all scheduled lease payments is greater than or equal to 90% of the fair market value of the leased asset.

At this point, you're probably questioning why it really matters whether accountants refer to the lease as Operating or Capital. Simply put, a Capital Lease must come onto the balance sheet via a debit to Leased Asset and a credit to Lease Liability. The amount recorded on the balance sheet is the present value of all future lease payments. Operating Leases on the other hand are not capitalized, and only appear to external stakeholders in the form of footnote disclosures in regulatory filings. The accounting for Operating Leases is relatively straightforward however; lease payments simply flow to the income statement and are recorded as Rent Expense. Capital Leases though, have interest and principle components that must be amortized over the lease term just like a debt instrument. Below is an amortization schedule for an asset of FMV $70,000 , a lease term of 6 years and $15,000 annual payments. Using the Internal Rate of Return (IRR) function on Excel, I'm able to discover that the lease contains an implied interest rate of 7.69%.
As I mentioned above, the leased asset must be depreciated over time. Below is the depreciation table for the same example.
The table above brings me to the next point: expenses under a Capital Lease are front-loaded, whereas an Operating Lease maintains consistency. In years 1-6 in the above example, the total expense for an Operating Lease would be $15,000/year. Keep in mind that my prior point isn't applicable to the cash flow statement; I'm only discussing income statement implications. From a cash flow standpoint, the interest portion of Capital Leases is classified as a Financing Activity, and the principal re-payment is considered an Operating Activity. Under Operating Leases, the entire rent expense is classified as an Operating Activity. In this sense, Capital Leases will result in higher cash flow from operations than a similar Operating Lease.

The final nuance that's important to grasp is that Operating Leases can distort certain leverage related financial ratios such as debt to equity and return on assets (ROA). The distorting effect can range from very minimal to materially drastic, especially in the case of businesses like airlines who lease the majority of their assets. Nevertheless, leases should be reason alone to spend some time examining the footnote disclosures found in your subject firm's financial statements.

*no positions

Corporate Inventory Analysis and Costing Methods

2009-11-11T15:13:00.004-05:00

For Home Depot (HD) and many other corporations, inventory represents one of the single largest items on the balance sheet. For 2008, inventory represented 25.9% of Home Depot's total assets. Furthermore, inventory turns over many times throughout the course of the year, feeding into the firm's income statement through cost of goods sold (COGS). In order to understand inventories, you first need to be aware of the three major inventory costing methods.

When the concept of inventory costing methods was first presented to me, I wasn't sure what exactly there was to talk about; if a company buys a widget for cost X, it would make sense that upon the sale of that widget, X dollars would flow to cost of goods sold. Furthermore, if you had to place a value on your inventory in it's entirety, it would make the most sense to simply report the sum of the cost of all items in inventory. Unfortunately, the accountant powers- that- be didn't design inventory costing in such a straightforward manner. As a corporation, you basically have three choices in terms of inventory costing: first-in-first-out (FIFO), last-in-first-out (LIFO), and average cost. In FIFO, the oldest price stored in inventory is assigned to cost of goods sold. With FIFO, the most recently recorded price is attached to the good and flows to COGS. Average cost, as the name implies, assigns the average cost of the inventory item. During inflationary times, the FIFO costing method is the most profit-advantageous because yesterday's cost is being booked as today's expense. The opposite would of course apply during times of falling prices. Because of the profit implications, the IRS requires corporations to remain consistent with their costing method. From what I've been told, the IRS will allow you to switch methods - but only once. Below is a quick example showing how different inventory costing methods can result in completely different COGS (and subsequently gross profit margins) - for the same transaction.
In this simplified example, I'm assuming that Company A is purchasing hammers from the manufacturer/distributor, holding them in inventory, and subsequently selling them at its retail locations. I'm also assuming some severe inflation in the hammer supply industry, but it was done to help clarify the point. As is evident though, FIFO leads to significantly lower cost of goods sold, gross profit margins, and ultimately net income. You should check the footnotes that accompany the firm's financial statements to determine which method is being used. This is important due to a profit-boosting phenomenon known as LIFO Liquidations, which usually occurs during times like now when corporations are allowing their inventories to dwindle lower and lower without replacement. The result is that new sales begin to cut through years of (assumedly lower) price layers, lowering COGS and boosting net income. This could result in a temporary profit windfall, however it's unlikely to repeat itself, and should almost be considered an extraordinary aspect of income (in my humble opinion).

Now that you have a cursory grasp of inventory costing, I'll move on to two ratios that will help to assess a given company's inventory situation: Inventory Turnover and Average Inventory Days Outstanding.

Inventory Turnover measures the number of times that a firm's inventory has "turned over" during the year. It's calculated as follows:

Inventory Turnover = Cost of Goods Sold / ( (Starting Inventory + Ending Inventory) / 2 )
Home Depot's Inventory Turnover
= $47,298M / ( ( $10,673M + $11,731M) / 2 )
= $47,298M / ($22,404M / 2)
= $47,298M / $11,202M
= 4.22

The implication here is that Home Depot's inventory turned over 4.22 times during its 2008 fiscal year.

Some sources provide a several step process for determining the next ratio, Average Inventory Days Outstanding. The shortcut though is to just 365 and divide it by Inventory Turnover. For Home Depot:

Average Inventory Days Outstanding = 365 / (Inventory Turnover)
=365 / 4.22
=86.49

This means that, during 2008, the average item spent 86.49 days in Home Depot's inventory. This ratio should be compared across several years to determine trends in the firm's inventory. As an example, during 2007, Home Depot's average inventory days outstanding was 87.25. This means that Home Depot actually improved its turnover from 2007 to 2008, which is contrary to what I would expect during a recession. This year-over-year comparison is probably most indicative of efficient inventory controls at the company. My expectation though is that when Home Depot reports fiscal 2009 results (towards the beginning of February 2010) we'll be able to observe an increase in the average inventory days outstanding. I may be wrong though, and HD could have conceivably scaled down its inventory to meet sales demand in an efficient manner that will allow it to remain consistent with its ~86 day turnover rate. It's items like these that should allow investors to discern between market leaders and laggards coming out of this recession (and into the new normal?)

*no positions

Liquidity Analysis Part 2: Current Ratio and Quick Ratio

2009-11-10T15:10:00.006-05:00

In the first installment of my liquidity analysis discussion, I covered Net Working Capital; which is defined as Current Assets minus Current Liabilities. There are two additional ratios that should be a part of investor's liquidity analysis: the current ratio and the quick ratio. Both the current and the quick ratio are calculated entirely from the "current" section of the balance sheet. To refresh, current assets are cash, short term investments, receivables, inventory, or any other asset that the company expects will be converted to cash within a year or less. Current liabilities are accounts payable, expenses that accrue on a regular basis like wages, short term notes, and the portion of long term debt due within a year or less. The "due in one year or less" is a consistent theme which applies to current liabilites. To illustrate this distinction, I've included Intel Corporation's (INTC) consolidated balance sheet (2006-8) below:
Although not entirely scientific, I like to think of current assets and current liabilities as the corporation's revolving door; these portions of the balance sheet are turning over constantly between reporting periods. In contrast, non-current assets like buildings and machinery are relatively immutable, as are the portions of debt which mature many years down the road. In that sense, a corporation could own every parcel of land on the east coast, but without the liquidity contained in current assets, might conceivably be unable to pay it's bills or service it's debt. The previous example, although extreme, underscores the importance of applying both of the following ratios during your analysis of financial statements.

Current Ratio
The Current Ratio is simply current assets divided by current liabilities. The point is basically to measure how many times the firm's current assets can cover it's current liabilities. I'll use the figures from Intel's 2008 balance sheet to calculate it's current ratio.

Intel's Current Ratio = Current Assets / Current Liabilities
= $19,871M / $7818M
= 2.54

Generally, a current ratio above 1 is indicative of a strong current liquidity position. At 2.54, Intel appears to have more than sufficient liquidity necessary to cover it's payables and other short term debts coming due within the year.

Quick Ratio
I think of the quick ratio as a more precise glimpse into the firm's liquidity position. It basically measures whether the corporation could, if needed, quickly pay down all of it's current liabilities. The calculation here is Cash/Cash Equivalents divided by Current Liabilities. Below is a calculation of Intel's quick ratio for 2008:

Intel's Quick Ratio = Cash and Cash Equivalents / Current Liabilities
= $6512M / $7818M
= 0.83

To verbalize Intel's quick ratio, I'd say that Intel has 83% of the cash necessary to fund it's current liabilities. This is actually a relatively healthy quick ratio, and isn't expected to be greater than 1. Furthermore, if you look at the rest of Intel's current assets, you'll see $5331M worth of Short Term Investments. As Intel cashes out these investments over the subsequent twelve months, it will have substantially more cash than necessary to meet it's short term liquidity needs.

*Note: many analysts will include marketable securities and accounts receivable in the numerator of the quick ratio, the theory being that these items could be liquidated quickly. You may want to look at both calculations; however, I don't like assuming that a company can just go out and factor it's receivables on the market without taking a substantial hit.

As usual, it's important to monitor how these ratios change over time, as it will illustrate whether the firm is becoming more - or less - liquid with the passage of time. In the current environment, it should be obvious which way you'd like to see these measures trending.

*no positions

Liquidity Analysis Part 1: Net Working Capital

2009-11-06T15:34:00.004-05:00

The term liquidity can be interpreted in various ways, depending of course upon the specific circumstances. In corporate financial accounting, liquidity refers to the firm's ability to pay its debts when they are due. The importance of possessing that ability should be self evident, as should the ability to evaluate a firm's liquidity position.

The first measure that you should be able to calculate is Net Working Capital:

Net Working Capital = Current Assets - Current Liabilities
Intel's 2008 Net Working Capital = $19,871M - $7818M
= $12,053M

In order to properly grasp the concept of Net Working Capital, you should be familiar with the two balance sheet accounts used to calculate it; Current Assets and Current Liabilities. Current Assets are basically those assets which are not necessarily long term in nature. It includes cash and cash equivalents, accounts receivable, and inventory held by the firm for sale. You should know however, that items like prepaid rent and prepaid insurance for the next 12 months also fall under Current Assets. Current Liabilities are short term notes payable, accounts payable, and the portion of long term debt that is due within the year. That being said, it should be evident that the prepaid rent portion of Current Assets wouldn't satisfy the cash obligation portions of Current Liabilities. The point is, investors need to dig in a little bit to determine the actual quality of a firm's net working capital. Also, it can be instructive to compare a firm's changes in net working capital over time. The chart below serves that purpose for Intel Corporation (INTC):
From the chart above, I'm not sure whether any discernible trend can be declared. Most likely, Intel was making use of it's cash for investments/acquisitions from 2003-2006, thus lowering it's net working capital. Intel is not a highly leveraged corporation - relatively speaking - though, so I wouldn't be too concerned with these fluctuations. If however, we observed that net working capital was declining, and over the same period the firm's debt-to-equity ratio was rising, it might be wise to pause and examine just why this was occurring.

*no positions

Depreciation and Financial Statements

2009-11-05T15:40:00.004-05:00

The formal definition of depreciation is the systematic allocation of the cost of an asset, as an expense, over a period of time. If I were able to provide a definition for depreciation, it would be " a non-cash expense on the income statement, recorded in order to display the theoretical consumption of an asset's useful life". Before I get started, it's important to understand the distinction between depreciation recorded on a firm's financial statements, and the depreciation expense used by a corporation to determine it's federal income tax liability. Basically, there are two separate books that can show different depreciation expense for the same asset, in the same year. The depreciation schedule that a corporation must follow on it's tax returns is known as the Modified Accelerated Cost Recovery System (MACRS). If you want to read about MACRS, you can refer to IRS Publication 946; I will be covering depreciation strictly from the financial statement standpoint.

The two concepts you need to initially understand about depreciation are "Useful Life" and "Residual Value". An asset's useful life is the period of time that the asset will provide an actual economic benefit to the company; although an excavator could in theory still be alive after 50 years, the company might know from experience that an average excavator can only usefully serve its purpose for 15 years; therefore, useful life = 15 years. Residual value is also called salvage value, and its basically an estimate of what the asset could be sold for (as scrap usually) after it has served the duration of it's useful life.

There are basically three accepted depreciation methods that corporations use to convey information on financial statements: straight line, double declining balance, and units of production. To determine the annual depreciation expense for an asset using the straight line method, you simply plug your numbers into the following formula:
Annual Depreciation Expense = (Cost of Asset - Residual Value) / Useful Life.
Let's say a corporation purchases a truck for $110,000, estimates a $10,000 residual value and 10 years worth of useful life for the truck. A depreciable base of $100,000 (cost-residual value), divided by 10 years (useful life) yields an annual depreciation expense of $10,000. Unless the firm ever determines that the truck's useful life or residual value has changed materially, this $10,000/year will remain constant for each of the subsequent 10 years.

To determine the annual depreciation expense under the double declining balance method, you first need to determine the annual rate of depreciation by plugging your information into the following formula:

Rate of Annual Depreciation = (100% / Useful Life) X 2
Using the same truck example from above, we'd calculate (100% / 10 years) X 2 = 20%. Step 2 involves plugging your depreciation rate into the following formula:
Year 1 Depreciation Expense = (Cost of Asset - Residual Value) X Annual Depreciation Rate
= ($110,000 - $10,000) X 20%
=$20,000
That $20,000 shows up as depreciation expense in Year 1 on the income statement, and also appears in a contra asset account on the balance sheet known as "Accumulated Depreciation". The calculation for depreciation expense in Year 2 is as follows:
Year 2 Depreciation Expense = (Cost of Asset - Accumulated Depreciation - Residual Value) X Depreciation Rate
=($110,000 - $20,000 - $10,000) X 20%
=$16,000
Once again, $16,000 flows to the income statement as an expense, and is added to Accumulated Depreciation, resulting in a new balance of $36,000 at the end of Year 2. What should be evident is that the double declining balance method results in a front-loading of an asset's depreciation towards the beginning of it's useful life. By the end of the asset's useful life however - in this case Year 10, both methods will have all of the asset's value except for the residual value.

The units of production methods is, in my opinion at least, the most effective/honest/straightforward method of depreciation. Unfortunately, it only works when the asset has a useful life that can be represented in terms of a unit of measurement. For instance, using the truck example again, let's say that the company estimates the truck will provide 200,000 miles worth of service. Operating off an identical depreciable base of $100,000, the company could state that each mile amounts to 50 cents worth of depreciation for the truck. Thus, if the trucks trip log showed 50,000 miles of service for the year, the formula for annual depreciation using the units of production method is as follows:
Annual Depreciation Expense = ( Units of Useful Life / (Asset Cost - Residual) ) X Units consumed
= ( 200,000 / ($110,000 - $10,000) ) X 50,000
= $25,000

The only other depreciation caveat to be aware of at this point is that sometimes management adjusts it's estimates regarding the asset's useful life and salvage value. Luckily, these estimate changes are applied to the depreciation schedule prospectively; that is, you simply readjust the schedule for the new variables based upon the already accumulated depreciation and original cost.

Practically speaking, you can use your knowledge of the accumulated depreciation balance sheet account to gauge the relative age of the firm's long term operating assets. Simply divide Accumulated Depreciation by the amount of long term assets to determine a depreciation percentage. If your answer is in the 10-20% range, the firms assets are relatively new, and so on. Older assets on the balance sheet could be a sign that the company will have to ramp up it's capital expenditures in the coming years.

Bond Pricing 101

2009-11-04T15:51:00.003-05:00

If you're going to learn how to effectively interpret corporate financial statements, it's a good idea to possess at least a cursory understanding of the pricing of long-term non-operating liabilities - also known as bonds.

To start off, you need to know that bond pricing involves two separate interest rates, the Coupon Rate and the Market Rate. The coupon rate, also known as the contract or stated rate, is the interest rate listed in the bond contract, and is used to compute the amount of the cash interest payments that are due periodically from the issuer. The market rate is the interest rate demanded by investors, and is usually referred to as the bond's "yield".

Next, you need to think of a bond in terms of the two distinct cash flows involved; the bond pays periodic, usually semiannual interest payments (interest annuity), as well as the lump sum principal amount (face value) which is returned at maturity.

Moving on, the next distinction which needs to be made is that the price of the bond varies depending upon the relationship between the coupon and the yield. If the two are the same, the bond is priced at what is known as "par". If the market rate is greater than the coupon rate, the bond will be priced at a discount; conversely, if the coupon rate exceeds the market rate, the bond is priced at a premium. I'll start with pricing a bond at par; it's a much simpler process, for reasons I'll touch on a bit later. The assumptions used in this example of pricing a bond at face value are as follows: Face amount of $800,000, annual coupon rate of 6%, semi-annual interest payments, and a 5 year maturity. The first step involves calculating the interest payment, the formula for which is:
Interest Payment = Face Value X Annual Coupon Rate X Payment Period (time)
= $800,000 X 6% X 6/12
= $24,000
Next you need to calculate the present value of both sets of cash flows. Instead of going into detail on the present value calculation, I'll just direct you to the PV() function in Excel. Present value is built on the concept that $24,000 today is worth less to the investor than $24,000 in three years, simply due to the time value of money. In the current example, it's easy to ascertain that the sum of the bonds interest payments over the five year period is $240,000 ($24,000 X 5 (years) X 2 (payments per year). However, the present value of those five years worth of payments is only $204,724.87. Along those same lines, the present value of (the lump sum principal payment of) $800,000 is only $595,275.13. Now, we sum the present value of the bonds future cash flows:

Present Value of Cash Flows = $595,275.13 + $204,724.87 = $800,000

Well then, this all looks pretty simple: the present value of a par priced bond's future cash flows is in fact the face value of the bond. For bonds sold at a premium or a discount however, the equation shakes up a little differently. For a discount example, let's assume that all of the variables are identical to the par example above, except that the market is demanding an 8% yield. The calculation of the cash interest payment still uses the coupon rate, so we arrive at an identical $24,000 semi-annual interest obligation for the issuer. The curve ball arrives when calculating the present value of the bond's future cash flows; these cash flows must be discounted using the bond's yield rate of 8%. Therefore, the present value of the discount bond's interest payments is $194,661.50, and the principal payment's present value is $540,451.34. Add them together, and you arrive at $735,112.83. What this means is that the bond issuer will receive $735,112.83 in cash from investors, but will still be required to make $24,000 interest payments (that were calculated using a face value of $800,000). The difference of $64,887.17 (discount balance) shows up on the balance sheet as a contra-liability account which reduces bonds payable in line with the amount of cash actually received by the issuer. The discount balance is then amortized over the life of the bond, and falls into the income statement as successively higher amounts of interest expense (although not an actual cash outlay). The amortization table for this example is below:

As you can see above, the bond discount amount feeds - in entirety - into the income statement throughout the 10 periods, until it is no more. A bond sold at a premium works in the exact inverse way; a premium balance is created on the balance sheet which effectively reduces the issuer's interest expense - by the premium amount - over the life of the bond. Obviously, the issuer would prefer to sell bonds at a premium. Despite the interest expense reduction, a premium usually means that the market judges the firm to be more credit worthy than implied by the coupon rate. Nevertheless, it's important to comb through a corporation's filings to determine the amounts and associated maturities of it's bond liabilities, and be able to understand the income statement ramifications.

Times Interest Earned and Credit Risk Analysis

2009-11-03T15:09:00.005-05:00

When determining an individual's qualifications for taking out a mortgage of a certain amount, the ideal situation involves the bank/mortgage broker/real estate agent calculating a simple ratio based upon payments/obligations to income. Where p=mortgage payment, r=other recurring payments, and i=gross monthly income, the ideal situation dictates that (p+r)/i should be less than or equal to 36%. A corporation's creditworthiness is inherently a more complex determination, although today's concept is - from a logical standpoint - similar in nature to the mortgage brokers "back of the napkin" recurring obligations to income ratio.

