Fractions to Save the Fractious Market

Eleven years after abandoning 1/8s and 1/16s, the SEC is considering bringing fractional prices back to the market, at least for less liquid stocks. Fractions, while considered an anachronism of old computing, used to prevent specialists and insiders from front running. Now they may be the cure we need against rapid trading. Trading in fractions bigger than decimals (cents) makes it more expensive to jump the queue in the limit-order book, perhaps making it fairer for slower small investors.
Ban calculators and let's start teaching fractions again in grade schools... Wait! Do the teachers know them?

The Student Loan Crisis Gets Worse

According to a new study, the average student who graduated in 2011 had $26,600 in student loans and 37.8% of graduates worked in jobs not requiring college education. The default rates hit a 14-year high. New Hampshire students had the highest debt load at $32,440, followed by Pennsylvania, Rhode Island and Connecticut; Utah had the lowest at $17,227, followed by Hawaii, California, Arizona and Nevada. 96% of students in private for-profit universities took out student loans borrowing 45% more than students at other colleges. Medical students debt levels are over $100,000 with students choosing lucrative plastic surgery over obstetrics to be able to pay that off. The total student debt has surpassed $1 trillion. Why is this happening?
Explanation 1. Economic crisis, governments slashing budgets lead to rising tuitions. Loan programs are complicated and students don't even know how much they owe.
Explanation 2. Overabundance of student loans at low cost leads to mispricing of default risk and misallocation of investment into what in Utah someone called degrees to nowhere", instead of into STEM fields (science, technology, engineering and math). Universities and for-profit colleges soak up the cash. Costs rise. Notice the parallel to the subprime housing crisis. Scary since the student debt bubble has not burst yet.

London to Tighten Rules on Listing

The WSJ reported today that the Financial Services Authority will raise the free float bar on listing shares in London. In May 2011, Glencore IPOed with only 13% of free float. Last year, Kazakh miner Eurasian Natural Resources ousted three directors who jointly owned 45% shares. London's reputation has suffered in recent years as many energy companies from Eurasian emerging markets managed to list through reverse takeovers or with minimal floats. When the free float (shares freely traded) is small relative to the total cap of the company, minority (public) shareholder rights are at risk. In China, foreign companies are minority shareholders by law. Recently, US companies learned the bad habits too. Instead of restricting float, they turned to supervoting shares (Zynga, Google, Facebook). Not good at all. If you want other people's money, you need to be willing to submit to their voting rights.

China and Japan's Appetite for US Treasurys Grows

The US Treasury sold $50 billion of notes in bonds in July. China added $2.6 billion; its total hoard stands at $1.150 trillion. Japan added $7 billion; it total stands at $1.117. We print dollars and buy cool stuff; what a racket! The only unfair thing is that the US government sells directly to them and then gets to spend, instead of selling to them, distributing the money to us, the citizens, and let us spend. I could use a new car and big flat screen financed by China..

Microsoft Raises Dividend by $1 billion

Microsoft had $56 billion in cash as of June 30 . The company decided to raise its dividend payout by 3 cents to 23 per share or up by $1 billion a year. This goes to the heart of corporate finance theory. If you cannot reinvest cash at ROI higher than your cost of equity, you should distribute cash to investors as dividends or share repurchases in order to avoid destroying shareholders' value. Apple had $117 billion incash as of June 30. It also started paying dividends this month.

Should Finland get out of the euro?

Everyone talks about Greece leaving the euro. Greece and the Greeks don't want to. Who in their right mind would buy a Greek government drachma-denominated bond? No one talks about the other side of the coin. If you were Finland, a small country with a 2011 GDP of $258 bn, and you were asked to jointly underwrite the debt of much bigger countries (~Spain's GDP $1491 bn), you had a AAA credit rating and a government surplus, would you not want to leave? Especially given that your cousins (Sweden, Norway) that are outside of the euro are thriving? I'll buy a Finnish markka bond, won't you?

Apple Computer Valuation Challenge

Here is a challenge to all finance students in my U of U classes.
The first one to provide the correct solution will get to write the next blog post :-)


Assume ΔCAPEX=0, ΔNWC=0, Depr=0, no debt.


Before the dividend announcement, we can use the FCFE1=E1 valuation method. Estimated E1=45 and r=18%. So a stock price of P0=600 implies the growth of free cash flow at 10.5%.


After the dividend announcement of D1=11 = 4x2.65+e, still the same r=18%, still the same E1=45, compute what Apple's rate of return on (plowed back) retained earnings has to be to justify the $600 stock price. Do you think Apple can earn it?


Bragging rights and extra credit possible. Don't ask any questions. The race is on.

March 20 Update - Apple, Treasuries, Banks, India

The $2.65 quarterly dividend plus $10 billion in share repurchases means about $25 bn in cash outlays. A drop in the bucket if you are generating more than that per year in free cash flows. The main signal from Apple is: we will not waste money on side bets/new technologies that will destroy shareholder value. We will keep the cash pile constant and have plenty of high-ROI plowback opportunities.

