A silver dollar for Volcker and Bornsley...

In a recent interview with Bloomberg, Paul Volcker shared his concerns over money market funds.

Prior to the Lehman bankruptcy, which caused Reserve Fund units to dip below $1, money market funds tended to receive inflows as market fears arose. Even after Lehman, fund assets remained relatively stable above $3.5 trillion, almost 25% of GDP. Aside from the Reserve Fund, no major fund broke the dollar.

Yet Volker understands that vulnerabilities in the financial structure must be corrected while problems are still speculative. Currently, fund managers value assets according to expected returns, rather than to market prices. This accounting treatment moderates volatility and allows for a stable unit value. It also makes sense, generally, given the short term and high quality characteristics of the assets. But in the event of a black swan or managerial error, actual values may surprise investors.

One might plausibly argue that money market funds practice sufficient diversification and risk management to make another Reserve Fund extremely unlikely. But who is checking? In the days following the Lehman collapse, money market funds quickly announced that they held no Lehman assets. Total assets hardly budged. Over time, successful placement of capital in a given asset breeds complacency, as demonstrated by the U.S. housing market and related securities. Why, given the pessimism surrounding the company, didn't investors pull out of the Reserve Fund en masse prior to Lehman's collapse?

To be sure, money market funds have not collapsed, and they have historically provided competitive returns safely. With that in mind, try to imagine the standing of these funds in the minds of investors 10, 20, 30 years from now. If, hypothetically, they remain pristinely unburdened by major problems, it's conceivable that investors will allow themselves to remain similarly unburdened by skepticism. Absent regulatory authority, however, credulousness may cause serious problems in the future.

Like Brooke Bornsley, the former CFTC chairwoman who attempted to regulate the CDS market in 1997, Volcker's warnings may be too prescient for serious consideration. Hopefully, investors will protect their interests with more care than they displayed with derivatives, mortgage securities, and other financial obligations.

The Value of Intellectual Capital

Paul Krugman wrote this article, White Collars Turn Blue, in 1996. He made a very canny observation about the future of intellectual capital in the internet era:

How, then, can creativity be made to pay? The answer was already becoming apparent a century ago: creations must make money indirectly, by promoting sales of something else. Just as auto companies used to sponsor Grand Prix racers to spice up the image of their cars, computer manufacturers now sponsor hotshot software designers to build brand recognition for their hardware. And the same is true for individuals. The royalties the Four Sopranos earn from their recordings are surprisingly small; mainly the recordings serve as advertisements for their arena concerts. The fans, of course, go to these concerts not to appreciate the music (they can do that far better at home) but for the experience of seeing their idols in person. Technology forecaster Esther Dyson got it precisely right in 1996: "Free copies of content are going to be what you use to establish your fame. Then you go out and milk it". In short, instead of becoming a Knowledge Economy we have become a Celebrity Economy.

The idea that advertising could produce intangible innovation formed part of the basis of my investment in Ticketmaster. The CD format is not protected when mp3s can be downloaded in seconds--and the gap between mp3 and CD is far smaller than that of CDs and vinyl records--but the live music experience has no substitute. I expect that live music will become increasingly important to bands, and that music lovers will have more capital to spend on live shows, as recorded formats become cheaper and more easily obtainable. Ticketmaster's ability to capture a portion of the proceeds from such events is less certain.

William Dudley speech on inflation control

William C. Dudley, President and CEO of the New York Federal Reserve, spoke at an Association for a Better New York meeting on July 29, 2009: http://newyorkfed.org/newsevents/speeches/2009/dud090729.html.

He waived aside concerns that the massive increase in excess reserves--bank reserves deposited with the Fed in excess of the required amount--will rush into inflation. Despite a prediction that Fed assets will rise to $2.5 trillion, Dudley maintained that the ability to pay interest on excess reserves acts as a spigot on bank lending.