Times Interest Earned (TIE) is essentially a measure of how many times a firm's interest expense is covered by it's earnings before interest and taxes (EBIT). Depending upon whether the company specifically reports EBIT in it's income statement, you may have to do some simple math to arrive at the ratio's correct numerator. For instance, you may only be provided with the firm's pretax earnings; in this case, just add interest expense in order to arrive at the EBIT figure. Below is the formula, along with Hewlett-Packard's calculation as an example:

Times Interest Earned (TIE)= Earnings Before Interest & Taxes / Interest Expense

Hewlett-Packard's TIE = EBIT / Interest Expense
= $10,940M / $467M
= 23.43

This rather impressive example means that, for FY 2008, Hewlett-Packard earned 23.43 times it's interest expense before taxes. That number is not so high for many other firms, as can be seen in the chart below:

As usual, it's most instructive to compare these figures across industries, and over time. Below is a graph showing Comcast Corporation's (CMCSA) TIE calculation for FY's 2004-2008:
In general, we can say that the latter part of this decade has been good for Comcast, as it's TIE ratio increased from 2X to 2.5X. If the company was incurring additional long term debt during the time period of 2004-2008, we can assume that these were prudent borrowings which allowed Comcast to grow earnings at a greater rate than it's increase in debt service. A five year TIE chart, similar to the one above, should be a part of any investors credit risk analysis.

*no positions

Intro to Credit Risk Analysis: Debt-to-Equity Ratio

2009-11-02T14:45:00.004-05:00

If recent financial market events have taught us anything, it's that a) leverage can work both ways, and b) when leverage works against an individual/corporation/investment entity, the results can be fairly disastrous. Although the pair of statements above are essentially commonly held knowledge, the behavior exhibited by market participants throughout the past 20 years was nothing if not a blatant disregard for this reality. Moving forward, it will be more prudent than ever for investors to perform a sober assessment of a corporation's use of leverage.

At the heart of credit risk analysis is a corporation's solvency, or in other words, it's ability to function as a going concern, capable of avoiding financial distress. The cornerstone of evaluating solvency is the Debt-to-Equity Ratio, which as the name implies, looks at a firms absolute debt level in terms of a multiple of total stockholders' equity. Both parts of the equation can be found on the balance sheet, and are plugged in as follows:

Debt-to-Equity Ratio = Total Liabilities / Total Stockholders' Equity

Verizon's (VZ) Debt-to-Equity Ratio is calculated as follows:
Debt-to-Equity Ratio = Total Liabilities / Total Stockholders' Equity
= $160,646M / $41,706M
= 3.85

In other words, for every dollar of Shareholders' Equity, Verizon holds $3.85 worth of debt. This ratio will obviously fluctuate greatly based upon the industry, and the composition of the firm's funding sources, i.e. relative breakdown of debt v equity funding. The chart below compares Verizon with seven other large firms from a debt-to-equity ratio standpoint:
Clearly, the debt-to-equity ratio needs to be examined from within the context of the individual firm and industry as a whole. For instance, there are two reasons why I wouldn't be alarmed at Verizon's high ratio of debt funding. First, it's subscriber based business provides relatively stable and predictable cash flows; a distinction that translates into ample access to the bond market. Secondly, a major portion of Verizon's borrowing activity over the past couple of years has been geared towards investment in it;s FiOs network. I haven't assessed that product from a consumer standpoint, but feel certain that Verizon will be able to leverage it's market leadership position into a substantial FiOs subscriber base.

Step 2 in the credit risk analysis process is determining the firms ability to cover interest payments from internally generated cash. That ratio will be addressed in a future article.

*no positions

Focus on Operating Efficiency: Net Operating Profit Margin

2009-10-26T09:53:00.003-04:00

In a previous installment, I covered a measure of after-tax operating profitability known as NOPAT (Net Operating Profit After Taxes). NOPAT serves as a relevant indicator of a firm's ability to operate efficiently, as it strips away many transitory, one-time items from the picture, focusing only on the firm's core business profitability. From an analytical perspective however, NOPAT may be more significant as a numerator of a ratio than as a stand alone measure. One of the most important such metrics is the Net Operating Profit Margin (NOPM).

Calculating the Net Operating Profit Margin is very easy, assuming however that you can properly calculate a firm's Net Operating Profit After Taxes. See this post if you need a refresher on NOPAT. Anyways, below is the formula:

Net Operating Profit Margin = NOPAT / Sales Revenue

Hewlett-Packard (HPQ) FY 2008 NOPM Calculation

Net Operating Profit Margin = NOPAT / Sales Revenue
= $8591M / $118,364M
= 7.26%

To verbalize HP's NOPM of 7.26%, we would say that for every dollar of sales, HP was able to generate 7.26 cents worth of after-tax operating profit. For many companies, operating profit margin may be a more concise measure of performance than the commonly cited Gross Profit Margin. Several small business owners I know are proud of what they perceive to be an impressive gross profit margin at their business. I usually dismiss such talk, as any fool can go out and sell cheaply manufactured products to generate a healthy looking gross profit margin. To pass the NOPM test though, you must be able to operate the organization efficiently and effectively. Because net operating profit margins vary greatly across industries, it's most productive to compare NOPM's across competing organization's within an industry. Below is a focus on HP and it's primary tech industry competitors from a NOPM perspective.

Clearly, industry leaders like IBM and Apple tend to have very healthy net operating profit margins. There's a little bit of "chicken or the egg" dilemma inherent to that observation; i.e. larger industry leaders are better able to exert their will down the supply chain and operate more efficiently.

Although NOPM is only one element that should be considered when evaluating a company's/stock's relative investment attractiveness, it is nonetheless a very insightful indicator of the profitability of a company's operations.The most important analysis that should be performed as a companion to the NOPM calculation is an evaluation of a firm's leverage. NOPM strips out interest expense, effectively looking at the firm from a non-levered position.I'll get into that portion of analysis later via an examination of the debt-to-equity ratio.

*no positions

Windows 7 Upgrade From RC to Home Premium

2009-10-23T17:56:00.004-04:00

Based upon the sheer level of confusion and misinformation that's percolating across the internet, I'd like to clear up an issue that many people have been speculating about.

Can I Use a Windows 7 Upgrade disc to install the recently released, fully operable version of Windows 7 on top of the RC installation? The answer is yes.

About a month ago, I installed the Windows 7 RC on a separate partioned hardrive of my Mac. I also own two copies of XP, and a copy of Vista Ultimate; however, both had been removed from my Mac prior to the RC installation. From within Windows 7 RC, I took the following steps that resulted in a fully functional install of Windows 7 Home Premium.

1) Purchased Windows 7 Home Premium at the student discount price (at least I'm recouping a fraction of the price of business school prior to graduation) of $29.99.
2) Downloaded the installation files onto my Windows 7 RC desktop. Time was approximately 40 minutes.
3) Click the setup.exe file to begin installation.
4) Select a "Custom" or "Clean" Installation.
5) Enter the product key provided during checkout.
6) Enjoy your fully operable version of Windows 7 Premium.

To the best of my knowledge, Microsoft has acknowledged that the above installation method is a viable possibility; however, they've also claimed that it is not a "supported" method of installation. I'll provide an update if there are any problems, but thus far everything is running perfectly smoothly.

Disclosure: no position in MSFT stock. Furthermore, Microsoft has absolutely no role in the publishing of this post, including but not limited to free products, or even a remote suggestion that I provide their new product with free publicity.
5) Enter the Windows 7 Home Premium product key obtained during

Evaluate Operating Performance: Net Operating Profit After Taxes

2009-10-19T12:05:00.007-04:00

Although I'm partial towards the use of Operating Cash Flow (OCF) as a primary basis for performance measurement, investors should nonetheless be familiar with Net Operating Profit After Taxes (NOPAT). NOPAT is completely derived from the income statement, subjecting itself to the usual non-cash adjustments dictated by GAAP. However, NOPAT is useful because, as the name implies, it is strictly a measure of operating performance.

Calculation of NOPAT is relatively straightforward, you're simply multiplying Income From Operations Before Taxes by the corporation's effective tax rate. To calculate the tax rate, divide income tax expense by net income before taxes(NIBT); make sure you place NIBT, also known as Pretax Income in the denominator, and not Operating Income. Once you've determined the total taxes owed, you just subtract it from Operating Income to arrive at NOPAT. The two step process is delineated below:

Tax Rate = Net Income Before Taxes / Income Tax Expense
Net Operating Profit After Taxes = Income From Operations Before Taxes X (1-Tax Rate)

*Note that a company's annual reports and 10-Q's will not always show a neatly constructed income statement that spoon feeds you the Operating Income, Pretax Income, and Income Tax Expense lines. GAAP doesn't require the income statement to be constructed in any special sort of way, thus you may have to occasionally deploy some common sense. Nearly all of the time however, websites like Yahoo!Finance and (if you have a subscription) S&P's NetAdvantage will go ahead and break out the necessary line items. The point is, pay attention.

I'll use Hewlett-Packard Company (HPQ) to illustrate an example calculation of NOPAT:
HPQ NOPAT - Year Ended October 31st 2009
Tax Rate = $2144M / $10,473M
= 20.47%

Net Operating Profit After Taxes = $10,802M X (1-.2047)
= $10,802M X 0.7952
=$8,590M

Hewlett-Packard's NOPAT of $8590M compares with net income of $8329M for fiscal year 2008; at only 3% less than NOPAT, 2008 net income is indicative of only a modest amount of interest expense for the year ($329M). The disparity between NOPAT and net income isn't always so minimal, as can be seen in the chart below:
General Electric (GE)'s large disparity between NOPAT and net income is an obvious first observation to make. The primary driver of this phenomenon is the $26,209M worth of interest expense incurred by the company during 2008. The second result of such a massive interest expense is that GE's 2008 effective tax rate was only 5.3% (interest is deductible). The relationship between these two variables will change based upon the industry, and circumstances specific to the company.

*long GE

Measuring Investment Capacity: Operating Cash Flow to Capital Expenditures

2009-10-16T16:27:00.006-04:00

The price that an investor is willing to pay to acquire a share of a corporation's common equity is largely a function of the corporation's potential earnings growth. When purchasing a stock, you are effectively paying for earnings growth in advance of its actual occurrence. At a basic level, in order to grow, a company must be able to invest in both its existing and future property, plant and equipment. A grading contractor who can barely afford the maintenance on his existing machinery will most likely not be expanding the business any time soon. Therein lies the analytical significance of the Operating Cash Flow (OCF) to Capital Expenditures (Capex) Ratio.

Once again, net cash flows provided by operating activities serves as the foundation of this ratio; because non-cash items on the income statement won't exactly help a company purchase a new tract of land or an excavator, we can go ahead an dismiss net income as irrelevant. The point is to isolate the cash generated by a company's operations, and determine whether it is adequate to fund investment in its income producing assets. To calculate the ratio, simply go to the statement of cash flows, and divide "Cash flow from operations" by "Capital Expenditures". A ratio greater than one (1) indicates that a company's operations are generating the cash necessary to fund its annual investment needs. I'll use the cash flow rich Exxon (XOM) as an example:

Operating Cash Flow to Capital Expenditures = Operating Cash Flow / Capital Expenditures
= $59,725M / $19,318M
= 3.09

During fiscal year 2008, Exxon generated over three times the cash needed from operations in order to fund investment in its plant, property and equipment. The chart below compares the ratio for several other companies.

Clearly, some companies are more cash rich than others, and are better prepared to fund growth internally. A ratio of less than one (1) is indicative of a company that may need to borrow money, or that is in decline. I think we all know the story of Blockbuster (BBI); its ratio is so low because it is in decline (to be fair, it is officially in decline from a brick and mortar video delivery standpoint). OCF to Capex is definitely an important ratio that should be part of every investors toolbox.

Operating Cash Flow to Current Liabilities: The Self-Sufficiency Ratio

2009-10-15T14:58:00.006-04:00

One of the most fundamental questions we can ask about a company is whether or not it is generating the cash necessary to service its debts. Furthermore, it's important to differentiate between cash generated from operations, and cash generated from financing activities (borrowing or stock issuance); once a company starts raising money for the sole purpose of meeting current debt obligations, we might as well just call it a Ponzi-scheme. To help make that determination, we'll use the Operating Cash Flow to Current Liabilities Ratio.

To calculate the ratio, first locate Net Cash Flow From Operating Activities (CFFO); its found on the statement of cash flows.Next, go to the balance sheet and locate Current Liabilities; this represents debt that matures in one year or less, accounts the company must pay within the year, and the current (one year or less) portion(s) of long term debt.You'll need to calculate the average amount of current liabilities for the period you're examining. Therefore, because the balance sheet represents only a single point in time, you'll need to average the current liabilities section from the two separate balance sheets which mark the beginning and end of the period for which you want to perform the analysis.Divide CFFO by the average current liabilities, and there you have the ratio. Any result less than 1 indicates that the company is not able to liquidate its current liabilities from operating cash flow; in other words, the company will probably have to sell assets, borrow money or issue stock in order to meet its short term debt obligations. (Hence, the "self-sufficiency" title to this post).The 2008-2009 solution is, of course, to conduct a mass layoff. Nothing frees up cash quicker than handing out 10,000 or so pink slips.

One company whose CFFO to Current Liabilities ratio I was particularly impressed with is Intel (INTC). I'll run through the calculation using Intel's numbers below:

Operating Cash Flow to Current Liabilities = Net Cash Flow From Operations / Average Current Liabilities

=$10,926M / ( ($7818M + $8571M) /2)
=$10,926M / $8194.5M
=1.33

As you can see, Intel's ratio of 1.33 stacks up quite favorably against the other companies in the chart below:

Obviously, despite Wal-Mart's poor looking ratio of 0.4, there is no reasonable chance that it won't be able to pay its bills. I imagine that, being the largest employer in America, Wal-Marts wages payable account grows by hundreds of millions of dollars every week. In fact, accounts payable represented around 70% of Wal-Mart's short term debt. As is always the case, this ratio is not a silver bullet, and needs to be used in conjunction with other tools.

Free Cash Flow: The Alternate Bottom Line

2009-10-14T10:46:00.004-04:00

One of the themes that I continually emphasize with regards to fundamental analysis is an approach that treats net income as an ancillary, rather than primary, valuation metric. Instead, investors should use Free Cash Flow (FCF) as a starting point from which to assess a company.

Fundamentally, free cash flow is cash generated in excess of a firm's operating costs and capital expenditures (CapEx). Capital expenditures are investments a company makes in its property, plant and equipment. CapEx can be investment in new land, machinery etc., or substantial "repairs" such as putting a new roof on a building. Therefore, CapEx can simultaneously be thought of as investment necessary for growth of the business, and investment necessary for maintenance of the firm's assets. Free cash flow then, is a pure cash measurement that is indicative of the firm's ability to finance expansionary activities from internally generated cash. Conversely, negative free cash flow is potentially indicative of the need for future borrowing.

I prefer to take one additional step in the FCF calculation, and net out dividends. If a company regularly declares dividends, a real cash outlay will occur, and it will detract from the firm's ability to expand operations. You could argue that dividends are voluntary and can be reduced or eliminated; however, that would adversely affect the stock price as the market adjusted to the new, reduced stream of cash flows. The point is, be aware that there are varying definitions of free cash flow. An example of the FCF calculation for General Electric (GE), 2008 reported results follows:

Free Cash Flow = Operating Cash Flow - Capital Expenditures - Dividends
Free Cash Flow= ($48,601M - $16,010M - $12,408) = $20,183M

GE reported $17,410M for its 2008 net income, obviously a couple billion and change shy of its free cash flow generated for the year. The chart below looks at free cash flow v net income at GE and four other companies.
Despite the fact that Exxon (XOM) makes every other industrial corporation look like a mom & pop general store, a major observation to be taken from the chart is that FCF can be either greater, or less than, net income. I wouldn't lay out a bright line rule as to what the ratio between these two should ideally be; the ideal relationship will change depending upon the specific corporation. For instance, Wal-Mart (WMT) primary method of expansion is via construction of new stores, a cash outlay that is already netted out of the free cash flow equation. There might not even be any new ventures for which Wal-Mart would need to apply its free cash flow. A diversified conglomerate like General Electric however, must constantly venture into new business activities, thus necessitating ample free cash flow. The more important point is to look at the FCF trend over time, and within the context of the company's current status.

Earnings Quality Analysis: Operating Cash Flow to Net Income

2009-10-13T14:26:00.012-04:00

In my intro to fundamental analysis, I focused on discrediting the P/E ratio as a viable means of gauging the relative value of a stock. The premise behind my campaign of disparagement was that net income, or the "E", is influenced by so many non-cash adjustments as to render its predictive value useless. In general, you could say that my complaints revolve around the concept of "earnings quality" (or lack thereof in many circumstances). Although earnings can consist of both cash and non-cash adjustments, I think we can all agree that earnings based on an increase in a company's cash position are of a higher quality than those which are not. Luckily, there's a useful ratio we can deploy against the income statement to determine the quality of a firm's reported earnings: Operating Cash Flow (CFFO) to Net Income

As the name implies, the ratio is calculated by dividing a company's operating cash flow by it's net income. Operating cash flow is an item found on the Statement of Cash Flows, and is often labeled "Cash Flows Provided by Operating Activities", or "Cash From Operating Activities". Basically, business activities are all placed in one of three categories: Operating, Investing, and Financing. Operating activities are the actions a company takes pursuant to its normal, or core business activities. For instance, a PC company like Hewlett-Packard (HPQ) sells computers and printers as it's core operating activity; if HP sold a piece of land it owned, that cash increase would not appear as cash provided by operating activities. Once you've located your CFFO number, move over to the income statement and find net income. Make sure you use the after tax figure. Divide the two, and there you have your ratio.

Example: Hewlett-Packard (HPQ), 2008 fiscal year totals
Operating Cash Flow: $14,591M
Net Income: $8329M
CFFO to Net Income = $14591M / $8329M = 1.75

The following chart should put HP's 1.75 CFFO to Net Income ratio in perspective; it shows that same ratio for HP and 6 other large tech firms.When a company's CFFO to net income ratio rises above 1, it is indicative of a strong ability to fund it's activities through generation of operating cash flow. In other words, a higher ratio means that the firm's earnings are of a higher quality. Both Apple (AAPL) and Intel (INTC) were able to generate cash from operations that was nearly twice reported earnings. Dell (DELL) however, actually generated less cash from operations than it reported in net income. If I were an investor in Dell, I would probably keep an eye on this ratio in order to determine whether it was a chronic issue at the company. A CFFO to net income ratio which remains below 1 for an extended period of time could be an indication that the company will need to raise money to fund its operations.

Next installment: Free Cash Flow: The Alternate Bottom Line

*no positions

Intro to Fundamental Analysis: What's Wrong With the P/E Ratio?

2009-10-12T15:52:00.006-04:00

Far too often, the relative attractiveness of a stock is discussed in terms of its price-to-earnings ratio (P/E Ratio). This is an inherently flawed method for determining a stocks value; although the "P" portion of the equation is an objective fact at any given point in time, the "E" is exceedingly more suspect in nature. For those new to this, "P" is the price of the stock, and "E" represents earnings, or net income. To keep things simple, suppose you have a $10 stock, issued by Company X. Let's also say that Company X has earned 25 cents/share each quarter of the past year, and it projects earnings of 25 cents/share for each of the next four quarters. In this situation, Company X will earn $1/share this year. Therefore, at a share price of $10, the stock is trading at 10 times earnings, or a P/E Ratio of 10. Note: Some investors like to use a forward P/E ratio, which basically looks at the next four quarter's worth of estimated earnings to determine the "E". Other fans of the P/E use trailing earnings to calculate the denominator; in other words, the sum of the four most recently reported quarterly per share earnings. I purposefully fashioned my hypothetical Company X earnings report such that both the forward and trailing P/E ratios are 10. This doesn't happen in real life.

Now that everyone is hopefully up to speed, I can get into the real issue here: What's wrong with the P/E ratio? Well, as I said before, the problem is with the "E" or net income. In small business, net income - or more commonly "profit" - is simply the cash left over after you pay the bills. It gets a little more complicated with publicly traded corporations, all of which must adhere to Generally Accepted Accounting Principles (GAAP). Under GAAP, the quarterly income statements that all corporations must file include, and in some cases are dominated by, non-cash items. Let's say a company purchases a tractor for $10,000. Fast forward one year, and the company has accumulated say $900 worth of depreciation on the tractor. That $900 will be recorded as an expense on the income statement, reducing reported earnings despite there never being a $900 change in the company's cash position. As a contrasting example, consider a company that extends credit to a large customer on December 20th, selling $1M worth of software. The seller's assets will increase by $1M via a debit to accounts receivable, and revenue will increase by $1M. Assume that the terms of the sale on account dictate payment within 30 days. For the year ended December 31st, that company will report the $1M as revenue, although they probably won't have received the cash yet.