"If banks are earning no interest on their excess reserve holdings, they will be willing to lend those reserves out to any creditworthy borrowers as long as the interest rate is positive after adjusting for risk. The borrowers would then spend these monies, thereby boosting economic activity. The funds would not disappear, but instead would flow back into the banking system as they were deposited by those who had received the income generated by the increase in spending, thus replenishing the reserves that had been lent out in the first round of lending. This would result in a new stock of excess reserves that would then lead to a second round of credit creation and a further increase in economic activity. This cycling of excess reserves into credit creation, and the corresponding increase in economic activity, would continue until the excess reserves were fully absorbed by an increase in currency outstanding and/or an increase in required reserves associated with the rise in the amount of banking deposits. Inflation would rise as the excessive credit creation generated by the excess reserves led to an overheated economy and a rise in inflation expectations.

But that is not the world in which we now live. Because the Federal Reserve now has the ability to pay interest on excess reserves (IOER), it also now has the ability to prevent excess reserves from leading to excessive credit creation. Because the Federal Reserve is the safest of counterparties, the IOER rate effectively becomes the risk-free rate.³ By raising that rate, the Federal Reserve raises the cost of credit more generally because banks will not lend at rates below the IOER rate when they can instead hold their excess reserves on deposit with the Fed. Because banks no longer seek to lend out their excess reserves, there is no increase in the amount of credit outstanding, no redeposit of the excess reserves, no increase in economic activity and no risk that excessive credit creation will fuel an inflationary spiral.

For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent with the amount of required reserves, money supply and credit outstanding consistent with its dual mandate of full employment and price stability."

It's not immediately obvious to me how the IOER plan differs from open market operations by the FOMC. The last paragraph of the passage quoted above provides a sobering reminder that the Fed plays a political role, full employment, as well as a monetary role in price stability. In an inflationary recovery scenario, the Fed must compete with the capital markets for funds, but it must also control the drainage so as to avoid impairing the recovery. Compared to open market operations, the IOER does not appear to offer a major advantage in dealing with the dual mandate.

Inscrutable hope in print media

Shares of media concern Media General, Inc. (NYSE: MEG, $4.68, 22.83M shares) doubled today on reported earnings of $20.6M. Lee Enterprises (NYSE: LEE, $1.06, 44.92M shares), Gannett Co, Inc. (NYSE: GCI, $5.21, 232.44M shares), and The McClatchy Company (NYSE: MNI, $1.10, 83.65M shares) rose between 5% and 54% on the news.

According to Reuters:

Right in line with the past week’s earnings results from McClatchy (NYSE: MNI) Company and Gannett (NYSE: GCI), newspaper publisher Media General’s aggressive cost-cutting helped it swing to profit in Q2. And while ad spending continued to fall, especially in classifieds, the Richmond, VA.-based owner of The Tampa Tribune, Richmond Times-Dispatch and 20 dailies, indicated that the declines have started to abate, particularly in auto ads. Retail is also showing some signs of having hit bottom.

Newspaper publishers’ digital businesses have generally been one area that has shown growth and Media General (NYSE: MEG) said that in Q2 the interactive media segment was able to benefit from revenue gains tied to its online coupon and shopping site DealTaker.com. In addition, local ad revenues were up 18 percent.

However, one-time tax benefits produced $11.1M of gains. The sale of a Jacksonville, FL CW station generated another $7.1M. Of the $20.6M originally stated, only $3.8M came from sustainable operations, excluding severance expenses of $1.4M.

The company's segment breakdown revealed continuing stress:

Publishing - 20.3% revenue decline matched against 24.8% expense decline. The expense reduction excluded severance and 'special charges' and benefited, to an unspecified extent, from a freeze of pension matching. In Q1, MEG underfunded its pension by $252M.

Broadcast - 21.4% revenue decline compared to a 19.6% expense decline.

Interactive - 5.7% revenue decline despite a 24% increase in Dealtaker.com revenue. Operating losses increased 68% to $1.1M.