A further earnings distortion occurs based upon the quarterly price fluctuations of balance sheet assets the company lists as "marketable securities". Often times, a company will use surplus cash to invest in other company's stocks. The change in market value of these securities, whether or not they are actually sold for a profit (or loss), will be recorded as income (or loss) on the quarterly income statement. Obviously, these items are neither indicative of the company's operating performance, nor indicative of changes in its cash position.

Hopefully, by now all readers are appreciative of the reality that a corporation's reported net income is a fickle beast, and that it should not be trusted. Therefore, any ratio whose entire denominator consists only of "net income" should be viewed through a skeptical lens. Don't worry though, as this post is only the first part of the Fundamental Analysis series. Future posts will help investors develop a more holistic and accurate approach to stock analysis and valuation.

Next up in the series: Cash Flow From Operating Activities (CFFO) to Net Income Ratio

How to Interpret Goodwill On the Balance Sheet

2009-10-09T15:43:00.007-04:00

Imagine that you purchased a home with the knowledge that you were paying $50,000 more than its true market value. Now imagine that as part of your personal financial planning, you decide create a personal balance sheet, and you list that $50,000 as an asset. This would make absolutely no sense right? The answer is, it depends upon whether you are an individual, or a publicly traded corporation. For the individual, that $50,000 on your balance sheet is nothing more than proof that you are an idiot. A corporation however, would be well within their rights under generally accepted accounting principals (GAAP) to record that $50,000 as an asset on its balance sheet, and label it "goodwill".

Technically, the above example is not entirely representative of the concept of Goodwill. Goodwill refers to the amount paid, when acquiring a company, that is in excess of fair value of the firm's net assets. Let's say the fair value of Company A's net assets are $7B, and Company B purchases Company A for an amount which corresponds to $10B. After the transaction, Company B will be left with $3B worth of Goodwill on its balance sheet. Supposedly, this amount represents some sort of intangible value that Company B believes will exist in the combined company. The problem as I see it is that Goodwill has the potential to inflate the perceived level of Shareholder's Equity in a corporation. Let's say Company X has $10B worth of assets, $9B worth of liabilities, and $1B worth of shareholder's equity. Now, assume that Company X has $3B worth of Goodwill recorded as assets. If this amount is a non-cash asset, and furthermore is unlikely to ever be converted into anything of value to the company, then couldn't the argument be made that Company X actually has -$2B worth of equity?

These cases do exist in real life. Take URS Corporation (URS) for instance. URS "provides engineering, construction, and technical services to the power, infrastructure, Federal, and industrial and commercial market sectors in the United States and internationally." As of January 2nd, 2009, URS reported $7B in assets, $3.15B of which is classified as goodwill. A little investigation indicates that that a substantial portion of this goodwill is attributable to the company's 2007 acquisition of Washington Group International. Given that none of this goodwill has been written down since 2007, one might ask: why? Well, my bet is that URS is benefiting from one of the luckiest acquisitions that any company could have made in 2007. The reason being, Washington Group - as the name might suggest - specializes in contracts through the Department of Energy, most notably nuclear waste management and disposal contracts. With the cyclical resurgence of new nuclear construction in the United States, and Uncle Sam's status as a profligate spender, it appears that URS acquired a company that will be uniquely resistant to recessions over the next couple decades. So, for now at least, we can say that the goodwill on URS's balance sheet is reasonably justified. This isn't always the case.

In 2008, Sprint (S) admitted that it's 2004 acquisition of Nextel was one of the poorest decisions ever made by a US corporation. Sprint didn't actually say that, but their balance sheet did; the company wrote down all of the Nextel related goodwill on it's balance sheet - all $29.5B worth. Way to go.

The moral of this story is that not all goodwill is created equal; it all depends on whether or not the acquisition which created the goodwill will ultimately be judged as a successful venture for the company. Such a determination is of course exceedingly difficult to make, as things like cultural incompatibility between the acquirer and the acquired can potentially ruin a deal that might have otherwise looked great on paper. Because of the obvious uncertainty in these situations, I personally tend to shun any stocks where the ratio of goodwill to total assets gets too high. How to define too high? I wouldn't issue a bright line rule on this one, but would just say that there is a 100% positive correlation between the goodwill-to-total assets ratio, and my level of discomfort with the company's fundamentals.

*Update: I realized that I neglected to mention a critical - and curious - component of goodwill. Unlike many other intangible assets whose "life" is fairly well defined, goodwill on the balance sheet is not amortized in any systematic way over time. Rather, it is subjected to an annual impairment test whereby the market value of the lingering goodwill is determined, and in the event that market is lower than book value, the goodwill must be written down to reflect this reality.

Duke Energy: Earnings Management or Prudent Policies?

2009-10-07T16:45:00.002-04:00

Earnings management is an ugly term; it carries with it the implication that a company has strategically timed and/or manipulated its financial statements in order to reach a more desirable earnings outcome. One of the areas that is susceptible to such tactics is the portion of the balance sheet labeled "Accounts Receivable"(AR).

Generally speaking, AR represents goods or services that a company has sold to a buyer on credit, i.e it has not yet received cash for the good/service, but it has booked the sale as revenue. The obvious question to arise from this scenario, especially during a recession is: what if the customer doesn't pay? The most precise answer to that question is that an aging analysis is performed, whereby increasing rates of loss are applied to the receivables based upon the number of days since credit was extended to the customer. For instance, we could classify all of our receivables as being 0-30 days outstanding, 30-60, and 90+. Experience might tell us that 2% of receivables in the 0-30 day category will end up defaulting, whereas a bill that's been out for over 90 days will "go bad" 10% of the time. These estimated loss rates are multiplied with the dollar value of receivable in each category, generating a loss estimate known as "Allowance for Doubtful Accounts". Interestingly, this number immediately counts as an expense in the income statement for the current quarter. If and when the debt is actually classified as "bad", there is no (net) effect on the balance sheet or income statement. Thus, the potential exists for a corporation to over estimate bad accounts in one quarter, and slowly bleed the "loss" back into the income statement over subsequent quarters. Need an extra 10 cents/share to beat analyst estimates? No problem, just dip into the "bad" accounts cookie jar and take it.

Now, I'm in no way claiming that Duke Energy (DUK) is engaging in this sort of chicanery. In fact, I own the stock and consider it to be a well-managed company. That being said, I'm intrigued by the fact that, since the recession began in December 2007, DUK's allowance for doubtful accounts, as a percentage of gross receivables, has steadily declined. On 3/31/2007, Duke classified 4.5% of it's outstanding invoices as "Doubtful". By 3/31/2009, in the depths of the recession, Duke only classified 2.79% of receivables as doubtful. These small percentage changes add up when you consider that DUK had $1.5Billion worth of accounts receivable as of the most recent reporting period. I'm surprised at this trend because I would assume that more households would forgo paying the electric bill during the recession than before.

There is of course another explanation which I, as a DUK shareholder, would prefer to believe. Duke Energy could simply be tightening its credit standards for new accounts. Presumably, that action would reduce the number of non-payers. Since I don't think the electric company can outright deny service to a household, my best guess is that they are either requiring a deposit of some sort, or are requiring less credit worthy individuals to set up an automatic account draft. Another possibility is that households are being forced to put their electric account in the name of a more credit worthy family member. Finally, Duke might simply be shutting off power to non-payers quicker than before, essentially eliminating several months worth of noncollectable accounts.

Obviously, Duke Energy has a fairly reliable and predictable stream of revenue. Other corporations may not, and as such, investors should be cognizant of this accounting trick before they pony up for potentially over valued common shares.

*long DUK

GE's Global Chief Warns of Chinese Slowdown

2009-10-05T09:30:00.003-04:00

The head of GE International, Nani Beccalli, told the Financial Times during an interview that he is concerned about the risk that the governments of the world will withdraw stimulus support too rapidly, and potentially jeopardize the tenuous global recovery. Surprisingly, when asked which specific country(s) are most at risk of a government misstep, Mr. Beccalli cited China, reflecting his view that the Chinese economy would suffer a significant slowdown if support from Beijing is withdrawn too quickly.

I would venture to say that Mr. Beccalli, who is in charge of all of General Electric's operations outside the United States, is uniquely positioned to accurately assess both the global economy as a whole, and the relative contribution of it's individual nation components. Thus, the GE executives assertion regarding China represents the most credible bucking of conventional wisdom about that country in some time. After all, if every economic tale told about China is assumed to be valid and true, then it could reasonably be surmised that the red-nation is on the brink of not only taking over earth, but also venturing into neighboring solar systems and subjugating their alien inhabitants. For some, it just seems that the US is out of growth industries.

What will America's next growth industry be? I certainly can't say with any certainty, however, a quick thought process might reinforce the notion that we aren't supposed to know what comes next. First of all, imagine the year is 1950, and you as an American as surveying the nation's economic prospects for the next half-century. Could you, at that time, ever imagine that the semi-conductor industry would give birth to powerful American corporations? No, because you wouldn't have even known what a semi-conductor was, or when it would be invented. The Technology Sector as we know it was nothing in 1950; we couldn't even conceive of it's existence. Most people probably thought that US auto makers would continue taking over the world, oblivious to the fact that an upstart US tech company - Google - would come closer to achieving that goal than GM ever had. A little bit of skepticism could go a long way towards a more accurate assessment of China, not to mention the future of the global economic and political landscape.

*long GE

Ken Lewis Bullied Into Retirement By Government

2009-10-02T16:12:00.004-04:00

As everyone knows by now, Ken Lewis, CEO and President of Bank of America (BAC), has announced that he will retire at the end of 2009. Most people won't shed a tear over the departure of a well paid CEO, especially when that CEO presides over the nation's largest bank by assets, and we are in the midst of an economic recession. Throw in the fact that this recession has been largely blamed on reckless banking practices, and it wouldn't surprise me to hear a few cheers over Mr Lewis's resignation. The problem is, this guy is the wrong scapegoat. Ken Lewis did the financial system a favor - whether it was voluntary or not - by purchasing both Countrywide Financial and Merrill Lynch. Furthermore, Bank of America's purchase of Merrill was the result of unprecedented Government coercion. The federal government has well established the fact that, in times of crisis, it may take virtually any action necessary to restore the "peace". Whether it be post-911, or post-Lehman, the reality is that the rights of any individual or corporation take a back seat to what the federal government feels is best.

My opinion of Ken Lewis as a person was distinguished by one story in particular. A good friend of mine served a term in Bank of America's internship program, during which he participated in the largely uneventful activities that occur during such stints. On the last day of the program, the bank held a small luncheon for the interns, where they were able to get a free meal and mingle with the bank's middle management. Once again, a potentially unremarkable event. In the middle of the festivities however, Ken Lewis made an unexpected appearance. He shook the hand of every single intern, and thanked each plebe for the time that he or she had devoted to the bank. Obviously, if you choose to take the cynical view on this one, the conclusion is that Ken Lewis did not care about the interns. However, the fact that the CEO of the largest bank in the country would appear at an intern luncheon is something I consider pretty remarkable.

The point is, Ken Lewis went down because of a dysfunctional federal government, and the political class' need to divert attention away from it's own culpability.

A Look at Aetna's (AET) Q2 Income Statement

2009-09-26T16:45:00.002-04:00

One of the primary pillars which underpin arguments in favor of health insurance reform is the idea that health insurance companies earn "fat" profits, and it is these profits which stand in the way of an equitable health care system in this country. I feel that this concept has not been properly examined to determine it's validity, a surprising state of affairs considering we are mere weeks away from a possible overhaul of the entire health care system. Below I'll briefly walk through Aetna's (AET) income statement for the three months ended June 30th, 2009. I chose Aetna because it is sufficiently large - it's membership is greater than 45M across the medical,dental, and pharmacy network - to provide a representative view of the industry. The Company also operates in each of the 50 states in the US.

For the three months ended June 30th, 2009, Aetna reported revenues totaling $8,657.6M. I'd like to focus on a top line number that's more applicable to it's core business though - Health Care Premium Revenue - which totaled $7,030.5M for the quarter. During the same period, Aetna incurred Health Care Costs of $6,102.4M. Health Care Costs are essentially what the Company paid out in claims throughout the quarter. Using this measure alone, one might conclude that the difference between what Aetna received in premiums and what it paid out in claims - $928.1M - represents a relatively "fat" 13.2% profit margin. This sort of analysis ignores the fact that Aetna must pay it's 35,500 employees to administer this entire operation; this expense shows up in the General and Administrative expenses line item, which totaled $1,160.2M for the quarter.

You might be saying "what a second, based upon Aetna's three most core measures of revenues and expenses, it appears that they are $232.1M to the negative." This observation would be correct: Aetna is spending more on health care costs and salaries etc. than it is bringing in via premium revenues. We know however, that Aetna reported net income of $346.6M for the quarter; how do we reconcile this?

When you really get down to it, Aetna is relying on fees and investment income to break into the positive. These two items totaled $1,151.2M for the quarter. Once you add in one more revenue item - Other Premiums ($475.9M) - and net out Selling Expenses ($303.8M), Current/Future Benefits ($503.8M), Interest Expense ($60.7M) and Income Taxes ($168.8M), you are left with only $346.6M in Net Income.

What this means is that Aetna's Net Income ($364.6M) represents just 3.997% of it's total revenue ($8670.8) for the quarter. That ratio for Exxon (XOM) during Q2 was 5.3%, for Microsoft (MSFT) it was 23.2%, for Nike (NKE) it was 7.24%, for McDonalds (MCD) it was 19.3%, and for General Electric (GE) it was 7.3%. These figures actually defy some conventional wisdom, as most of the comparison companies own significant amounts of depreciable assets. Depreciation is recorded as an expense against net income, but it is not an event which affects cash flows. This accounting rule often leads to reported net income which is substantially lower than cash flow from operating activities (CFFO). Aetna's business however, deals in the somewhat intangible realm of insurance; thus, they do not benefit - from a taxable income standpoint - from the depreciation charges enjoyed by firm's having large amounts of physical assets.

Let's be honest here. If the government somehow forced Aetna to operate as a non-profit corporation, it would only allow the company to pay out an additional $515.4M (net income before taxes assuming non-profit status) in claims. This would only represent a 7.8% increase in quarterly claim payouts. This calculation of course assumes that the "new" Aetna would have an identical cost of capital to the "old" Aetna. The money just isn't there.

*long GE

The Merits of HR 1207 (Audit the Fed)

2009-09-24T14:30:00.003-04:00

A blast-out email I received this morning from Rep. Alan Grayson (D-Fl) confirmed that HR 1207 - the "Audit the Fed" bill - has gained significant traction in the House of Representatives, having gained over 290 co-sponsors. In anticipation of tomorrow morning's debate concerning HR 1207, to be heard before the House Financial Services Committee, I'd like to briefly share the fundamental reasoning which underlies my support of this bill.

First and foremost, I am a pragmatic libertarian; i.e. I understand that certain externalities are bound to occur when the universe of private transactions are allowed to take place in complete absence of regulation. In other words, I agree with preventing one man from polluting his own land (private property) if that pollution can flow down the river to another man's property. Similarly, I am of the opinion that the global financial system has grown sufficiently complex to warrant the existence of the Federal Reserve. True, the founders of this nation did not establish anything resembling a central bank. However, these men could never have envisioned the current scenario, whereby the dollar serves as the world's reserve currency, let alone that a financial instrument such as a "collateralized debt obligation" would even exist.

Having established the Federal Reserve's right to exist, I think we need to seriously consider the question: Under what conditions will the Federal Reserve be allowed to exist? Certainly, I see nothing wrong with a Federal Reserve capable of intervening during times of acute stress in the financial markets. However, accompanying this incredible power should be at least some modicum of transparency. To use a popular cliche, "Sunlight is the strongest disinfectant". This concept of transparency is the ultimate equalizer in a democratic society; conversely, a lack of transparency by the Government is the most necessary element of tyranny.

Some may argue that to audit the Federal Reserve is to deprive it of the independence necessary to conduct it's job. That argument might be relevant in the event that HR 1207 proposed some sort of Congressional oversight of the Fed. However, audit does not equal oversight or interference. The Supreme Court is an independent branch of the federal government that rules on the constitutionality of federal law. Members of Congress do not influence Supreme Court rulings; however, at the end of the day, the public is allowed to read a majority opinion stating the Court's reasoning behind the decision. Why is there no similar measure of transparency at the Fed?

Finally, the primary problem with the current state of the Federal Reserve is that this board of unelected officials is arguably more powerful than the President of the United States. At least show us how you are choosing to exercise that power.

Housing Continues to Offer Mixed Signals

2009-09-24T10:25:00.004-04:00

The National Association of Realtors released data on Existing Home Sales this morning which showed existing home sales declining 2.7% from July to a (SAAR) rate of 5,100,000 dwellings per year. The one year chart of existing home sales (blue line) above shows that we've spent the latter half of the past 12 months witnessing a rise in sales of existing homes. In fact, August's decrease was the first decline in activity since the March numbers were released; ironically, March also marked a low for US equity markets.

If you're looking for the silver lining, the number of months worth of housing inventory on the market is down 19.8% year over year. At 8.5 months of available housing inventory, we are still above the 6 month level which normally constitutes a "healthy" housing market. However, the inventory trend is headed in the right direction.

The risk I see going forward is that a) existing home sales moderate, or stagnate, around their current levels, and b) new housing starts continue to rise, possibly as a function of stimulus funds making their way into the economy. The government has already displayed a willingness to use stimulus funds to revive construction of politically advantageous housing projects; this sort of activity may be beneficial in the short term from a pure employment perspective, but it ultimately exacerbates the single largest fundamental drag on the US economy, i.e the anemic housing market. Housing starts and existing sales either need to both be trending positive, or starts need to be falling while sales are rising. The August trend - rising starts and falling sales - is a recipe for a continuation of housing's woes. Obviously, there is no use in over-analyzing each new data point; I'm merely pointing out the disadvantages the market faces if the current month's trend were to continue.

Professional Sports As a Model For Bankers' Pay

2009-09-23T11:08:00.003-04:00

Many commentators have, in the aftermath of the destruction wrought by reckless financial industry behavior, promulgated the view that restrictions should be placed on bankers' pay. The theory goes that there is a direct correlation between excessive risk taking and the expected monetary compensation derived from said risk taking. Most problematic is the reality that, contrary to the concept of risk - i.e it correlates with reward to the upside and loss to the downside - it appears that a downside never actually existed for some folks. Couple this perversion with the fact that Wall Streeter's annual compensation has reached a multiple of average US pay rivaled only by professional athletes, and it's easy to see why a lot of folks are outraged.

Watching ESPN last night, it occurred to me that professional sports has done a far superior job in structuring compensation for it's highest value added contributors - the actual athletes - than Wall Street has managed to do for it's upper echelons. A professional sports team is in fact a self-contained business, employing a wide range of individuals who are mostly paid standard, competitive salaries. The same holds true in the banking industry; a teller working at the deposit window is earning a modest wage, despite the handsome rewards that are doled out to those running the organization. The difference between the two industries however - besides the obvious variations in core business, is that professional sports leagues in America were able to foresee the adverse effects of ballooning salaries at the top of their member organizations, and implemented effective regulation of those salaries. Interestingly, each of the top three professional sports leagues in the US - NFL, NBA and MLB - have implemented differing strategies for tackling this problem. The three approaches can be likened to the respective league acting as the State, with varying degrees of interference. A brief description of each league's salary regulations follows:

National Football League
The most recent Collective Bargaining Agreement (CBA) between the League and the NFL Player's Association sets a salary cap for each team that is based upon the League's Projected Total Revenues (PTR). For 2008, the formula which determined the maximum amount each team could spend on player salaries was (PTR X 0.575 - League wide projected Benefits) / n , where n= the number of NFL teams for that year. Keep in mind that the CBA is a 361 page document, so in addition to knowing that attorneys had a field day with this one, we can infer that there are some exceptions to the above formula that can result in a higher or lower annual salary cap than the formula would imply. The point is though, each team has the exact same amount of money to spend on player's salaries each year.