Given the uncertain future of the American economy, and of the ad market in particular, MEG should only be viewed as a highly speculative play. In addition to relying upon printed media for over 40% of sales, the Tampa, Florida segment of the business, once significant, has dwindled to nothing. The company also owes $711M in term loans that mature in 2010 and 2011. The pension fund remains significantly underfunded despite a stock market rally since March 31, when the obligation stood at $252M. Purchase obligations numbered over $190M last year; even assuming massive reductions in print production and decreases in broadcast relicensing fees, purchase obligations impose a large off-balance sheet liability.

MEG does not have the owner's earnings or asset value to provide a margin of safety. In light of the serious issues regarding capital structure, business model, and macroeconomic sensitivity, this company is a pass.

And that's why you start with the downside...

Delta Financial Corp. announced on 12/06/07 that they were unable to economically securitize their portfolio of fixed-rate subprime loans in time to forestall bankruptcy. Equity shareholders likely regain nothing as Delta's business model relies upon large short-term leverage, and because their portfolio of subprime loans are unlikely to price well.

So what happened? Mohnish Pabrai came out earlier this year with a thesis that DFC could make $5 per share when the credit market stabilized. Whether or not you agree with his estimates, DFC did stand out among subprime lenders for their unwillingness to overweight ARMs. At around $7 a share, even if housing fell into the pre-2002 trend line, DFC would still have been cheap...if they survived.

As it turns out, the credit crunch was not a subprime problem, but the result of a credit big bang. As housing prices marched up, weak borrowers refinanced, resulting in better credit ratings. Lenders looked at their low default rates and decided to lower their covenant and LTV requirements. Then the securitization markets stepped in, and lenders turned their eroding risk management ethic into a mass loan production focus. Securities ratings agencies gentrified it; PE shops boosted it; and banks abetted it.

After a few years, capital swapping between financial firms obscured the true quality of borrowers. When the housing market slowed, the markets realized how much leverage had been built, and now here we are.

So the upside thesis may have been correct, but the downside thesis needed some tweaking. It's true that a value investor focuses on the company, but when a company doesn't have a capital pool to sustain macro down trends, a macro analysis is also necessary.

Still a Pabrai fan though.

Appearance Matters: Delta Financial

I don't know much about Delta Financial (DFC), other than the fact that Mohnish Pabrai owned it earlier this year. Here are some of its positive attributes:

1. They have an LTV of 78%. That's not exactly Wells Fargo worthy, but its better than Nova Star Financial at 82%.
2. 87% of originations are fixed rate, and they discontinued ARM originations in the second quarter 2006.
3. They sold $950M loans on a servicing released, non-recourse basis. A deal of that magnitude, in this environment, even at a loss, speaks to DFC's credibility relative to other subprime originators.

But that's the problem: they look good compared to other subprime shops. DFC's most pressing problem, lack of financing, results from a poor public image due to their affiliation with less cautious subprime lenders. They also carry a stigma due to predatory lending charges that were settled in 1999. According to a representative of Fair Finance Watch, a community advocacy group:

"If you did word association, I would say 'predatory lender,'" said Matthew Lee, the executive director of Inner City Press/Fair Finance Watch, a community advocacy organization based in the South Bronx. "They're still one of the most vicious and biggest subprime lenders."

Such opinions reinforce the conviction that all subprime firms deserve the same label: Bad News. Prospective investors see a company with no short term financing recourse, but that requires constant financing to survive, and, naturally, they shy away. Meanwhile, DFC's price continues to slide, seemingly confirming that DFC is just like any other subprime lender. Former clients, who normally purchase loans from DFC, watch the proceedings and question its ability to continue operations. As a result, regardless of underlying asset quality, no one wants to buy their structured products.

I will pursue more in depth research into DFC, but it will be interesting to see how much real influence market perception will have on company fundamentals.

The Small Cap Advantage?

I found a very interesting essay by Robert Arnott. In the 2005 Sept./Oct. issue of the Financial Analysts Journal, Arnott noted that a single large cap could describe two companies: one with a large book value and a commensurate price; the other a small company, as measured by equity, with a healthy valuation. Of course, the same potential for ambiguity existed within a small cap. As a result, a reliance upon price as an indicator of company size conflated the value of market opinion at the expense of real assets and earnings power.

So Arnott separated a group of small market cap stocks, from 1967-1987, by sales and by book value. He found that the smaller BV groups benefited much less from the "size effect" compared to the higher sales, lower market cap stocks.

Here is the essay in pdf format, http://www.rallc.com/ideas/pdf/disentaglingSizeValue.pdf.

Money Markets are not treasuries

Here is a Bloomberg article about the placement of money market funds into subprime debt:

http://www.bloomberg.com/news/marketsmag/mm_1007_story2.html

I don't know whether those figures count indirect exposure to subprime, but at $11 billion against $2.66 trillion, the money market business isn't likely to collapse soon.

What I found interesting was that money markets seem to be given the same risk considerations as FDIC insured savings accounts. The article said: "On Aug. 8, just after the Bear Stearns hedge funds filed for bankruptcy protection, U.S. money market fund total assets reached a record high of $2.66 trillion, with investors pouring $49 billion into such funds in one week, according to the ICI." This is a phenomenon to consider for the future. As people become more comfortable with savings account alternatives, money market managers may find themselves with far too much money to NOT play around. And if everyone treats these investment vehicles as nearly risk-free accounts, who watches the Watchmen?

Investing in the future...

Summit Global Management is an investment firm located in San Diego, CA that specializes in water related companies. They have a couple interesting documents explaining their focused circle of competence.

Summit Capital

Some interesting points:
1. China holds 21% of the world's population and 7% of its renewable water sources.
2. Urban area are expected to contain two-thirds of the populace by 2030.
3. Population growth is expected to be 1.16% compounded between 2000 and 2025. At that rate in 18 years there will be 8 billion people.
4. Water demand increased by 1.96% from 1900 to 2000, but in the US, over the last thirty years, the rate jumped to 4.73%.
5. The American Water Works Association, an international non-profit whose members study, or work within, the water industry, estimates $250 billion will need to be spent over the next thirty years simply to replace aging American pipes.
6. China recently put forth $128 billion as the cost of future water infrastructure needs.
7. U.S. water utility shares lag international peers, yet they are (typically) twice as expensive on a price to book basis.
8. M&A in the water industry did not reach the conglomerate scale until 1999, when Vivendi purchased U.S. Filter for $6.2 billion.

We take water for granted, but a fresh, clean glass of aqua is far more valuable than the newest IPhone. And we are still fairly dependent on nature to provide us with access to renewable sources. Look at Australia, where they should be far more conscious of water shortages: http://news.bbc.co.uk/1/hi/world/asia-pacific/3992231.stm.

80% of Sydney's water supply comes from a single source, the Warragamba dam. God forbid an extended drought or an infrastructure failure; there isn't much of a hedge.

A more current article on Australia's situation:
http://www.reuters.com/article/environmentNews/idUSSYD7417520070516.

A quick write up of Encore Wire

Note: Inventory is marked to FIFO to better represent inflation. Copper price volatility may over or understate inventory, equity, and asset values. Cost of goods sold uses LIFO numbers.