National Basketball Association
The NBA's collective bargaining agreement is similar to the NFL's in that it's based upon a percentage of the League's annual revenue, and is allocated evenly across all teams. The NBA's system is more flexible however, evidenced by the fact that many teams "live" above the salary cap. There are specific portions of the CBA which allow for salary cap violations, most notably when a team wishes to re-sign a veteran player who has already spent at least 3 years with the team. There are also salary cap "taxes", meaning that for instance, if a team's salaries exceed a pre-specified amount, that team will be taxed by the league for it's excesses. By the way, those taxes are distributed evenly amongst those teams which did not disobey the salary cap.

Major League Baseball
MLB's Collective Bargaining agreement, the most free-market-like in professional sports, states that a player's salary is an amount to be determined between the player and the owner of the baseball team. There is no annual limit to the amount that a baseball team may spend on it's players salaries. There is however, a stipulation known as the Competitive Balance Tax; without getting into details, the Competitive Balance Tax is the theoretical equivalent of the progressive income tax system in the United States.

The three models above provide what I see as a relatively reasonable framework for the proper structuring of high level Wall Street pay. Salaries for each financial institution could be collectively based upon the trailing year's revenue. A substantial portion of that designated pay should be placed into an escrow account for around 5 years, and will be distributed accordingly assuming that certain performance measures have been met for the subsequent half-decade. In the event that the financial institution has significant losses for a given year, the escrow account will be used to shore up the bank's capital position. In the event of any sort of accounting scandal, the funds will immediately be distributed - in their entirety - to shareholders.

Could such a compensation model have prevented many of the problems we face today? My bet is yes.

*no positions

A Hypothetical Interview With Barney Frank

2009-09-21T22:14:00.004-04:00

The following represents an entirely hypothetical conversation. It did not happen; rather, I am suggesting it is what would happen under the circumstances.

Me: Senator Frank, I often hear you deride financial institutions for their stupidity over the past decade.

Barney Frank: yes, I do, because they did act stupidly; they should have all been arrested.

Me: Did you not know what was going on Sen. Frank? Because if you did, aren't you as much to blame as the perpetrators?

Barney Frank: No, well if you put it that way, I didn't know exactly what was going on.

Me: How did you not know?

Barney Frank: Because nobody told me about it.

Me: So, in your multiple decades of service as a United States Senator, nobody ever thought to give you an investment tip?

Barney Frank: Yes, I have been given investment tips. But it didn't matter than, because I - and everybody else - were making money too. Senators have money in the stock market too you know.

Me: So Barney. You are the chairman of the House Committee which is devoted to Finance. Presumably, you know a thing or two about the subject. You are also rather old; that is, you've seen a lot of economic cycles. Have you ever heard of the price of a house doubling in three years? Of no documentation loans?

Barney Frank: Yes, but all the economists said the housing rally was for real.

Me: So because you thought that housing was rising alongside your own personal wealth, you didn't necessarily care that something questionable was going on behind the scenes.

Barney Frank: This interview is over.

Free Markets Don't Exist in the US; Stop Pretending They Do

2009-09-19T11:59:00.003-04:00

Americans cling tightly to their respect for the concept of "free markets", often citing this ideal as a principal reason behind opposition to numerous policy proposals. The concept of a free market typically extends into issues of taxation, where the free market crowd tends to excoriate any policy that contains the smallest element of the much-despised "redistribution of wealth". The problem I see with this way of thinking is that, realistically, free markets haven't existed in this country for a very long time. Furthermore, if you ever plan on enrolling in Medicare or accepting a Social Security check, you don't really have the right to criticize anything on the grounds that it is a government mandated redistribution of wealth.

Let's take the housing market for instance. I almost hesitate to use the word "market", because that would imply that real estate prices are determined via a discovery process between willing buyers and sellers. Some individuals ignorantly believe that this is the case, but it's just not true. The housing market of today has become a swollen, government supported beast that features Uncle Sam's involvement at literally every turn. Just think about it. Interest rates on home mortgages are currently being held at artificially low levels; the byproduct of the Federal Reserve's $Trillion+ experiment into purchasing Treasury bonds and Fannie/Freddie's repackaged filth. Of course, the Fannie/Freddie foray is also providing the housing market with mortgage fund availability by transferring risk from the private lender to the government entity. Next, as your mortgage goes through the origination process, it is increasingly more likely to be insured by the FHA. In 2006, less than 10% of new mortgage origination's were insured by the federal government; today, over 40% can be placed in that ignoble category. It doesn't end once you've purchased your American dream of a home though; the government has heavily subsidized housing through it's structuring of the tax code. The mortgage interest deduction effectively convinces millions of people that they can afford a more expensive house just by the virtue of top-of-napkin calculations and the perverted logic of "pay more to save more on interest". Thus is the intoxicating effect that home-ownership inspires in so many people.

Now let's talk about the federal government's entitlement programs: Medicare and Social Security. To make this a little more personal, let's talk about this issue in terms of the paycheck you bring home from your job, or to be more precise, the part of your paycheck that you don't get to bring home. These deductions are Ponzi-schemed away from every one of your paychecks, and direct-deposited into the bank account of a Social Security recipient. If we as Americans have decided that this little sleight of hand is an appropriate way to handle retirement funding, then so be it (Well actually, only "so be it" until the United States is forced, by it's creditors, to end it's profligate ways. At that point, we'll need to take machettes, not scalpels, to the federal budget. Line item #1, the biggest one by the way, is Social Security.). Nevertheless, I refuse to acknowledge Social Security as anything other than a modified version of communism. It's modified because, instead of everybody propping up everybody else (a collective sort of propping if you will) we have a situation whereby only one segment of the population is being propped up by all the rest. It's well established via civil rights legislation and Supreme Court case law that the federal government is prohibited from discrimination on the basis of - among other categories - age. Why then, is the federal government fundamentally structured to provide benefits to one age group at the expense of all the rest? If you're getting mad right now, you can go ahead and calm down; I'm not advocating that anybody be "cut off", and I understand that the circumstances surrounding aging in general merit special consideration from a societal point of view. The only thing that I would propose is that millionaires be barred from receiving social security benefits. When you look at the name of the damn entitlement - "Social Security" - you should understand that it's true purpose is to provide income to those who weren't dealt a hand which led to millions in the bank at retirement time; it shouldn't serve as a supplement for those who have already assured their personal "Social Security" through the massive accumulation of capital. In other words, if two men, we'll call them "A" and "B", pay fire insurance premiums on their home for 30 years. Let's say A's home burns down, and he receives a payout from the insurance company. B is more fortunate; his house doesn't burn down. In this case, it would make no sense for B to receive a refund for his year's worth of premiums paid; sure, he paid into the insurance pool, but in the end he didn't need it.

The most recent example of the complete lack of free markets in the US is the brewing controversy surrounding "net neutrality". The internet, at it's infancy, was kind of an un-regulated wild west of commerce. Now however, the government is gearing up to micromanage the way service providers are allowed to treat traffic that utilizes their bandwidth.

Bottom line, free markets don't exist, so let's not pretend that they do. Invoking the "free markets work best" line of reasoning is essentially a thinly veiled justification for opposing a policy which happens to not benefit you. Once you've disavowed buying a home, taking a Social Security check, and using the internet, then maybe you are qualified to preach about the merits of free marketeerism. If you haven't (and you won't) then such proselytizing amounts to little more than hypocrisy.

How Much Does Experience Matter in Business?

2009-09-18T15:52:00.002-04:00

When considering the true value of experience as it relates to the attractiveness of an employee, or more specifically a manager, we need to establish a competing attribute against which to weigh the relative importance of experience. The best attribute I can describe in terms of a competing quality is simply general intelligence, an attribute whose spectrum ranges from dull, to extremely mentally acute. To clarify, intelligence in the context of a manager should be loosely defined as the ability to effectively interpret constant streams of changing data, properly diagnose problems within an organization, and implement the "as-needed" adjustments necessary to solve the problem.

To begin with, the attributes of experience and intelligence are not mutually exclusive; experience can certainly lead to the advanced recognition of common problems and the formulation of effective solutions. Taken to it's extreme, it is not reasonable to assert that a brand new college graduate will possess superior management skills on his first day of work than the manager who has 30 years experience. However, I would like to focus on the more practical question of whether business experience ceases to add considerable management effectiveness after a given period of time. That is to say that, with each passing year, a manager gains sequentially less prowess than was accrued the year before. In other words, is the business experience v effectiveness function one which rises positively in the first 10 years on the job, only to flatten out in coming decades.

My primary argument is that, as the world's general pace of change increases, simple measurements of managerial worth such as "years of experience" become less and less relevant. Much more important, I believe, is a manager's ability to recognize the changing winds of business, and act accordingly. To that affect, I would argue that excessive years of industry experience (30+) has currently - and will increasingly going forward - serve to act as a detriment to that individual. I've found these "super-experienced" individuals to be overly fixated upon the way things "have been done for years". In today's market, I would much rather entrust the management of my company to an adaptable, mentally acute individual with 15 years of experience, rather than a similarly intelligent individual with 35 years of experience.

Lastly, managers with substantial amounts of experience are excessively prone to the Gambler's Fallacy - the idea that past events are a reliable indicator of what the future holds. Each year of experience seems to add a layer of mental callousness to an individual, whereby they become increasingly averse to the idea of processing new information, in favor of applying previous outcomes to a new situation. Fundamental facts may have changed that these individuals have become structurally unable to recognize.

I'm in no way disparaging the possession of business experience, however, my personal observation is that year's of service to a particular industry will more often hinder, rather than aid, an individual's ability to develop new solutions to new problems. Obviously, the old guard of business will resist this concept - selfishly in many cases - to the detriment of their organization's effectiveness and efficiency. Pass it on.

August Housing Starts Rise; May Delay Recovery

2009-09-17T10:29:00.002-04:00

The US Census Bureau released August housing starts data this morning which showed a 598,000 (seasonally adjusted annualized rate) rate of starts. The August rate was 1.5% higher than July's 589,000 figure, but still 29.6% below the August 2008 rate of 849,000.

The current recession has decimated housing starts far more than has ever been witnessed during the modern era of data recording. Prior to the current state of malaise, analysts had viewed the 1,000,000/year rate as the level at which new starts could not remain below for any extended period of time. After all, history has shown that whenever starts slip below 1 million, they do not remain so for long, and quickly spring upwards. With US starts below that threshold for the past 13 months however, that conventional wisdom has been shattered.

In order for a sustainable recovery in housing to occur, starts must remain at these depressed levels for at least another year. Unless builder's plan on selling all newly constructed homes below their cost, they will not be able to compete with the massive foreclosure inventory that is bleeding onto the market.

August's numbers do not indicate that starts have raced ahead of a level conducive of a recovery, however, further "improvements" in the starts area will serve to hinder, rather than promote, a housing market recovery.

Baucus Unveils America's Healthy Future Act

2009-09-16T14:19:00.003-04:00

The Chairman of the Senate Finance Committee, Senator Max Baucus (D-Montana), today released his "marked up" version of proposed health care reform legislation. The legislation, entitled "America's Healthy Future Act", will likely spend the next couple of weeks running the political gauntlet prior to being voted on by the Senate Finance Committee. Below are selected highlights from the 223 page document; don't get too comfortable though, as the content is exceedingly subject to change.

Places a restriction upon which factors can be used by an insurance company to determine the price of your premium; additionally, relative weights are assigned to each of the permissible factors insofar as the extent to which they may affect premium price. Factors are: Tobacco Use (1.5:1) , Age (5:1) , Single (1:1), Adult w/child (1.8:1), Two adults (2:1), Family (3:1)
Allows any individual who has been denied health care coverage because of a pre-existing condition to enroll in a "high risk pool". Premiums within the high risk pool are subject to the restrictions outlined in my previous bullet point.
States have 24 months from the time of enactment to establish the much vaunted health insurance exchanges; if they don't HHS will contract with a non-governmental entity to see the creation of the exchange through. (If I were a State, I'd probably just purposefully neglect to set up the exchange, just to save the cost of planning such a thing. I also wonder whether some States - Texas comes to mind - will refuse to follow this mandate on purely ideological grounds)
Those with an existing policy will be permitted to renew that policy.
By the year 2015, and through a framework which will be developed by the National Association of Insurance Commissioners (NAIC), States may establish "health care choice compacts" which will essentially allow for the sale of health insurance policies across state lines. (A clever work-around the Commerce Clause issue?)
Establishes a classification system for health insurance policies that's strangely similar to the various plateau's one may reach by donating to a University's athletic program. The levels are Bronze,Silver,Gold and Platinum. I won't get into the specifics of the categories; it should be fairly obvious which plans offer the more comprehensive set of benefits.
Provides refundable tax credit for individuals and families who purchase health insurance through the state exchange systems.
Provides a tax credit for small businesses who make the correct moral, ethical, and talent retention strategy choice of providing employees with health insurance.

I think I've covered the major points here. Noticeably absent is the explicit establishment of a public insurance option. This was the politically smart thing to do; it leaves Republicans grasping for straws with which to criticize the nature of the reform package, and it doesn't alarm older voters by attempting to make a huge change to anything. Slow and incrementally wins the race.

The Constitution and Health-Care Reform: Vague at Best

2009-09-15T14:59:00.003-04:00

Judge Andrew Napolitano blasted a constitutional expose across the op-ed pages of the Wall Street Journal this morning, citing Supreme Court precedent which he believes has the effect of rendering unconstitutional any Congressional effort to legislate health care reform. Ultimately, the Judge failed to shed much of any light on how the Supreme Court might approach such an issue.

Napolitano takes the Commerce Clause route, which is to say that he questions the relationship between health insurance regulation and interstate commerce. On one hand, the Judge makes sense; all 50 states have established some sort of Insurance Commission and tasked it with the regulation of that State's particular insurance industry. Furthermore, the nature of competition within the health insurance industry is that it's fought on a state-by-state basis. The Judge's argument is flawed, I believe, in the assumption that "health insurance", as a commodity, does not already trade across state lines. For instance, the entire theory behind Medicaid is that the Government has an interest in providing health insurance to those who lack the means of affording it in the private marketplace. If private health insurance were priced around $20/month for a family of four, it would eliminate the need for government based systems.

Aside from my basic theoretical objections to the Judge's argument, I was a little disappointed with the sole Supreme Court precedent he used to justify his position. United States v. Lopez - the Judge's only supporting citation - dealt with the furthest outer-limits of the commerce clause. Basically, Lopez told Congress that it couldn't pass "no guns in school zones" Acts because they had nothing to do with the sale of goods and services across state lines. This was the first instance in several decades that the Supreme Court had reigned in Congress' broad interpretation of interstate commerce; however the facts of that case in no way resemble the facts in a hypothetical Constitutional challenge to a federal health insurance regulation.

In fact, I Shephardized the Lopez case just to see whether it was even still valid case law; in doing so, I came across Gonzales v Raich, a case that upheld the Government's right to enforce the Controlled Substances Act in the face of a Commerce Clause challenge. I found the following Supreme Court language particularly relevant to the question of health care regulation:

"The Supreme Court has never required Congress to legislate with scientific exactitude. When Congress decides that the total incidence of a practice poses a threat to a national market, it may regulate the entire class. In this vein, the Supreme Court has reiterated that when a general regulatory statute bears a substantial relation to Commerce, the de minimis character of individual instances arising under that statute is of no consequence"

With the absence of any Supreme Court precedent bearing similar facts, the outcome of a Constitutional showdown over health care reform remains debatable. The facts however, would seem to indicate that health insurance regulation would likely withstand a Commerce Clause challenge.

A Closer Look at the FDIC's Deposit Insurance Fund

2009-09-14T14:45:00.003-04:00

After falling victim to conventional wisdom last week, and speculating whether the FDIC had weeks or days remaining before it would need a Deposit Insurance Fund restoration bailout, I determined that the prudent course of action was to dig a little deeper into the issue. Specifically, I wanted to know the basics behind whatever accounting procedures took place at the FDIC in order to generate the headline "balance" of the Deposit Insurance Fund. In doing so, I came across several dissenting opinions (including an especially well-written article in American Banker) which, through a more precise look at the DIF, determined that the Fund has actually remained relatively stable despite there being nearly 100 bank failures in 2009 alone. Furthermore, I would argue that the Deposit Insurance Fund is not only far from depletion, but also unlikely to come under any considerable stress throughout the forthcoming year.

Most media representations of the DIF involve the reporting of the final line of the Deposit Insurance Fund's balance sheet, which is labeled "Fund Balance". While this may seem like the logical thing for journalists to do, the truth is that it is an inaccurate measure of the FDIC's funds available to absorb depositor losses.

Basically, the DIF's balance sheet is arranged much like any other corporation's would be, although the underlying "accounting equation" carries one distinct label; Assets = Liabilities + Fund Balance. To assume that the line labeled "Fund Balance" is inclusive of the FDIC's total deposit insurance resources at the moment is to ignore a line in the liabilities section labeled "Contingent Liabilities: future failures". This line item represents the FDIC's best estimation of the next four quarter's worth of failure related DIF losses, and is adjusted based upon the FDIC's assessment of troubled bank's balance sheets/loan losses/deposits etc. At the end of Q2'09, the FDIC had set aside $31.968B to cover losses it expects to occur over the next year. For the 12 months ended June '09, the DIF's headline "balance" has declined by $34.849B; however, Contingent Liabilities have risen by $21.378B. In other words, although the Fund's balance has declined 77% year over year, the FDIC's loss absorbing resources have only declined by 24% over the same period of time.

When you consider the substantial rise in Contingent Liabilities, along with the fact that the DIF has guaranteed revenue in the form of FDIC "assessments" on the banking industry, it becomes clear that the Deposit Insurance Fund is in a lot better shape than many give it credit.

*no positions

*InfoNgen was used to research this article

When Will the FDIC's Bailout Come to Fruition?

2009-09-12T16:16:00.002-04:00

The slew of bank failures that typically accompany a Friday night have inspired many people to approach these bouts of creative destruction as if it were a sport - say college football - worthy of following, documenting, and parsing. I am one of those people. That being said, I think it's about time that I devote some attention to the arguably mythical creature known as the FDIC's Deposit Insurance Fund (DIF). This fund is theoretically used to bridge the gap between the value of the deposits recovered in a bank failure, and the total value of bank depositor's claims that are insured by the FDIC. The DIF is largely funded via an assessment (read: tax) on FDIC member banks. A couple years ago, nobody paid that much attention to the DIF; it's balance remained relatively stable throughout time, and was only affected by the occasional bank failure. Presently however, the FDIC is in the midst of a 92-bank-failure-year which has reduced the balance of the DIF from $45.217B at the end of June '08, to a mere $10.386B as of the quarter ended June 30th, 2009. It is this fact alone which most discredits comparisons between today and the S&L crisis; although the S&L fiasco saw a much longer list of bank failures, consolidation within the banking industry over the past 20 years has led to fewer - yet much larger - banks today. For instance, last night's failure of Chicago based Corus Bank will cost the FDIC's DIF $1.7B.

It's become clear that the FDIC will be unable to prevent the depletion of the Deposit Insurance Fund; the question is how long it will be before the FDIC officially receives it's "bailout" from Treasury, in the form of a "loan" from the taxpayers. Well, we know that the DIF's balance is still in the billions of dollars, although it is certainly in the single digits by now. I can also state that a reasonable number of monthly bank failures - for the next 6-8 months at least - is between 15 and 30 banks per month. However, the total number of bank failures doesn't offer a very predictable estimate of DIF losses; as we've observed over the past year, the range of failed banks total assets/deposits is very large. My most reasonable estimate is that monthly DIF losses will range between $100MM and $3B; this doesn't allow for any black swan events of course, but those are useless to attempt to forecast. That being said, the FDIC could require a Treasury bailout in as soon as 2 months, or in the best case scenario, as far into the future as May/June 2010. If I were a bookie, I would probably set the under/over date for an FDIC bailout at December 15th, 2009. It's probable that I could balance my books with a date like that, however, my personal bet is that the bailout will have to occur before the end of October 2009.