Encore Wire Corporation produces copper wiring for the residential and non-residential markets from its manufacturing base in McKinney, TX. It sells to wholesale distributors, who place orders through independent manufacturer's representatives. Encore focuses on four product lines:
1. NM-B, non-metallic copper wiring for residences;
2. UF-B, underground cable for residences;
3. THWN-2, single conductor wiring for non-residential projects;
4. Armored Cable, multiple conductor wiring for non-residential projects.
Due to the soft U.S. housing market and to declining copper prices, Encore is slightly undervalued at 5.23x 2006 earnings. Hidden beneath the difficult operating environment is a company with strong management, an assets heavy balance sheet, lean operations, and potential for long-term, organic growth.
Smart Growth
Copper prices are usually passed on to customers. But, as copper wiring products are not significantly differentiated, manufacturers set prices in response to the next cheapest competitor, until a close relationship forms between copper and wire. Accordingly, depressed copper prices strongly compress margins for inefficient manufacturers with high fixed costs.
Between 1997 and 2002, copper prices averaged less than a dollar, off from $1.06 per lb.and 21,800 short tons in inventory in 1996. By 2002, copper hovered around $.72 per lb. while LME warehoused over 900,000 tons. A wave of consolidation followed, as the capital intensive nature of wiring ate into the margins of inefficient operators. Superior Telecom purchased Essex Wire in 1999 and filed a Chapter 11 by 2003. Southwire Company went on a buying spree and snatched up straggling competitors. Despite the struggles of similarly sized operations, Encore survived because their low cost operations allowed for an average 3.6% net profit margin. Receivables and FIFO inventory exceeded total interest bearing debt, and the current ratio stayed above 3x.
Encore consolidated their operations during those lean years. It spent $25 million, from 1999 to 2001, on a pvc plant to allow for on-site jacketing. $33.2 million, in 1998, went towards a copper rod mill for on-site production. These initiatives insulated the company from rising transportation costs and value-added premiums. More importantly, by eliminating the need to order rods and pvc material, Encore accelerated its ability to respond to customer demand. An additional $43.3 million between 2004 and 2002 went towards a third plant, machinery, a railroad, and distribution center expansions. The result: 40% growth in pounds of copper sold against a 43% decline in SGA/Sales over the last 5.5 years. When copper prices finally recovered in 2002--explosively, from $.72 per pound to $3.09 per pound in 2006 using COMEX monthly averages--Encore's expanded operations and cost controls resulted in compelling numbers. Operating margins, flat from '99 to '03 at 6%, averaged 11% to 2006 as expanded on-site operations handled greater volumes at low incremental costs. While copper prices rose at a formidable 34% CAGR, net earnings rocketed 80.7% CAGR 2002-2006.
Near-Term Growth Story: Industrial and Commercial Wire
With the introduction of armored cable in 2006, Encore's product mix is 67% non-residential to 33% residential wire by pounds shipped. Industrial and commercial wire may be more prominent; CFO Frank Bilban has recently stated that as much as 70% of the business was non-residential.
The new armored cable factory is the culmination of $39.6 million expenditures, over the last two years, to meet demand from existing clients. That customers request this particular product is telling; Encore's largest competitor, the privately owned Southwire Co., already offers a broad line of armored cable products and has spent upwards of $250 million, since 2005, to expand its operations. Southwire does not publish order fill rates, but Encore, at 99.95%, has a very strong service reputation.
Through 2008, the American Institute of Architects (AIA) expects an inflation-adjusted 5.2% increase in industrial construction spending, the largest end-use of armored cable, and 3-4% in overall non-residential activity. AIA also publishes the Architects Billing Index (ABI), a survey of monthly architect billings. According to the AIA, the non-residential spending lags the index by five to eleven months with a correlation of .79. The June ABI reveals steady increases in billings since a first quarter dip. Reed Construction Data also forecasts strong non-residential spending in 2007, as much as 12.5% growth, but has not made a prediction for 2008.
Protecting the Competitive Edge