Democrats Awash in Out-of-State Campaign Contributions

2009-09-11T15:40:00.004-04:00

The symbiotic relationship between politics and money is well known; it almost seems that we as Americans are so dependent upon our television sets for information about the world, that simply airing more commercials than your political opponent is a sure fire prescription for victory. With campaign contribution limits in place though, this relationship initially sounds reasonable enough, largely because one might assume that there is a correlation between a candidate's support in his or her district, and the amount of money that he or she is able to raise from the district. The alarming truth however, is that some candidates hardly raise any money at all from their home district. Furthermore, it is Democrats who dominate the list of Representatives who have received the least amount of campaign funding from donors in their own state. In fact, on a list prepared by Congressional Quarterly which showed the members of the House with the highest proportion of out-of-state campaign contributions, you must go to the list's ninth position in order to find a Republican. For the 2010 election campaign, there are four Democrats whose out-of-state donations exceed 90% of their total campaign contributions. Below is a list of those four Democrats, the amount of out-of-state money they have raised, and the entities which so graciously donated to these folks. Keep in mind that when a corporation is listed, the headline donation amount is a cumulative number, indicative of many employees "choosing" to contribute to that specific campaign.

Rep. Chellie Pingree (D-Maine) - 98% Out-of-State
Top Donors:

Paloma Partners, $52,800
ActBlue, $20,200
Prudential Connecticut, $4800

Rep. Patrick J. Kennedy (D-Rhode Island) - 93% Out-of-State

Thornton & Naumes, $16,500
Pepsiamericas Inc $11,200
Lhc Group $8200

Rep. James L Oberstar (D-Minnesota) - 92% Out-of-State

Livingston Group, $7800
Naismith Engineering, $5500
L&G Engineering, $4800

Rep. Howard L Berman (D-California) - 91% Out-of-State

NorPAC, $13,400
Akin, Grump et al, $6900
Vivendi, $6400

Just to provide some perspective, the top Republican on this list is Rep.Don Young (R-Alaska), who logged 79% of his campaign contributions from out of state individuals; that number is still high, but at least it's not in the 90's.

My primary issue with this sort of data is that it suggests that the residents of a particular Congressional district have been subordinated - from an influence perspective - by out of state donors. When an individual is elected to Congress with the help of non-resident contributions, he or she will inevitably spend an undue amount of time answering to the interests of those donors. The devil's advocate would, at this point, assert that since a district's residents are the only individuals eligible to vote for their particular representative, they can easily vote a non-cooperative Rep out of office. Unfortunately, these sort of "power of the vote" arguments fail to acknowledge the fact that the vast majority of voters have absolutely zero influence over which men or women appear on the ballot. Candidates do not simply spontaneously appear on the ballot as a result of the citizens collective wishes; it takes money to even get on the ballot, and there is nothing preventing out-of-state money from asserting substantial control over a district. With that said, I think it would be completely reasonable to suggest amending campaign finance law, so that candidates may only receive donations from the residents of their particular district.

There is currently a picture perfect example of how out-of-state money can distort a Congressional race; it's so perfect in fact that prior to it's occurrence, I would only have considered describing the situation in hyperbolic fashion. Anyways, we all know that Joe Wilson had an outburst during the President's health care speech, screaming "you lie!" in the middle of it. Rep. Wilson is entitled to his opinion, although I don't necessarily agree with the way in which he chose to express himself, but that's beyond the scope of this article. As a result of Rep. Wilson's - in the grand scheme of things irrelevant - outburst, Democrats have launched a nationwide fund raising campaign, the proceeds from which will be used to fund the election campaign of Rob Miller - the Democrat who will be challenging Mr. Wilson in 2010. Since Wednesday, over $700,000 has been raised for Rob Miller by various Democratic groups, including ActBlue.

Recognize ActBlue? That's because they are listed as Rep. Pingree's 2nd largest contributor (above) raising over $20,000 for the Congresswoman from Maine. Organizations such as ActBlue have become too powerful, and are distorting elections which should be decided by the residents of that district, not out-of-state activists.

Will Illegal Immigrants Receive Health Care Under H.R.3200?

2009-09-10T09:02:00.004-04:00

After Representative Joe Wilson's (R-SC) outburst last night, it's clear that there is a distinct concern amongst conservatives as to whether H.R.3200 - the health care bill that everyone has been roaring about - will effectively subsidize health care for illegal immigrants. The Right has long suspected that Democrats are willing to buy Hispanic votes at any cost; Rep. Wilson's outburst is merely a publicly displayed manifestation of that suspicion. What's the truth though? Will H.R.3200 provide free health care to non-citizens/illegal immigrants? Once again, I've decided the easiest way to answer this question is by reviewing the latest Congressional Research Service report, titled "Treatment of Noncitizens in H.R.3200". The report is encrypted, so I can't load it up to the site right now; I can email the report to anyone who thinks I might be misrepresenting it's content, but otherwise you'll need to trust me.

Coverage Requirements
First of all, H.R.3200 would require that all legal permanent residents, non immigrants, and unauthorized aliens (who meet certain requirements pertaining to amount of time spent in the country) obtain health insurance coverage. Well, actually H.R.3200 would only amend the Internal Revenue Code such that an additional tax would be levied upon any of the individuals listed above who do not obtain health insurance coverage; men in black suits will not be appearing at your doorstep to compel you to sign a health insurance policy. Clearly, unauthorized individuals could obviate this provision by simply not filing taxes; however, speaking for myself, I probably wouldn't file my taxes either if the government was unaware of my existence.

The Health Exchange
H.R.3200 would establish - effective 2013 - a health insurance exchange; the exchange isn't in and of itself an insurance provider, it is merely a uniform way of presenting the various private insurance options alongside the public option. H.R.3200 does not address whether or not an individual must be a legal US citizen in order to participate in the exchange, in theory making it completely possible that an illegal immigrant could participate. A bit of editorial here though: the alternative is emergency room visits that drive up the cost for everyone. Also, please read the "Credits" section below before you jump to conclusions.

Health Care Credits
Enough with the euphemisms, the portion of H.R.3200 that refers to "credits" is talking about a government subsidy of health insurance premiums for lower income individuals. For the purposes of this article, it's irrelevant how the government will calculate the amount of subsidy that an individual is eligible for. What is relevant though, is that in order to qualify for a health insurance subsidy of any sort, an individual must be lawfully present in the United States. There are a handful of exceptions, although they may have been added to the bill in an attempt to trick Republicans into opposing their inclusion. The following groups of people MAY receive subsidies, even if they are not lawfully present in the US: trafficking victims, crime victims, fiancees of US citizens, and those who have applied for US citizenship but whose application has been stalled in the bureaucracy for 3 years or more.

The CRS report - which was prepared by Alison Siskin (immigration policy expert) and Erika K. Lunder (legislative attorney) - makes an intriguing point that is nearly identical to my first impression of the immigration related provisions of H.R.3200. Specifically, the bill would require certain resident aliens to secure health care coverage, but would prohibit them from receiving credits towards it's purchase - even if they qualified from an income standpoint!. Thus, I don't think it's too much of a stretch to state that, in many instances, it will be foreigners/illegals/noncitizens (whatever your preference) who will be subsidizing health insurance credits for others!

Parsing H.R.3200: End of Life Care Provisions

2009-09-09T16:06:00.002-04:00

Typically, I've tried to tackle political issues on this site without the use of ideological talking points; besides the fact that I abhor the concise, pre-packaged way of thinking about the world that is advanced on cable TV networks, I find it much more constructive to 1) assess who is likely to win upcoming elections, and 2) point out blatant dishonesty when I see it. Now, because of the dishonest nature of politics, I was forced to insert the word "blatant" into the previous sentence. That is to say, I only feel like the most egregious acts of political dishonesty are worthy of discussion. That being said, on the eve of President Obama's Congressional address concerning health care reform - an effort that in my opinion will ultimately be viewed as a failure - I'd like to go head first into the topic of HR 3200 and End of Life Care Provisions. Depending upon your political disposition, you may prefer to use the term "death-panels"; I however, will refrain from using this sort of dishonest innuendo-laden terminology.

My assessment of HR 3200 and it's end of life care provisions is based upon a research report prepared by the Congressional Research Service. The CRS is sort of like the policy analysis equivalent of the Congressional Budget Office; it produces objective legislative and policy analysis that is relevant. For those who don't have time to consume the full report, I'll summarize the portions of HR 3200 that deal with end of life care below.

Advance Care Planning
HR 3200 would expand Medicare to cover an advanced care planning consultation with your physician. This consultation would be completely optional, and would allow adults to have a discussion with their doctor about the various stages involved in end of life care. It would also provide patients with the education they need concerning "health care proxy's", or the appointment of a spouse or other family member who can effectuate medical decisions in the event the beneficiary has become incapacitated. This provision would also standardize end-of-life-care preference statements across jurisdictions so as to avoid confusion.

Quality Measures
This provision would incentivize physicians to report on end of life treatments from a quality perspective; that is, whether the treatment rendered helped improve the quality of the patient's life. Since improving quality of life should be the underlying purpose behind any end of life treatment, it seems that a centralized Medicare data collection initiative would have the best chance of maximizing that goal. This provision does not in any way institute panels which would make end of life decisions; it simply gives physicians a 2% bonus for reporting the effectiveness of a procedure.

Educational Aspect
Finally, the bill would update the well-known Medicare handbook titled "Medicare and You" to include language about advanced care planning. A separate House Energy and Commerce Committee amendment would direct the HHS secretary to establish a toll-free national hot-line that would provide answers to questions about advanced care planning.

There you have it. The above provisions are the only ones included in HR 3200 that deal with end of life issues. There will no be no government bureaucrats deciding whether you live or die. The ironic thing about that argument is people pretend there isn't already somebody else making these decisions for them. Given that very few people can actually pay cash for medical procedures, they are always relying on either an insurance company or the government to pay for them. In the case of the elderly, they are on Medicare, so the government is already making judgments concerning their benefits. This is the sort of thing that gets fleshed out in an intelligent debate; however, I haven't seen very many of those occurring.

Blockbuster Could Collapse in 2010

2009-09-07T13:41:00.003-04:00

The corporate graveyard is littered with companies that were either unable to adapt to structural changes within an industry, or were - in the saddest of situations - unaware that these changes were even happening. Blockbuster Inc. (BBI) currently suffers from a combination of those two factors, a predicament exacerbated by the emergence of aggressive competition to it's core video rental business. This competition has intensified to the point that Blockbuster could be forced into either bankruptcy or irrelevancy within the next 12 to 18 months.

Most of us have stepped inside one of Blockbuster's brick and mortar video rental locations; at one time, getting in the car and heading to Blockbuster was actually an exciting event. Then Netflix (NFLX) came along, offering customers video rentals by mail, and immediately siphoning sales from Blockbuster. Presently, subscription based video-by-mail services account for 36% of all videos rented by consumers, compared with a 45% share for rentals purchased at physical store locations. Blockbuster has also attempted to offer a Netflix-like service, however, it has clearly been unable to compete in this arena. The Company's total revenue was nearly $700MM less in 2008 than in 2003; a sign that it has been woefully incapable of replacing lost brick and mortar sales with online and mail alternatives. As a comparison, Netflix logged 2008 revenue that was over $1B more than it recorded in 2003.

Recently, video rental kiosks have made an enormous splash by offering cheap $1/day rentals, in prime locations (WalMart, grocery stores). DVD's rented at these kiosk locations now account for 19% of all video rental activity. More importantly however, is the marketing research firm NPD Group's prediction that, in the year 2010, 30% of all video rental transactions will take place at kiosks! A market share shift of that magnitude, in such a short period of time, will likely destroy Blockbusters brick and mortar sales. The Company appears to understand the dying nature of a DVD rental physical storefront, and has plans to charge headfirst into the kiosk rental business. Blockbuster only has 500 such machines right now, but expects to roll out 7000 in the year 2010 alone. Alas, this effort may be a textbook example of "too little, too late"; the leading player in the kiosk game - Redbox - already has machines in over 15,000 locations. The traditional real-estate cliche - location, location, location - has distinct parallels in kiosk site selection; a kiosk must be located in a venue that is convenient for the consumer. With a 14,500 machine disadvantage, it's likely that Blockbuster will struggle to compete with Redbox in the battle to place kiosks in the most convenient spots. Over the next year, the largest threat to the kiosk distribution model will be licensing disputes with change-averse Hollywood studios. As far as Blockbuster is concerned however, the question of whether or not studios will succeed in stymieing kiosk sales is effectively the difference between a bad or worse outcome for the Company; they will either continue to make a push into the market - from an extremely disadvantaged position - or their only chance of survival will be squashed by the studios.

This rapid shift in the video rental business is occurring at a horrible time for Blockbuster. The Company's revenues are on pace to decline $1B, or almost 20%, in 2009 compared to 2008. Assuming that NPD Group's projections regarding kiosk market share are correct, Blockbuster's second half numbers will deteriorate even further from already depressed current levels. I wouldn't be surprised if the Company logs less than $4B in revenue for 2009, a greater than 33% decline in annual revenue since 2004's $6B year. Unfortunately for Blockbuster, that isn't even the bad news; the Company has $415MM worth of debt obligations due between now and the end of 2010. So how does a Company with less than $100MM in cash, rapidly declining sales, and gruesomely negative cash flow meet such an obligation? Well, Blockbuster's strategy is to do the only thing they can: slash G&A as rapidly and as deeply as possible, and sell assets like there's no tomorrow (because there might not be). This was a borderline-achievable goal prior to the rapid ascent of kiosk rentals; under present conditions however, it may be impossible. Simply put, sales may be declining faster than Blockbuster's ability to preserve cash via cost cuts and asset sales.

Many people still visit Blockbuster's physical locations, and may be disheartened in the event the Company is unable to meet it's looming debt obligations. My movie viewing habits will not be disrupted though; I've been streaming Netflix video content, on-demand, through my XBox for several months now.

*no position in any Companies mentioned in article

Will Health Care Reform Impact the 2010 Midterm Election?

2009-09-06T17:52:00.004-04:00

Many political prognosticators - myself included - have speculated that conservative opposition to any sort of health care reform will strengthen the Republican party's base, allowing the GOP to gain Congressional seats in the upcoming 2010 midterm election. Historically, midterm elections have turned out favorably for the opposition/minority party, even in the absence of a catalyst issue such as health care. Furthermore, the current situation is reminiscent of 1994; a time when Republicans rallied against universal health care and government largess in general to command a large victory in that year's midterm election. The most recent polling data also provides empirical evidence that the public is growing increasingly dissatisfied with the President's push for health care reform. Recent Rasmussen polls indicate the following:

40% of voters say deficit reduction should be the President's #1 priority, versus 21% who think health care should be #1.
68% of voters say that health care reform legislation is likely to increase the federal budget deficit.
54% of voters say that a tax cut for the middle class is more important than any health care reform spending.

The last decade has shown us that Republicans barely possess a modicum of fiscal discipline. The GOP has however, through it's criticisms of $10MM portions of $780B pieces of legislation, positioned itself as the Party of deficit warriors. I'm not exactly sure how the GOP can make this claim, given that Clinton is the only modern-era President to actually run budget surpluses; perhaps rhetoric is more important than the facts. This strange reality, combined with the fact that more Americans now disapprove of President Obama than approve of him ( 49% approval latest Rasmussen poll), should logically translate into a strong Republican showing in 2010. When you zoom into district-specific polling data however, it appears that Democrats may emerge from the midterm election with even wider majorities in both the Senate and House.

In the Senate, there are seven seats that could realistically go to either Party; five of those are currently occupied by Republicans. As we get closer to election time, I'd predict that Harry Reid (D-NV) and Arlen Specter (D-PA) will be added to the list of imperiled incumbents. Still though, Democrats are in a position to gain one, or possibly two Senate seats. The other "toss-up" seats, as determined by polling data collected by CQ, are:

Dodd (D-Connecticut)
Burris (D-Illinois)
Bunning (R-Kentucky)
Bond (R-Missouri)
Burr (R-North Carolina)
Gregg (R-New Hampshire)
Voinovich (R-Ohio)

In the House of Representatives, only three districts are presently legitimate "toss-ups"; Minnick (D-Idaho), Kratavil (D-Maryland), and McHugh (R-New York). On the cusp of being classified an at risk district however, are the seats occupied by Kirk (R-Illinois), Gerlach (R-Pennsylvania), and Melancon (D-Louisiana). That being said, the current calculus would indicate no net change in the political composition of the House.

The wild card for 2010 may still be based upon the final outcome of the health care debate; most importantly, the perceptions of swing-district voters with regards to whether their representative has cast a health care vote that is in their best interest. This dynamic may be exacerbated in the event Democrats resort to a budget reconciliation procedure to pass health reform legislation by a majority vote. Nevertheless, the current "furor" over health care reform has done little to change the potential outcome of the 2010 midterm election.

First Bank of Kansas City - And Others - Fall Into the Government's Arms

2009-09-04T18:56:00.003-04:00

I realize that today's bank failure - First Bank of Kansas City being the wilted financial institution- is a relatively insignificant event which shouldn't realistically be compared to the General Motors bankruptcy. However, I found the Wall Street Journal's headline on that day to be so humorous, that I've saved a copy to look at while at work. In case you're new to reading, the headline read "GM Collapses Into Government's Arms". Anyways, I've been looking for a chance to invoke the concept of a corporation's 1) knees buckling 2) falling towards the ground 3) caught and embraced by the benevolent arms of the federal government - into a post title. Because the First Bank of Kansas City has (had) assets totaling only $16MM, I would imagine that it's collapse did not cause any undue strain upon the government's arms. Technically, the cost to the FDIC's Deposit Insurance Fund (DIF) is estimated to be $6MM. Although I'll snidely point out that six million bucks represents a larger percentage of the DIF balance than it would have been if measured at any other time this year, it isn't very much money at all. For instance, Goldman Sachs could easily replenish this $6MM portion of the DIF by donating 23 minutes worth of trading profits to the FDIC (assumes $100MM daily trading profit generated at a constant per second rate ($4327/second) during the 6.5 hours of a standard trading day)

Update - before I could finish writing this post, the FDIC announced the 86th and 87th bank failures of the year, as Inbank and Vantus Bank have both apparently fallen into the increasingly crowded arms of the government. This development ruined the latter part of my post, as I had planned to comment on the fact that a 1 bank failure Friday is a rare thing indeed. Furthermore the failures of Inbank and Vantus Bank will cost the DIF an estimated $66MM and $168MM, respectively. On a $100MM trading day, it would take Goldman Sachs 2.34 days to replenish the DIF for the losses it has incurred as a result of the wilting of these two banks.

Assessing Natural Gas as an Investment

2009-09-03T14:20:00.003-04:00

Natural Gas, an abundant yet integral component of US energy supply, has today reached a price of $2.52 per million British Thermal Units - a level not seen since 2002. I'm always intrigued when the price of an asset reaches a multi-year low (unless of course that "asset" is the common stock of Fannie Mae), especially when the asset is a commodity that is used for daily and essential functions such as heating homes and cooking food.

The catalyst for today's drop in natural gas prices, according to most media outlets, was the Energy Information Administration's report which showed a 17% year over year rise in the nation's underground gas inventories. As evidenced by the chart below however, there isn't a definitive relationship between the price of natural gas (as measured by the United States Natural Gas Fund) and the total volume of gas in underground storage.
While UNG may not be the most accurate measure of spot natural gas prices - the fund trades at a ~10% premium to it's net asset value - it's certainly reliable enough to illustrate the point. Additional concerns abound regarding the contango that's developed in the natural gas futures market; that is, near month contracts are trading at a steep discount relative to those further in the future. From my perspective, this is a concern that should only apply to individuals who are establishing short term trading positions. In other words, if you can stand to watch your brokerage account balance fluctuate over the next several months, it may be wise to base your investment decision on the potential future demand for natural gas.

I am of the opinion that, while the private sector fuels the lions share of economic growth in this country, large structural changes are most often effectuated via the federal government. Within the broad context of energy sources, this dynamic can be observed in the recent revival of nuclear power - an area where the US lags far behind many European countries. Similarly, legislation recently introduced in the Senate has the potential to spur investment in natural gas technology, specifically in areas beyond NG's traditional scope of use. S.1643 would provide a $3500 tax credit for homeowners who convert their heating system from an oil, to a natural gas based system. S.1350 proposes to substantially increase tax credits for the purchase of a vehicle fueled by natural gas, as well as expand the credits available to anyone who builds a natural gas fueling station. There are other similar bills in the House of Representatives whose objectives are essentially the same. The bottom line is that Congress has identified natural gas as a cleaner, viable alternative to crude oil. Clearly, the switch won't be made overnight, but I suspect that natural gas will eventually overtake crude oil as our nation's primary energy source.

*no position in UNG

Tom Daschle's Poorly Conceived Op-Ed on Health Care

2009-09-03T12:15:00.003-04:00

For anyone who missed it, Tom Daschle, Democrat and former Senate majority leader, wrote an extremely ill-conceived op-ed which appeared in today's Wall Street Journal. After Senator Daschle's embarrassing admission earlier this year that he had "overlooked" paying taxes on over $300,000 worth of income - an admission that ultimately forced him to decline his nomination as HHS secretary under the Obama Administration - I assumed that he would slip quietly into the political night. Apparently though, Daschle is intent on wreaking additional political havoc on the Democrats' health care reform agenda.

Daschle's politically tone deaf article begins with a glorified account of the late Senator Edward Kennedy's funeral, emphasizing a eulogy at that event which he found particularly moving. Under most circumstances this would have been entirely appropriate content for an op-ed piece; however, Daschle's ultimate purpose in writing the article was to advocate the need for health care reform. Apparently, the soft-spoken Senator from South Dakota is unaware that Republicans are laying in wait for any and every opportunity to accuse Democrats of over-politicizing the death of Senator Kennedy. Daschle's article reeks of just that, and will likely be hoisted atop the Republican flag pole as evidence that Democrats are unable to refrain from exploiting Kennedy's death for political gain. To make matters worse, Daschle chose the WSJ editorial pages - the epicenter of intelligent conservative thought - as his venue, ensuring dissemination amongst Republican strategists.

In further aggravation of his cause, Daschle presented a largely emotion-based argument that won't sway a single fact-seeking moderate voter. In summary, Daschle lived up to every expectation and stereotype that Democrats have ever been accused of.

Democrats Ponder Budget Reconciliation on Health Care

2009-09-02T11:41:00.004-04:00

Despite commanding a 60-40 majority in the U.S. Senate, Democrats have thus far struggled to push their health care reform agenda past the committee level. The threat of a Republican filibuster has served as the primary deterrent to this point, however, some Democrats have recently begun suggesting the use of the budget reconciliation process in order to bypass the need for a filibuster-proof majority.

The Budget Reconciliation Process has it's origins in the Congressional Budget Act of 1974, and was originally intended to allow Congress to pursue deficit reduction measures in an expedited fashion. In the years following 1974 though, reconciliation became somewhat bastardized, as it was commonly deployed to increase government spending in targeted portions of the budget - often in violation of committee jurisdictions, and without the usual time for debate. In reaction to widespread abuse of the reconciliation process, Senator Robert Byrd (D-WV) led an effort to reform the process with the introduction of what is now known as "The Byrd Rule". This rule essentially established a procedure whereby members of Congress could object to an "extraneous" element contained in a reconciled budget bill. There are however exceptions to what can be labeled "extraneous" for purposes of a Byrd Rule attack, most notably (if):

The provision will (or is likely to) reduce outlays or increase revenues: 1) in one or more fiscal years beyond those covered by the reconciliation measure; 2) on the basis of new regulations, court rulings on pending legislation, or relationships between economic indices and stipulated statutory triggers pertaining to the provision; or 3) but reliable estimates cannot be made due to insufficient data.

I've specifically pointed out this "exception" because it would seem to offer the Democrats a justification for avoiding the Byrd Rule, and forcing health care reform legislation through the reconciliation process; after all, the President has long argued that the purpose of health care reform is to save money. The real question however is not whether Democrats can use budget reconciliation to achieve their domestic agenda, but whether they will. It's safe to say that the political consequences would be enormous, eradicating even the appearance of Republican cooperation for the remainder of President Obama's term in office. Senator Lamar Alexander (R-Tennessee) even said that, if Democrats should choose to pass health care legislation through the reconciliation process: "There'll be a minor revolution in this country"

I'm not exactly sure what Senator Alexander meant by a "minor revolution", but I'm fairly certain that health care via reconciliation would arouse the Republican base in ways not seen since 1994. The election of that year was coined "The Republican Revolution", as the party assumed control of the House of Representatives for the first time in 40 years. Although these staunch conservatives represent a minority of the country, it's not about how strong your numbers are, but about how many in your ranks vote.

*Great primer on budget reconciliation process and the Byrd Rule

CMBS Delinquency Report Improves on Aberration

2009-09-01T15:56:00.003-04:00

Realpoint - the competition enhancing, transparency embracing, antithesis of the big three NRSRO's - has released it's monthly CMBS delinquency report covering the time period through July 2009. At first glance, my illustrative chart above would indicate that the month of July was a respite of sorts for the agglomeration of toxic underwriting, better known as commercial mortgage backed securities (CMBS). Thanks to Realpoint though, we know that July's decrease was the result of $4.8B worth of loans that have been conveniently returned to "current" status. Apparently, something "went wrong" with these loans in June, causing an insufficient stream of cash to flow down to apprehensive bondholders. We don't have any hard information as to what exactly happened to this $4.8B slug of debt, but it's likely that some sort of temporary workout/modification/capitulation occurred through the efforts of whatever entity is charged with servicing this sludge. I doubt that these loans will ultimately escape the grasp of delinquency, as the current US economy is extremely bifurcated in terms of businesses access to capital and general viability/solvency.

Basically, we've come to a fork in the road where, as a corporation, you are either reveling in the amount of capital that you have access too, or you are slowly burning cash as you drift into the abyss. Furthermore, you are either growing steadily more confident in your firm's top-line and new order prospects, or you are in denial that any economic improvement has occurred since January. My guess is that, at the heart of this $4B "hiccup", there are businesses which fit the latter description, and have become unable or unwilling to honor the terms of their lease agreement. Modifying these loans will not repair the deteriorating fundamentals of the businesses that are struggling to pay for the storefront. This dynamic will continue to characterize the US economy in the months to come.

Parsing the Health Care Reform Polling Data

2009-08-31T15:33:00.004-04:00

As Congress prepares to return home from it's cherished recess, the debate over health care reform stands as the most contentious issue the country is currently dealing with. As such, public opinion polls on the subject are being monitored with a level of vigilance which suggests either ignorance or disregard for these polls' margins of error. Nevertheless, the polls are instructive insofar as offering a reasonably representative snapshot of American opinion. The data I'm using in the following discussion was taken from the most recent NBC News/Wall Street Journal Survey, dated July 2009. The poll interviewed 1011 adults; all but 100 were reached via land-line.

The majority of discussion pertaining to health care reform has, in my opinion, fostered an under appreciation for the role that age plays in determining one's stance on the subject. Perhaps this is because it is easier for the media to discuss this issue in terms of either broad ideological preferences of weak v strong government, or class based, "ability to pay v not" scenarios. Whatever the underlying reasons may be, I believe it's distracted us from the obvious reality that voters tend to advocate for - or against - those policies which they perceive to be the most personally advantageous. For voters who are currently Medicare beneficiaries - or are close enough to the age of eligibility to ascertain that the system will still be solvent at the time of their eligibility - the personally advantageous option is to oppose health care reform. The justification is simply that any new health entitlement program would be partially funded through changes to Medicare; this doesn't necessarily mean cuts to benefits, but seniors would prefer not to test the government on this one. Younger voters on the other hand, are well aware that Medicare will not exist in it's current form by the time they are eligible. They are also somewhat cognizant of the fact that rising health care costs have, over the past decade, taken the place of substantive salary increases. That being said, let's look at the age dispersion from the most recent NBC/WSJ poll:

The age dispersion of the poll's respondents indicates that 50 years old is the 50th percentile; in other words, half of respondents are below 50 years old, and half are below 50 years old. While keeping the age of the poll's respondents in mind, let's move to what I consider to be the most compelling question of the survey: Would you find it acceptable to fund the current health care proposal by reducing payments to hospitals and drug makers for the services or products they provide to patients on Medicaid or Medicare? Below is a chart showing how respondent's answered that question:
With a ~3% margin of error for this survey, you can see that the two answers are statistically very close. My guess is that those between the ages of 18 and 49 answered with a majority "Acceptable" response, and those over 50 responded "Not Acceptable". I'd also guess that as you get closer to the 50th percentile (50 years), the rate of those responding "Not Sure" increases.

Now, however, let me introduce the game-changer: those in the 55+ age bracket show up to the voting booths in far greater numbers than any other age group. Furthermore, this group's voting influence increases significantly during mid-term elections (think 2010). Voters over 55 show up in heavy numbers at both Presidential elections and the mid-terms; younger voters have been known to get excited over a Presidential candidate (think Obama) and increase their turnout at that election, only to dissipate,lose interest, etc. by the time mid-terms roll around. Obviously, this has Congress worried.

Perhaps the above dynamic represents the largest flaw in President Obama's strategy of tossing the health care idea to Congress, and settling into a "hands-off" management approach. I'll reserve final judgment of that strategy until all is said and done; however, should the health reform effort fail, fault may lie with the politically powerful President who ceded the majority of the process to a mid-term fearing Congress.

Which Credit Rating Agency Provoked SEC "Suspicion"?

2009-08-29T14:32:00.004-04:00

The federal government's campaign to tighten the regulatory vice-grip on credit rating agencies (CRO's) intensified yesterday, when the SEC's Inspector General released a report which criticized the very process by which the SEC qualifies and approves those companies designated as Nationally Recognized Statistical Ratings Organizations (NRSRO). The 124 page report featured numerous redaction's, the majority of which seemed to be for the purpose of concealing the identity of one rating's firm in particular. This firm, whose name is as of yet unknown, was discussed in the Inspector's report in the context of SEC "suspicions" regarding the information contained on it's application to become a NRSRO. According to the report, these suspicions pertained to "the accuracy of the financial information provided in its (the secret CRA) application and concerns about the authenticity of a number of certifications". Interestingly, the SEC chose to approve this organization's application prior to any sort of an investigation into the merits, if any, behind these internal "suspicions". In other words, the ratings firm in question is conducting business at this time. Now, for reasons likely based in my own naive/idealistic opinions regarding the need for transparency at all levels of government, I would like to know the identity of this NRSRO.

The Wall Street Journal has already conducted an initial round of leg-work on this issue, mentioning that the SEC's report reveals that the troubled firm is funded by subscriber-fees. With this knowledge in hand, we can apparently rule out S&P, Moody's and Fitch - all three of these major NRSRO's are compensated by the Company whose debt/securities are being reviewed. With the three market share leaders ruled out, the question becomes: who is left?

According to the SEC's website, ten separate companies have received commission orders granting NRSRO registration. Three of those ten have been ruled out, leaving the following seven as potential candidates:

Egan-Jones Rating Company
Realpoint, LLC
LACE Financial Corp.
A.M. Best Company, Inc
DBRS Ltd.
Japan Credit Rating Agency Ltd.
Rating and Investment Information, Inc.

Based upon the NRSRO registration orders, both Realpoint and LACE Financial Corp. had to cross an extra hurdle with the SEC prior to receiving their respective designations. In both instances, the firms had to convince the SEC to be lenient in it's application of a regulation which prohibits an NRSRO from receiving greater than 10% of it's revenue from a single client; the obvious implication here is that, above that 10% threshold, a client could wield undue influence on the ratings firm, possibly compromising the independence of the rating decision. It appears that both CRA's were able to circumvent this requirement by asserting that "the 10% client" (SEC documents didn't reveal the identify of these firm's largest client) would only represent ~7% of revenue in the year immediately following NRSRO designation. I'm not sure this specific issue fits the description of the SEC's suspicions from the report; it also appears that the SEC conducted it's due diligence with regards to Realpoint and LACE - an action that was notably not taken insofar as the single suspicious NRSRO is concerned.

A review of the remaining CRA's will take a little more time than I have today, so this will have to be followed up with a more detailed analysis. I will say that it's unlikely A.M. Best is the source of SEC angst, as they have been around for 100 years or so. Anyone with any ideas about this can shoot me an email; the address can be found by following the "view my complete profile" link on the right-handed side of this page.

*no position in any credit rating agency, NRSRO, or their parent or affiliated companies.

Durable Goods and New Home Sales: Deciphering Government Noise

2009-08-26T19:35:00.002-04:00

The string of positive economic news continued today, as orders for durable goods - bigger ticket items expected to last at least two years - rose 4.9% from a month ago. This news was accompanied by a report which showed new home sales rising 9.6% from a month ago. Unfortunately, both data points could have been significantly influenced by short-term government programs; a prospect that now forces investors to decipher which pieces of economic news are in fact positive, and which are the result of a government distortion.

We all know that Cash-For-Clunkers was a major success, at least in the short term, for overall sales of automobiles. When looking at the durable goods numbers, it's important to realize that new auto orders were included in this data. Whether the rise in durable goods orders is sustainable will be tested in the coming months.

With new home sales, the reality is that buyer's most likely took advantage of the first time home buyers tax credit with a slight bias towards new homes. Builder's are able to price new home more attractively than the individual homeowner, and can offer very appealing incentives. Many homebuilders are offering to pay a buyer's mortgage points, effectively lowering the interest rate to below 5% on a standard mortgage product. A seller of an existing home has an outstanding mortgage balance to contend with, and might not be able to compete with a public corporation's ability to write down the value of newly sold homes for tax purposes.

I don't want to convey that there is no reason to have hope for an economic recovery; the point is that digesting data now, and in the near future, will require a second or third look to determine the actual viability of a developing trend.

Social Security's Cost of Living Conundrum

2009-08-25T14:41:00.003-04:00

As anyone who receives Social Security benefits probably knows by now, the trustees who oversee that vast entitlement program have forecast that there will be zero cost of living allowance (COLA) over the next two years. COLA's are calculated by the government every year, and are meant to provide Social Security recipients - many of whose incomes are fixed in nature - with a small "raise" if you will, in order to cover the rising cost of living. The government uses the consumer price index (CPI) as it's preferred measure for determining the acceptable COLA amount for each year. Anyways, this latest news concerning a lack of cost of living allowance for the next two years has obviously aggravated seniors. Although headline CPI is in negative territory, nothing about the cost of living actually feels like it has decreased. Furthermore, prescription drug prices are on the rise, and since many Social Security recipients have their drug premiums deducted straight from their benefits, it's pretty certain that next year's checks will be smaller than today's.

As we all know however, senior citizens are especially fond of the voting booth; in turn, politician's tend to cater towards issues that seniors care about. The National Committee to Preserve Social Security and Medicare (NCPSSM) understands this reality, and has already begun lobbying Congress for a one-time cash payment to social security recipients. This bailout of sorts would, in theory, bridge the gap between what the NCPSSM believes SS recipients should be earning next year, and what the CPI has dictated they shall earn. My research does show that cost of living allowances have been particularly generous in the past; for instance, the 2009 COLA will boost payouts to seniors by 5.8%. As you can see from the 10-year chart below, cost of living allowances have historically been consistent and fair.

As a nation, we frequently and vaguely lament the fact that "tough decisions" will need to be made if we are to ever get our budget balanced and our finances generally in order. Well, this is one of those tough decisions. I completely understand the difficulties that seniors face, particularly with regards to the seemingly parabolic rise in health care costs. However, I would assert the following:

Social Security benefits need to be based in some sort of reality, that is, based in some way upon the ability of the government to tax the wages of those who are currently paying for SS. We all know that current recipients have paid into the "fund" for most of their lives, however, that money is gone. Social Security is a Ponzi-scheme that I am paying for right now. Private sector wages are quite depressed right now, therefore less is available to pay for this program. Continuing to borrow with the hope that the problem will fix itself isn't an option.
This is what a difficult decision looks like. It is difficult because specific examples of hardship can be legitimately cited by opponents of the difficult decision. This is a shortcoming of democracy (the worst form of government, except for all the others of course).

We all know that Social Security is on a ridiculously unsustainable path; let's not destroy it beyond recognition (I'm assuming we're not there yet) because annual CPI didn't go beneficiary's way this year. I'd hate to see such a precedent established.

S&P/Case-Shiller Price Index Turns Positive For June

2009-08-25T10:15:00.005-04:00

June of 2009 was a positive month for home prices across most of the nation, according to today's S&P/Case-Shiller Home Price Index report. The release indicated that home prices in the 10 and 20 city composite rose 1.4% MTM. More impressive though, was the news that the 2nd quarter as a whole posted positive price action compared to the first quarter - the first quarterly gain recorded in three years. The chart above illustrates the well-defined trend which began somewhere between March and April of 2009, and characterized by a stabilization of sorts in US housing prices. Other notable observations:

Cleveland once again posted the strongest MTM performance, with a 3.8% rise in house prices. Las Vegas was the loser, with a -2.86% decline in home values.
Dallas home prices held up the best over the past year, only declining 2.27%. Las Vegas home prices logged a -32.42% YOY price performance, the worst in the nation.

Today's report indicated that, potentially, the adverse pricing effect of foreclosures is beginning to moderate. My read is that the unprecedented level of foreclosure activity will continue to hold down the headline average and median prices for most of the nation's metropolitan areas. However, this report may be a signal that foreclosures will no longer contribute to percentage declines in the headline. The high volume of foreclosure activity recently - they represented roughly a third of July's existing home sales - indicates that for the most part, foreclosures are priced at a level attractive enough to spur investment. I haven't seen any valid data yet showing what proportion of foreclosure sales are being completed by funds investing in distressed real estate, but I suspect that this sort of opportunistic buying is strongly contributing to the uptick in activity.

API Report Derides Waxman-Markey Legislation (H.R.2454)

2009-08-24T11:12:00.003-04:00

An American Petroleum Institute (API) commissioned report, released today, examines the potential consequences of H.R.2454 - a.k.a the Waxman-Markey bill - insofar as it may impact the US refining sector. Readers should understand that the report, produced by consulting firm EnSys Energy, was commissioned and funded by the lobbying arm of the United States oil and gas industry. Proponents of H.R.2454 will likely compare today's report to the infamous tobacco industry research, which for years denied the existence of adverse health outcomes from cigarette use.

I would venture to say however, that EnSys Energy has chosen to focus on some of the oil industry's more valid points, namely that Waxman-Markey will:

Decrease the level of investment in US refineries; thus reducing the country's overall refining capacity, and increasing our dependence on foreign sources of oil.
Have a negligible effect on CO2 emissions produced by emerging markets; the countries that currently represent the lion's share of worldwide growth in carbon dioxide emission.

My major contention with the policy debate surrounding climate change is that skepticism - the default position of science - has been characterized as sheer villainy when applied to any discussion of CO2 and it's effect on climate. Furthermore, I am not convinced that the level of investment supposedly required to curb CO2 emissions is in any way proportionate to the benefits that we can expect to receive. This is not to say that I am against investment in renewable sources of energy; peak oil is fast approaching (if not already here), and the US is dangerously dependent on foreign sources of energy. With that being said, I can live with piling "climate change" on the list of reasons to diversify away from petroleum as our primary source of energy. None of this should be overdone though, as we should, without a doubt, be maximizing our sources of domestic oil while the transition takes place.

ENSYS Cap and Trade Briefing 8-20-09

Why Are Banks Raising Credit-Card Interest Rates?

2009-08-23T02:55:00.002-04:00

I'm quite interested to know why any credit-card issuing company would be raising the interest rate it charges card holders at this time. If you'd prefer to be realistic about a company's motivation for doing such a thing, you must consider the symbolic nature of what such an act means, particularly in light of the government's recent directive. The Credit Card Accountability, Responsibility and Disclosure Act was a direct challenge to those banks involved in credit card issuance to American consumers. The Act basically reigns in some of the industry's more abusive practices, such as requirements that a bill must be delivered at least 21 days prior to it's due date. Extremely restrictive.