Encore's competitive advantage stems from its near perfect order fill rate. Management understands that, and has shown the discipline to temper their ambitions even in the face of tremendous inflation of their products. A company like Southwire owns many factories, but it also services clients throughout the U.S. and Canada. Given the high cost of warehousing, most clients expect the manufacturer to store inventory. But with factories in Canada, Mexico,Alabama, Tennessee, Georgia, and so on, and with copper rods coming out of Georgia, Southwire negotiates complex supply-chain management issues. By contrast, Encore produces copper rods, pvc jackets, wire, and cable from its factory in McKinney, Texas. It then ships inventory to manufacturer's representatives, who maintain an adequate inventory supply. The bareness of the model allows for rapid changes in supply in response to demand shifts. It is a simple model, but management warrants some credit for not transforming into serial acquirers when times were good.
Encore also matches its inventory profile to rapid growth. Between 2003 and 2006, pounds sold increased by 32%. Beginning in 2004, finished goods to raw materials + works-in-progress rose to 4.2x. Previous years found ratios around 2-3x. It has since stayed above 4x.
In the Meantime
Encore maintains a strong balance sheet. Using second quarter figures, the current ratio stands at 8.7, with $48.7 million in cash. Debt to equity is a low 25%. If copper, at $3.09 per pound, loses half of its value tomorrow, the current ratio settles into 6.7 and D/E is an acceptable 32%. 2006 data claims an interest coverage of 24x. The company is likely to remain solvent in the near future.
Valuation
Management believes that 2007 earnings are temporarily depressed due to inventory liquidation by competitors. Some evidence supports that view. Encore normally charges a 17% premium on their CGS, excluding highs of 24% and 25% from 2006 and 1998. In the first quarter of 2007, it earned a 10% premium. The following quarter it returned to 17%.
Assuming that sales premiums remain at 17%, and that lbs. sold are fixed, we can determine a range of CGS scenarios. Copper prices create substantially all of the unexpected intra-year earnings variation; a fair estimate of CGS will give a decent earnings picture. It takes about two months for inventory to be sold, so second quarter 2007 CGS of $286,073,000 probably consists of an average $3.22 per lb. Copper is 82.3% of CGS according to 2006 ratios; the remaining CGS, assuming zero net change in pounds sold, can be fixed at $50,634,921 quarterly. Holding SGA at $17 million and interest at $1.2 million, copper can plummet 76%, to $.77, before Encore cannot meet payments with gross income.
Assumptions:
1. Fixed quantity of goods sold (Q2 2007).
2. Fixed non-copper dollar costs of goods sold (17.7%, 2006).
3. No additional debt, although figures are rounded up to account for rising LIBOR.
4. 17% premium to costs of goods sold.
5. $3.22 per pound average copper price for Q2 2007.
Using the same logic over four quarters:
Copper Price per Lb. Tax Net Income P/E (Diluted)
$2.00 .36 $39,085,716 15.4
$2.50 .36 $54,996,065 10.9
$3.00 .36 $70,906,415 8.5
July Avg.: $3.62; August (to date) Avg.:$3.38.
These P/E ratios seem reasonable for a company with good management, a good business model, and an excellent reputation. Encore has held P/E ratios around 15. In an environment with stifled residential construction and higher credit rates, and with Encore's growth cap. ex. likely to subside, the price is not attractive enough to merit a strong buy. However, it is a fair price to hold an excellent company in a cyclical industry.
Bear Points:
1. Encore does not delineate sales by products or by volume. Analysts can not determine, through the financial statements, the relative impact of individual products.
2. Copper prices may trend downward over the long term. Subsequently impaired inventories may reduce net income.
3. A privately owned competitor, namely Southwire Company, may create economies of scale through recent acquisitions and organic growth. Such a company may pressure Encore's margins.
4. Residential construction may weaken more, and/or longer, than expected. Non-residential construction may not perform as anticipated or construction spending may pool into institutional building, which benefits aluminum wiring.

Wire has lost about 18% YTD, but, as mentioned, it isn't really a compelling value yet. Furthermore, as much as I like Encore's mangement team, I have a hard time buying into a cyclical commodity play. Copper prices ran down for a decade even as absolute global construction grew; who is to say that won't happen again?

Up and at 'em...

This investing journal will be a catalog of investment successes and failures, as well as an opportunity to practice writing.