With this knowledge in hand, I'm really wondering why I know people whose credit card interest rates were just raised on Thursday. Perhaps they think that most people will just sit back and absorb the painful rate increase. It's apparent that they are mistaken on this assumption. The funny thing about capitalism, is that it creates a service whenever there is a need. Balance transfers will spike upwards in the next month, considerably.

University-Themed Bud Light Cans Cause Misplaced Furor

2009-08-21T15:25:00.004-04:00

I can't help but comment on a front page WSJ article from yesterday, entitled "Team-Color Bud Cans Leave Colleges Flat". Basically, Anheuser-Busch is facing the once-unthinkable prospect of a decline in annual Bud Light sales (by volume). In a bid to revive sales, Anheuser developed a marketing campaign that is the functional equivalent of a politician rallying his base of voters. The base, in this case, is the college drinker. Anheuser apparently identified 27 of the larger state-funded Universities, and began customizing the color scheme of Bud Light cans sold in these markets so that they would correspond approximately to the respective institution's school colors. For instance, Bud Light cans sold in the Baton Rouge, LA area were painted purple and yellow, the official colors of Louisiana State University (LSU). To clarify however, the cans do not bear the school's name, nor do they claim to be affiliated with the university in any way. Needless to say, the marketing campaign was not a big hit with the administrations of several universities; some of which even resorted to calling in the lawyers to demand that the cans be removed from store shelves. I have two problems with this sort of reaction, both of which are derived from my experience in college.

First of all, I must assume that any official efforts on the part of university administrations or advocacy groups to condemn alcohol related marketing have, as their primary purpose, the desire to reduce the total amount of college drinking. I would presume that with regards to students of legal age, these groups would have as a goal the reduction of binge drinking - a push towards moderation if you will. Next, I must also assume that state universities are forced to take the position that there should - in an ideal world - be zero consumption of alcohol by students under the age of 21. Assuming (once again) that these are reasonably attainable goals, the question then becomes whether attacking a Bud Light marketing campaign is an effective strategy towards achieving that goal. I'll go ahead and answer my own question: it is not (an effective strategy). I can state with certainty that a university-themed Bud Light can will not convert a single non-drinker into a drinker. Decisions about whether or not to drink in college are personal in nature, and are not influenced by the uniqueness or cleverness of a beer maker's marketing strategy. The only effect that these specially colored cans will have upon beer purchases is that, almost certainly, Bud Light will steal market-share from other brands of beer. Ironically, it's most likely that Bud Light's gain will come at the expense of Natural Light and Busch Light (the most cost effective choice); both of which are Anheuser/Inbev products! Therefore, I must come to the conclusion that university officials are either out of touch with reality, or - and this is the more likely scenario - their motivation has more to do with creating the "appearance" of doing something about college drinking. The universities that are actually in tune with reality, and setting policy that is truly in the best interest of college students, are those institutions with the courage to offer shuttle services for students to and from the area's nightlife/bar centers. Measures like that are amazingly effective at curbing drinking and driving which, let's face it, poses the more substantial safety risk to students.

My second problem with university officials is that, while condemning the simple color of a beer can, they are actively allowing credit card companies to solicit their product on college campuses; often while using alcohol related marketing to push credit cards onto students. Within a week of arriving on campus as a freshman, I was accosted by a credit card salesman on the way to class. The guy had a booth set up in the middle of university property, where he was prominently displaying free T-shirts available to anyone willing to fill out a credit card application. These T-shirts had a super-sized image of a bottle of Absolut vodka on the back, which were customized with my school's name via the headline message "Absolut [insert university name here]". Luckily, I had the sense to fill out the card application, pocket the free Tshirt, but never accept delivery of the credit card. Others were not so fortunate, and subsequently fell into credit card debt prior to even graduating into the real world. The point is, allowing these solicitations on campus is extremely hypocritical of the universities in light of their attacks against an off-campus Bud Light marketing scheme.

This latest case of alcohol related university furor is completely misplaced, and should be directed towards solutions that will actually help improve the lives of students.

*no position in Anheuser-Busch/Inbev

Housing Market Improves as Tax-Credit Deadline Approaches

2009-08-21T10:39:00.005-04:00

The National Association of Realtors this morning announced it's estimate of US existing home sales for the month of July. The data showed a substantial uptick in sales, representing an increase of 7.2% from the month of June, and a 5% increase compared to levels seen a year ago. The latest surge in activity is a relatively well-timed "event", as new housing starts have stagnated at an extremely subdued level over the past few months. The combination of stagnating or declining starts, and rising sales is a confluence of activity that is necessary for a recovery of the US housing market. As I've stated previously, the further that these two trends diverge - think widening spread - the faster the market can absorb the glut of unsold inventory. Although today's release indicates that we are currently diverging in the proper direction, there is a risk that still remains.

As the cognizant amongst us are aware, the stimulus package has provided for a First-Time Home Buyer Tax Credit worth $8,000. And yes, this credit is "the good kind"; in other words, it isn't a deduction against taxable income, but rather a full, refundable even, credit against taxes owed to the federal government. The problem is, to be eligible for the credit, you must purchase your first home prior to December 1st, 2009. The question then is, to what extent can we attribute the recent jump in existing home sales to the existence of an $8,000 tax credit? Additionally, are we merely witnessing a phenomenon whereby the majority of tax credit related purchases have been delayed until the final months of the "program"? Another somewhat similar government program, Cash-For-Clunkers, was exceedingly more measurable due to the real time processing of rebates by auto dealerships. With the home buyer tax credit though, we'll have to wait until tax season before any reliable data becomes available. The alternative indicator would be a severe drop in existing home sales beginning with the December 2009 data. Hopefully we won't have to find out that way.

Private Prisons: A Reliable American Growth Industry

2009-08-20T15:38:00.007-04:00

With the exception of the government's borrowing and spending activities, there are hardly any segments of the US economy that appear to have been inoculated against the recession which began in December 2007. There is one aspect of society however, that has continued to expand despite the difficult economic circumstances: the prison population. Additionally, and contrary to what many believe, the construction and management of jails and prisons are not functions exclusive to the government. In fact, the fourth largest correctional system in the nation is owned and operated by the Corrections Corporation of America (CXW) - only the federal government and two states operate prison systems containing more bed space than CCA. As you can see from the chart below, the United States prison population has consistently risen since 1980 (earliest year I could find available data).
Furthermore, over the same 28 year period, the total US jail and prison population has represented an increasingly larger percentage of the total US civilian population.

Regardless of whether the US economy has technically bottomed or not, the reality is that cities and States across the country are dealing with substantial budget gaps that will require difficult decisions. (The same is obviously true at the federal level, with the exception of the difficult decisions part; Washington tends to avoid those). The situation is unlikely to improve in 2010, as continued property reassessments will diminish the property tax base even further. That being said, the decision to privatize prison construction and operation should appear ever the more attractive to States looking to save money.

Let's assume for a moment though that, for whatever reason, the growth of private prisons does not deviate from it's current trajectory, and CCA simply continues doing what it has over the past 5 years. Construction Corp. of America has clearly demonstrated solid revenue growth over the past half-decade. The Company's earnings have been growing at a more subdued pace since 2005, but capital expenditures have absolutely exploded; growing from $73.9M in 2005, to $516M in 2008. CCA isn't pouring nearly a third of it's annual revenue into new property/plant investments without a reason. I'd expect that in the coming quarters, this amount of investment will begin to yield tangible returns for the Company.
Throughout the history of modern society, there has been a consistent need for the State to remove criminal offenders from the civilian population. In fact, this is considered the most basic responsibility of a government to it's people. As the need for prison space continues it's inevitable rise, the Correctional Corporation of America should be uniquely positioned to offer government an efficient incarceration solution.

*no position in CXW

How Many Votes Does a Health Care Bill Need?

2009-08-20T09:47:00.006-04:00

As the August recess nears an end, and those politicians who managed to survive their respective town hall events - intact - prepare to return to Washington, the focus of the health care debate is slowly shifting towards vote calculation scenarios. Although the Democrats command overwhelming majorities in both houses of Congress, it would appear that the Party can not count every Congress person with a "D" beside his/her name as a vote in favor of Health Care reform. Furthermore, the newly invigorated Republican Party has begun to seize upon the tenuous level of support in Congress for the plan, suggesting that any health reform bill must receive the blessing of at least 75-80% of Congress in order to be perceived as a legitimate mandate. Senator Mike Enzi (R.,Wyo.) had the following to say about the health bill, and the Congressional support that is supposedly required of it:

"We need to get a bill that 75 or 80 senators can support...If the Democrats choose to shut out Republicans and moderate Democrats, their plan will fail because the American people will have no confidence in it"

After pondering Senator Enzi's statement for a moment I realized that the Senator simply should know better than to make such a bold assertion. Mike Enzi has been in the Senate for over 12 years you see, so he would have to have been around for the Senate's 2003 passage of the Medicare Prescription Drug Improvement and Modernization Act; the legislation that instituted Medicare's Part D prescription program. Ironically, that bill passed the Senate with a 54-44 vote - a confidence-less margin by Senator Enzi's reckoning - yet has likely become an immutable aspect of our health care system.

This inconsistency could possibly be explained by examining the voting tendencies of Medicare Part D recipients v those who would benefit from today's proposed legislation. Younger people have largely abandoned voting due to disillusionment with the system as a whole, in addition to the pervasive apathy that's too common. Lawmaker's understand who shows up on election day, and they act accordingly.

*there's a great movie entitled "10 Trillion and Counting"that provoked some aspects of this post.

Commercial Property Prices Drop 1%, Sales Volume Surges

2009-08-19T16:08:00.003-04:00

Moody's and REAL Capital Analytics today released it's monthly commercial property report, which includes price data derived from transactions occurring through June 2009. I was planning on including the full report below, but apparently I had underestimated the technological prowess of Scribd, who emailed me about my copyright violation only seconds after uploading the document. Forgive me for assuming that a public posted document (you can download here) is hands off.

Anyways, the key message to take from today's report is that aggregate measures of commercial property prices continued to decline through June. The silver lining however, is that the May-June decline of 1% represents a substantial improvement from the 7% decline during the April-May period. Moreover, the significant lag in data reporting means that the price declines could have moderated further during July and August. Other relevant notes from the report:

All commercial property types, on aggregate, have declined 26.9% in price from a year ago
Atlanta was the top performing city across all property types (Office,Retail,Apartment,Industrial)
Washington DC was the worst performing city across all property types
The dollar value of sales volume increased 40% in June v May

The percentage declines in commercial property prices actually seem relatively mild when compared to the year over year declines in dollar value of sales volume. In June of 2008, the Moody's/REAL data recorded nearly $20Billion worth of commercial property transactions; by June 2009 that volume had dropped to $4.4Billion, or a 78% decline. Once again in real estate, we're faced with a dynamic where the headline data may indicate a high percentage increase from the previous month; however, the increase is only high in percentage terms because of the infinitesimally small base from which it's measured. The truly bearish of the world keep waiting for the commercial shoe to drop; hasn't it already?

Bloomberg: Goldman Sees Strong 10- Year Note

2009-08-19T10:56:00.003-04:00

Goldman Sachs predicted today that the 10-Year Treasury note will rally considerably in the next 6 months, according to a Bloomberg exclusive. The yield on the 10 year, currently at ~3.45%, is forecast by Goldman to reach 3.3% in the next 3 months, and 3% in the next 6 months.

For reference sake, the 10 Year Treasury note last yielded 3% on April 28th, 2009. At this time, we were in the midst of an 8 month decline in Treasury prices, following the flight-to-safety panic buying of Treasuries that peaked in December of 2008. Consequently, on April 28th, the S&P 500 stood at ~855, or ~13% below today's value of 987.

Many pundits have explained the ferocious rally in US equities as being partially a result of investor's re-allocation of capital out of safe assets and into riskier ones. This trend, according to the punditry, has been most pronounced in the selling of US Treasury notes/bills/bonds, and the purchasing of equities. Assuming that this line of reasoning is correct - the alternative is that there is no rational basis behind the stock market's rally - the logical conclusion is that the next 6 months will feature an under-performance by stocks relative to Government debt. Although such a trend may hurt the feelings of stock market investors, it may be necessary if the US Government is to issue the massive amounts of debt that it has planned for the upcoming months.

*long several components of the S&P500. This will likely change after Friday, as I've overwritten all positions and look to be called away on each.

Why July's Decline in Housing Starts is Good News

2009-08-18T16:17:00.005-04:00

The Census Bureau, along with HUD, today released it's monthly update on various measurements of new housing construction and related indicators. I'd direct readers to focus on the housing starts figure, as this data series is arguably the most indicative of the future direction of the US housing market. For July, new starts for all categories of residential housing logged in at a seasonally adjusted, annualized rate of 581,000. That number represents a 1% decline from the prior month, and a 37.7% decline from the rate reached in July 2008. Despite being what can be described as the continuation of a sharp decline in new housing activity, today's figures should be construed as positive news for both the economy and the housing market.

Economists talk a lot about the need for an "equilibrium" to be established in the housing market. Basically, this means that excess inventory must be removed from the market so that the supply of housing can be reduced to meet current levels of demand. An equilibrium can also be reached by stronger demand, but in order to remain realistic I'll focus on the supply side of the equation. Clearly, in order to reduce the supply of something, you have to stop producing so much of it. Based upon the chart above, the period between 1959 and the present contained a relatively reliably level to which starts needed to drop in order to compensate for subdued demand. For the most part, housing starts have rarely remained below the 1 million annualized rate for any extended period of time. The current recession however, introduces a destructive wild-card to the equation: foreclosures. There may be some estimates out there, but nobody truly knows just how many foreclosures are sitting on bank's balance sheets. Further exacerbating the problem is that bank's are releasing these toxic properties onto the market in a way very similar to the slow drip of medication from an IV. Moreover, the rate at which this shadow inventory will be released back unto the market is roughly commensurate to the speed at which financial institutions are able to increase earnings growth.

The bottom line is, the faster and further that housing starts fall, the sooner the market will be rid of it's excess inventory. I'd really like to see housing starts drop to the unprecedented annualized rate of between 350-400,000. I'm fairly confident that at that point, we could begin the process of reducing inventory levels that is an obvious pre-requisite to a sustained recovery. The best stimulus measure that the government could have instituted for housing was to purchase vacant homes on a widespread basis, and literally demolish them. For now though, we'll just have to wait for the market to perform the functional equivalent of that idea on it's own.

Does Private Health Insurance Involve Death Panels?

2009-08-18T09:15:00.002-04:00

By now, assuming that you are at least vaguely cognizant of what's happening in the health care debate, you are well familiar with the concept of "death-panels". The notion that under a public health insurance option, one's ability to continue receiving care at an old age would be dependent upon the decisions made by a bureaucratic panel of "Deciders", was abruptly injected into the public discourse by Sarah Palin, courtesy of her Facebook page. Thus, we are led to a logical fork in the road: Either Sarah Palin is choosing to be deliberately dishonest, or she has exceedingly poor reading comprehension/analysis skills. In reality, none of the proposed health reform bills contains anything remotely close to the establishment of a death-panel. Perhaps Ms. Palin misunderstood a portion of the bill that would provide Medicare coverage for end of life counseling with a doctor. Regardless of the former vice-presidential candidate's motivations, her guerrilla warfare did provoke some pondering on my part. My logic proceeded as follows:

Let's assume that the government did establish death panels. They are distasteful yes, but the public is provided with the explanation that these death panels will increase efficiency and save everybody money. Still though, critics insist that the government can never be as efficient as the private health insurance industry. I would respond to those critics by completely agreeing with them. Why? Because in the realm of private health insurance, the industry has evolved - in a capitalistic sense - beyond the use of something so inefficient as a death panel. It's an extreme waste of time to force a panel of professionals to hear these cases one by one by one by one. Especially in the coming years, as the baby-boomer population ages, can you imagine how busy that death panel would be? Besides, these death panels - according at least to the popular portrayals of such - would be forced to take into account the person's worth to society, and calculate how many years of productive life he/she had left on this earth. The private health insurance industry however, being an evolved specimen of an industry, long ago realized that the only way to operate the gig profitably was to run the business strictly by the numbers. I had a statistics professor in college who turned out to only be a part-time employee of the university; her full time job was with Blue Cross Blue Shield, where she ran statistical models all day to identify wasteful claims. Health insurance companies don't have death panels, they have actuaries and statisticians running models which have a degree of complexity beyond the grasp of average citizens. Your fate lies in the hands (microprocessor) of a computer.

Perhaps therein lies the heart of the confusion. Maybe folks are just more scared of the easily envisaged Government solution than the insurance models, for which they don't know what they don't know. But wait a minute. If we've already confirmed that a government option has no provision for the mythical "Death Panel" creature, then what are we really to conclude?

Citizens United v FEC Poses Major Campaign Finance Test

2009-08-17T15:38:00.003-04:00

An extremely compelling Supreme Court case is approaching oral argument time, currently scheduled for September 9th, 2009. The case, Citizens United v. FEC , will simultaneously invoke issues concerning the First Amendment and Campaign Finance reform. Here's a brief background:

In late 2007, a conservative advocacy group named Citizens United - a 501 (c)(4) nonprofit whose activities include the routine creation of political films - finished production of a film titled "Hillary: The Movie". Without getting into too much detail, it's safe to say that "Hillary: The Movie" is not a film that seeks to portray the Secretary of State in a very positive light. Anyways, one of the ways that Citizens United attempted to promote it's new film was by paying a cable news network to offer it "on-demand" to it's subscribers; that's of course in addition to the typical means by which a movie is promoted. The promotion of this film was abruptly halted however, when the Federal Election Commission determined that the Citizen United film amounted to "electioneering communication" or EC. This relatively new component of campaign finance law, EC, was put in place to prevent corporate treasuries from funding campaign commercials within 30 days of a primary and 60 days of a general election. Although the logic behind the regulation of electioneering communication is immediately recognizable, there is a legitimate case to be made that the government has engaged in suppression of political speech - a first amendment violation.

Adding a considerable amount of intrigue to this case is the composition of the groups which have filed supporting briefs to the Supreme Court, and more specifically, which side of the issue these groups stand. For instance, the ACLU and Republican Senator Mitch McConnell have sided with Citizen United; doesn't Fox News consistently portray the ACLU as an extreme right wing organization? On the FEC's side, we have a healthy dose of women's advocacy groups, John McCain, and Russ Feingold, among others. My initial inclination is that this case strikes a chord with conservatives, who traditionally speaking, have not been as successful as their liberal counterparts in developing widely distributed film productions.

The case took an interesting turn earlier today, when Senator McConnell (R-KY) successfully petitioned to the Supreme Court to extend the time allotted for oral arguments from 60 to 80 minutes.; obviously, this was so that his lawyer would have time to argue. The Senator's interest in Citizens United v FEC stems from a 2003 case - McConnell v FEC - in which several portions of the Bi-Partisan Campaign Reform Act (BCRA) were overturned as unconstitutional.

Ultimately, I'd say that the conflict which led to Citizens United v FEC is more a reflection of our nation's inability to craft reasonable campaign finance law than it is an issue of Big Brother censorship. In an ideal world, a politician's success would not be contingent upon his or her ability to raise vast sums of cash; unfortunately though, there is an almost unbreakable symbiotic relationship between finance and politics. As long as cash continues to be funneled into nonprofits and special interest groups, for the purpose of advancing their political agenda, it's literally pointless to attempt to impose limitations upon individual donors. Besides, the restrictions on individual giving are even flagrantly violated on a regular basis; just check out OpenSecrets and search for a donor by his last name. Notice all of the donors who list their occupation as "Home Maker", and maxed out their donation along with someone else sharing their last name? Here's my suggestion:

Have everyone in the country contribute 50 cents a year towards election financing. Then, take that $150Million and apportion it across federal elected positions according to some sort of sliding scale. Obviously, Presidential campaigns cost more than a House Seat. Television commercials will be regulated such that each candidate has an equal amount of air time. Television commercials will only be allowed 30 days prior to an election. Republicans and Democrats will not have a monopoly on this funding either; it should be determined based upon the ability to garner a reasonable number of signature on a petition - depending of course upon the size of the electorate. These funds will also be used to purchase a campaign bus for all qualifying candidates; the bus must meet fuel efficiency standards. Each candidate(s) will have the same amount of cash to finance campaign trips - the transportation for which will be limited to trips on the bus of course. Special interest groups will be allowed to set up a website advocating their position. It may include videos or other interactive media features. The federal government will host it's own website, which will link to all of the various special interest group sites according to category or issue. A reasonable site-traffic threshold will be established that must be met in order to have your interest group's site listed. Prior to the election, public libraries will make special accommodations for those who can't afford a computer so that they may view the special interest group websites. Those who are computer illiterate may also visit the library, or they may pay an extra $1 on their tax return to fund a small printing effort that will distribute copies of all interest group literature to those who choose that route. Finally, any politician caught using cash outside of the "public pool" to finance his election will be barred from public office for life. Any other suggestions?

*Research for this post facilitated by InfoNgen

Treasury International Capital (TIC) Update June 2009

2009-08-17T10:18:00.003-04:00

The Treasury Department this morning released it's monthly Treasury International Capital (TIC) update. Despite the two month lag time in the data, the TIC update serves as an instructive indicator of foreign appetite for US Treasury bonds and notes. I'll try to update the chart on a monthly basis to include a 24 month rolling snapshot of net foreign purchases of US Treasury bonds and notes. The data provided by Treasury breaks the headline net purchase number into categories based upon the nature of the foreign entity, i.e Foreign Official Institutions, Other Foreigners, and International & Regional Organizations. Barring any substantial deviations in the purchasing ratios between these three groups though, the headline figures from the chart above should suffice in gleaning the overall picture. Other notable data points from the release:

US residents net purchases of foreign securities for the month totaled $32.9Billion
Banks' net dollar liabilities to foreign residents decreased by $82.9Billion

I would expect the next couple months worth of data to indicate an even larger increase in foreign holdings of US debt, due simply to the record breaking size of Treasury auctions that were conducted in those months. For now, it appears that the US is still a parking garage for the world's surplus capital.

*research for this post facilitated by InfoNgen

Which Demographics Will Benefit From the Proposed Health Care Reform?

2009-08-15T19:31:00.003-04:00

After observing and absorbing the furor which has erupted in opposition to President Obama's health care agenda, I concluded that there are a number of inconsistencies and contradictions inherent to the opposition's argument. As a disclaimer, I'm not speaking from any particular point of view here; simply observing and applying a dose of logic.

First of all I must pose the question of who, exactly, stands to benefit most from a public health care option. Many of my acquaintances, in addition to many in the exasperated town-hall-attending population, are convinced that President Obama's purpose in pushing health care reform is to provide the poorest segment of the American population with free, or heavily subsidized, health insurance. Some of the more ignorant comments - which are not worthy of further examination - attempt to inject some sort of racial angle into the President's calculus.

Another cause for the anger being shown by many is the perception that Medicare will either be viciously trimmed, or in some strange instances, removed altogether. Simply stated, seniors hear the word "inefficiencies" in the Administration's rhetoric, and they immediately interpret this as code for "cuts to benefits".

Some people think that their ability to purchase good old private health insurance will be taken away by any reform effort. I'm not sure why anybody has arrived at this conclusion; most likely they are taking too seriously President Reagan's comments in which he likened a public option to a Trojan Horse, whose ultimate goal is to abolish the private health insurance industry altogether.

Who will benefit from the proposed health care reform? Perhaps the better question is, Who doesn't have health insurance right now? Well, upon turning 65, a citizen is automatically entitled to Medicare; seniors are obviously not the beneficiary. What about the poor? Well, they are eligible for Medicaid; assuming of course that they are eligible under State guidelines. Each State has a separate set of guidelines, but the bottom line is that most people at or below 133% of the federal poverty line will be eligible for Medicaid. For perspective, there are roughly 2.4Million eligible Medicaid recipients in Florida alone. So now we've ruled out both the poor and the old. What's left are the middle-aged and the middle class; my assumption of course being that the upper echelons of society are not overly burdened by health insurance premiums. Why don't people get this? The people doing the most screaming at the town-halls would seem to be those who stand to benefit the most!

To address those amongst the elderly who are concerned about cuts to Medicare, I would simply propose an either or situation that will occur at some point; I am nearly 100% certain. Either taxes must be raised in the near future to fund Medicare's ballooning cost, or the entitlement program will have to be trimmed down to meet the federal government's capacity to pay for it through tax receipts. If you oppose health care reform because "we can't afford to pay for it", I would respond by saying that we certainly can not afford to proceed with a business as usual attitude. Medicare and it's growing costs could potentially bankrupt this country; something will HAVE to be done about. The choice is, whether the elderly would prefer that reform to occur now, or when the nation has literally reached a crisis point over this program. If I were a Medicare recipient, I would prefer that reform happen now. As history has shown, the United States is prone to reacting irrationally in a crisis. Now at least, baby boomers and Medicare recipients represent a majority of the registered voter population. Keep in mind that in 20 years, this likely won't be the case. Proceeding forward with reform now will at least give boomers and the elderly a majority voice in shaping the characteristics of a more sustainable approach to health care.

July CPI Figures Highlight Deflation Risks

2009-08-14T16:38:00.002-04:00

The Consumer Price Index (CPI), a broad measure of the prices paid by American consumers for a broad basket of goods and services, fell further into negative territory for the month of July. The data, released today by the Bureau of Labor Statistics, corroborates the assertion made by many - including myself - that deflation poses a more imminent threat to the economy than the widely assumed inflation threat. The inflation-phobes - of which there are many - are simply unable to fathom a future that Doesn't contain rampant inflation. This primarily has to do with a certain relationship which is falsely assumed true by the public, specifically:

Media headlines that have routinely contained figures in the hundreds of billions with respect to the size of Federal Reserve intervention and money-supply creation.
The widely accepted belief that If money is created, Then inflation will follow.

Such analysis completely ignores what is presently occurring in the economy in general, and the labor market in particular. It is common knowledge that labor costs (wages etc.) represent the largest single expense for the majority of companies. With record numbers of unemployed individuals today, competition in the labor market is fiercely intense. That competition results in workers accepting far lower wages; a reasonable trade-off considering the alternative. Thus, the largest expense that a company faces is shrinking. Lower wages beget less consumer spending and heightened price consciousness, triggering high levels of competition for attractively priced goods and services. And so the process continues, resulting in what economists refer to as deflation.

Greenpeace Intercepts Rogue Oil Industry Correspondence

2009-08-14T15:24:00.005-04:00

It's important that any organization, whether involved in international espionage or more subdued activities, be careful about what, and to whom, it emails. Such is the lesson learned today by the American Petroleum Institute (API) - the oil and natural gas industry's robust lobbying arm - when the environmental advocacy group Greenpeace purported to have intercepted an email from the API to it's membership. The three page email (below) describes the methods by which the API intends to oppose key climate-change legislation; at times the email even cites the results of public opinion surveys to corroborate the claimed effectiveness of a particular message or strategy.

The API and Greenpeace are mortal enemies. Therefore, we should probably assess this latest development with caution. For it's part, Greenpeace claims to not support the Waxman-Markey bill either - although their opposition stems from the group's feeling that the bill is too industry-friendly. Finally, I'd point out that this leaked correspondence directs API members to engage in what has become known as "Astroturfing" - a nearly worn out phrase intended to suggest that a forgery of a grass roots movement is at hand. In the health care debate, the left has continually accused the right of staging these AstroTurf protests; a claim that the right has both taken offense to and denied. Anyways, the emergence of actual proof that astroturfing is alive and well with the right wing may - just may - help to support liberal claims that the practice is more widespread, and is actually being used by opponents of health care reform. The process by which that occurs is obviously a "find an example and extrapolate to an entire population" procedure; not the most logically/empirically sound, but effective nonetheless.

*Research facilitated by InfoNgen

API Email to Membership

$12M Ad Campaign Launches in Support of Health Care Reform

2009-08-14T09:27:00.003-04:00

Yesterday marked the launch of a well-funded, targeted television ad campaign, designed to engender support for President Obama's health-insurance reform agenda. This initial campaign comes with a $12M price tag, and is financed by an unconventional consortium that includes organizations representing union - as well as corporate - interests. The coalition, which is known as Americans for Stable Quality Care, is comprised of the SEIU, the American Medical Association, and the pharmaceutical industry's primary lobbying arm - the Pharmaceutical Research and Manufacturers of America (PhRMA).

The nationwide blitzkrieg of President Obama's health care message comes at a politically crucial moment, as the raucous nature of recent town hall events has virtually consumed all major media coverage of the evolving debate. The media's decision to devote vast swaths of programming time to health care reforms boisterous critics has created an interesting irony of sorts. Most networks have remained skeptical as to the legitimacy of the protesters; continually emphasizing their assertion that these angry demonstrators represent a small yet vocal portion of the population that is ultimately not representative of the nation's aggregate mood towards health insurance reform. By doing so however, the media is undermining it's own message, and further legitimizing the opposition. Just a humble observation here.

I've provided one of the full-length commercials below; as you can see, the 30 second clip keeps it brief and to the point - a strategy proven to be effective. I've previously stated, from an apolitical angle, that the health insurance reform bill(s) had little to no chance of passage. This opinion was based largely upon Obama's ill-rehearsed address to the nation, where he appeared more frustrated than at any time in his nascent political career. However, the expediency and shrewdness of the President's deal with industry stakeholders - the results of which can be viewed below - have necessitated a revision to my previous prognostication.

The next 10 days will inevitably decide the fate of the health care reform effort; specifically, passage of the House or Senate bills will be decided by the effectiveness of the television campaign, and it's ability to undermine the uncivilized town hall events.

ABA Objects to Accounting Standard Changes

2009-08-13T15:16:00.005-04:00

The American Banker's Association has released a white paper detailing it's concerns about the Financial Accounting Standards Board (FASB) and International Accounting Standards Board's (IASB) "direction in which they are heading"; specifically with regards to some major proposed changes to the scope and reach of fair value accounting. I'll start out with an executive summary of the report, and for those like myself who are blessed with performance enhancers and/or thrive on a little bit more detail, I'll pierce through the surface of the report a little more further below.

Executive Summary

The ABA's entire white paper is best summarized by the statement - which is targeted towards the regulatory bodies of course - "Let's slow down a minute". Both of these standard setting boards (FASB in the US and the IASB in Europe/elsewhere) have, in all fairness, proceeded extremely rapidly - especially for a bureaucracy - through the initial stages of rule changes. To further aggravate the situation, each Board is pursuing a somewhat different end-game, which threatens to create a compliance nightmare on elm street. The proposed changes, argues the ABA, would only exacerbate the cyclical nature of banking, thereby introducing unnecessary and inevitable volatility to the Markets. Keep in mind throughout all of this that the ABA is essentially the lobbying arm of the banking industry; it will pursue policies that have the best interest of that industry in mind.

Detail Oriented - Performance Enhancers Recommended

The policies pursued by both the FASB and IASB will expand the use and application of mark-to-market accounting (MTM) in monumental fashion. Most significantly, the proposed rules will require that banks value all loans on it's book according to market pricing. This determination must be made quarterly, and at least insofar as the IASB is concerned, fluctuations in the loan book will be counted towards - or against - net income. This calculation would in fact require an additional line be added to the income statement, indicating the effect of the quarter's MTM determinations. According to the white paper, the FASB is primarily focused on the effect that marking loans to market will have upon a bank's tangible common equity (TCE). TCE is generally hailed as the "purest" measure of a bank's capital adequacy. The ABA is apparently concerned introducing MTM of loans into the TCE equation will force banks to hold an excessive amount of capital as a cushion against losses.

All of this being said, the ABA seems most confident in it's assertion that the two standard setting boards are:

Proceeding separately towards different solutions.
Failing to exercise "due process" with regards to the rule making process.

On the one hand, it doesn't entirely make sense that the FASB and IASB would be rushing to implement rules that would increase the cyclical nature of banking. On the other hand, I found the ABA's white paper to be somewhat lacking in substantive criticisms of the regulatory proposals; there was a distinct feeling that they were trying to shift the brunt of the attention onto the procedural deficiencies thus far in the process, while only briefly touching on the practical implications.

Parsing the July 2009 Foreclosure Data

2009-08-13T10:17:00.003-04:00

Foreclosures - and the combination of adverse consequences thereof - are arguably at the heart of our financial and economic malaise. That being said, the monthly RealtyTrac foreclosure report should be reviewed regularly by anyone hoping to decipher the trends or current state of the economy.

The headline most commonly derived from the latest RealyTrac report - current as of July '09 foreclosure actions - has read something to the effect of "Foreclosures up 7% in July". This headline represents an aggregate, month-to-month rate of change for all 50 states and the District of Columbia. I feel that the year over year figure is far more instructive; in this case indicating that US foreclosure filings (default notices, scheduled auctions, and bank repossessions) were up 32.32% in July from the same period a year ago.

The chart above takes the analysis a step further, and plots the percentage change - in ascending order according to % change from a year ago - for each state + the district of Columbia. As is evident from the illustration, there is a wide range of disparity between the different states and their respective change in foreclosure filings. Relevant points from the data:

13 States (includes DC) recorded a decline in foreclosure filings from a year ago
22 States recorded a greater than 50% increase in filings from a year ago
10 States recorded a greater than 100% increase in filings from a year ago
West Virginia, Hawaii, and South Dakota each recorded a greater than 250% increase in filings from a year ago.
Florida, California, Nevada, and Arizona accounted for more than 50% of all US foreclosure filings in July.

When assessing recent foreclosure data, it's imperative that readers be aware of the various foreclosure moratoriums that have been enacted in various states. These moratoriums have a severe distorting effect on the data for those States, and serve only to create a dangerous backlog of homes that will be drip-released back to the market for years to come. They do score short term political points with members of State Legislatures though.

Adecco Results Confirm Jobless Recovery

2009-08-12T15:39:00.004-04:00

Adecco Group, a Zurich based human resources company, yesterday posted dismal Q2 results; no matter which line of the income statement you'd prefer to look at. Top line was down 31% from the prior year's quarter - a relatively disappointing hit to revenue; that is until you drop down to EBITA for the quarter, which declined 90% from Q2 '08. Breaking the results out geographically, revenue for the US & Canada came in only slightly better at -29%.

How is this relevant to the employment situation? Adecco Group's euphemism of a business description - Human Resource services - is known colloquially as a Temp Agency. Adecco isn't just any temp agency though; it's a Fortune 500 Global Company that operates in 60 countries, and supplies roughly 500,000 workers to 100,000 clients each Day. Furthermore, the Company provides more than just the stereotypical temp who shuffles paper and is gone after a week; much to the contrary, Adecco matches workers up with clients who require a wide-range of skill sets, including those in the Finance, Legal, Medical, Scientific and Information Technology industries. They are (to steal a line from the Dos Equis commercials) the most representative employment agency...in the world.

The post-Lehman economic shock caused many businesses to slash payrolls at a merciless rate in order to contend with a shrinking top line. As the economy bottoms out and businesses gain confidence, they are expected to look disproportionally towards temporary and contract workers - you know, the kind that don't require severance packages. That being said, Adecco Group is likely to be one of the first corporations to feel the effect of a turnaround in the labor market. Perhaps they should even be viewed as a leading indicator of the labor markets in North America and Western Europe. Regardless, the Company's precipitous drop in revenue does not bode well for the near term labor market outlook.

*no position in Adecco Group

Bank of England Sees Low Inflation Through 2010

2009-08-12T14:55:00.003-04:00

The Bank of England (BOE) released it's quarterly report on inflation expectations today, which stated that the Bank expects inflation to remain in the 1-2% range over the coming two and a half years. What the headlines about this release didn't reveal is that, according to the inflation probability model provided by the BOE (Chart 5.4), the year 2010 will be characterized entirely be year over year percentage decreases in inflation. In fact, the Bank of England's models are forecasting some probability of the country experiencing negative inflation towards the end of 2010. Obviously, there is a difference between disinflation and outright deflation; however the notoriously flexible central bank models are grazing dangerously close to the deflationary realm.

From a macro standpoint, the report below tells us one very important thing: the Bank of England is expecting the next 18 months to be characterized by very slow, very weak growth. Any other assumption, when factored into an inflation probability model, would exert at least some upward pressure on the price of goods and services across the UK. As I've already pointed out, the BOE is expecting an entirely dis-inflationary 2010. For now, I remain firmly in the camp that perceives deflation to be the far greater threat than inflation.

BOE Q2 Inflation Prospects

Assessing Obama's Deal With the Pharmaceutical Industry

2009-08-12T10:46:00.002-04:00

When news broke that President Obama, along with the Senate Finance Committee and AARP, had forged an agreement with the Pharmaceutical Research and Manufacturers of America, the left-most portion of the political spectrum reacted with a predictable level of vitriol and general dissatisfaction. The President, exclaimed leftists, had spent his entire campaign excoriating the pharmaceutical industry and it's ill-conceived profits; empowering his supporters with the idea that, once and for all, the strong arm of Government would bring down it's mighty fist and crush this profiteering segment of corporate America. Ignoring the obvious logistical impediments that stand in the way of such an action, I would propose that a widespread desire for retribution, combined with a short-sighted approach to health care reform, has effectively led these critical voices astray; distracting the left from it's much cherished "end" in favor of a myopic obsession with the "means". By allowing themselves to become so utterly obsessed with a perceived "deal with the devil", liberals have completely missed the political genius inherent to the President's newly forged arrangement. To better convey the totality of my argument, let's begin with a cursory review of the deal's term sheet as it exists today.

The Basics

The President agreed that any newly formed government health insurance entity will NOT negotiate with pharmaceutical companies to obtain prescription drug savings in excess of the $80Billion that has already been agreed to.
The pharmaceutical industry has agreed to run television ads in support of health insurance reform. Roughly $150Million has been budgeted industry-wide to pay for these ad spots.

To begin with the obvious, any criticism of the deal outlined above assumes that there is a dollar amount of savings - which could be reasonably extracted from the industry - that is substantially in excess of the $80Billion already promised. On this fact it's important to realize that despite popular folklore, the pharmaceutical industry is not a bottomless pit of money. Those corporations commonly referred to as Big Pharma face massive competition from generic drugs, in addition to new drug pipelines that are dangerously dry. I've actually heard people refer to the "Trillions of Dollars" that supposedly exist unencumbered on pharmaceutical balance sheets which are said to be available for extraction of some sort. This is not true.

Having dispelled that fallacy - at least amongst folks open minded enough to change their opinion once in a while - I will turn to what I perceive as the brilliant underlying strategy behind an Obama + Pharmaceutical alliance: Divide and Conquer. We must not forget that there are two very powerful industries - pharmaceutical and health insurance - which stand to be affected by any substantive health care reform. Both of these industries are capable of spending vast amounts of money to fill television ad spots throughout the entire August recess; meanwhile the stalled House and Senate bills sit impotent and prone to attack. An alliance with Big Pharma immediately turns half of those ads into messages of support. Granted, Pharma's ads will be somewhat diluted and feeble messages of support. They will not however be of the mud-slinging nature that has proven itself to be so effective in American politics.

If you can understand the divide and conquer philosophy, then you should also be able to comprehend why the pharmaceutical industry was the correct side to ally with. Simply put, spending on prescription drugs only accounts for 10% of total health care spending. Spending on hospitals (31%) and physician services(21%) account for a far greater share of overall health spending (Source: Kaiser Family Foundation Report). President Obama has conceded a less than 10% portion of the entire health care picture, in exchange for a 50% or greater share of the advertising/public persuasion budget. Therein lies the political genius of the deal.

If after evaluating my argument, you are still angry at the President because of the pharmaceutical industry arrangement, then allow me to make one final claim: Health care reform had zero chance of becoming a reality without the support of a major stake-holding industry. Democrats have a solid majority in both branches of Congress, and they have the Presidency. Despite these numerical advantages however, a bill has not even made it past Committee. That being said, this arrangement must be taken for what it is; a means to an end, and nothing more.