The 10-year Treasury yield rose 0.36% to 2.38% last week. Watch the long rates for signals about the economic recovery. For the yield to rise, investors must think that the economy is stronger than the offsetting purchases of long-term bond by the Fed, and, more importantly, that they can earn more elsewhere - in stocks and real estate

Most banks passed the stress tests last week, except Citibank. Vikram Pandit can't run a bank and doesn't even know how to cook the books. Of course, the dumbest thing is the Fed stopping the stress test-failing banks from paying dividends. So they keep losing money and investors can't take the money out. Only the government can come up with that.

And lastly, if you felt depressed about the U.S., here is something that will cheer you up. Of the 1.2 billion people in India, 670 million have cell phones, but only 500 million have access to toilets. Come on Apple, get working on the toilet app!

Pandora: A Case Study in Valuation

Pandora Media boasts over 1.5 bn listening hours in Q1 2012, predicted to grow to 3 bn in Q1 2013. Business model: Revenues - ads only since most users opt out of the ad-free service and pay nothing; 70% of the content streamed to mobile devices where ads cost 1/3 of what they cost online. Costs - for every song streamed Pandora pays royalties. The result: a net loss and the stock down 24% on Wednesday. Unless advertisers pay up, more subscribers will simply mean more losses.

Greek Bond Deadline

The deadline for the holders of the Greek bonds to submit to the "voluntary" restructuring is the end of the day today. The choices are: accept the swap deal and take a 70% haircut (=accept a reduced principal and super low interest payments through 2020 dropping the PV of the bonds by 70%) or sue the Greek government in a Greek court. If enough creditors accept the deal then it will not be deemed a default and credit default swaps will not be triggered (insurance will not be paid). The analogy would be to an insurer saying that your house burned down but so did your neighbor's so they don't owe you an insurance payout. An interesting interpretation of an insurance contract.

Oh no! China Diversifies Out of Dollars. Oh yes, They Are Smart

WSJ reported that the share of the $3.2 trillion of China's official reserves allocated to the U.S. dollar dropped from 75% in 2002, to 65% in 2010 and to 54% in 2011. Are they going to stop financing us? Is the world going to end?
No. Point No. 1: They have been cleverly diversifying, buying low-selling high for years. When the dollar was weak at $1.60 per euro, they bought dollars. Now that the dollar is stronger at $1.30 per euro, they try to allocate a larger share of each year's increase in reserves to other currencies. Point No. 2: The yield on the 10-year Treasury went from close to 4% at the beginning of 2010 to around 2% in 2012. I also bought more bonds in 2009-10 than in 2012 to lock in higher rates. This is just common sense, not a devious plot to take over the world or reflection on the dollar losing its reserve status.
The bigger story about this that people miss is: Why do we have no foreign currency reserves while they have huge ones? Who is scared here?
The mercantilist closed capital account policy has worked for China redirecting investment inward. Now the signs of wasteful investment into real estate and infrastructure are growing. The only solution to that will not be a "smarter" government interference in the economy (the U.S. is currently proving the case), but the opening of the capital account.

Term vs Whole Life Insurance - Basics

Term: You pay a fixed schedule of premiums for a one-time death benefit. The future value, with interest compounded at the insurance company's rate of return, is equal to the death benefit (at your actuarial life expectancy). Minus profit to the insurance company and commissions to the selling broker. Whole Life: You pay much larger premiums which go into an account earning the insurance company's rate of return, profit and commissions being subtracted from that. Out of the account, premiums are paid for a term life policy to provide the actuarial death benefit; the rest accumulates for a cash value. So theoretically, whole = term + investment account. Universal is a variation on the whole life theme where the rate of return in the account is up to you and not the insurance company. Considerations: 1. Can you earn an after-tax rate of return on investment that is higher than of the insurance company? Most people think yes, but the trick is to compare apples to apples risk-wise. The insurance company's return is likely to be a stable bond-like return since that is what they do with your money. 2. Do you like the credit rating of the insurance company, because that is the risk of your investment fund? If the company is AA-rated and pays 4% interest, that is pretty good. 3. The whole / universal life policies are more complicated allowing the insurer to hide mulitple layers of fees (admin, investment management, insurance, etc.), and the borker commissions come out in the first few years. If you understand compounding, having money come out at the beginning reduces fures values a lot. 4. The good side of whole life is the forced savings mechanism. If you buy term, are going to commit to save extra and to invest it? 5. If you plan to die tomorrow, buy term, pay little and have your loving wife cash out early. If you plan to die much later, the whole policy may give you the option of cashing out vs your estranged ex-wife cash out on your policy..
Did I miss anything? Comments please.

Facebook IPO to Save California? At Least For a While

According to today's WSJ, Facebook executives and employees cashing out after the IPO will bring $0.5 billion in 2012 and $2.5 billion in income taxes into the coffers of the State of California by 2015. The Sacramento politicians will spend spend it all giving them a short term illusion that all is well in CA, after which misery will follow. High marginal income tax rates lead to huge volatility of tax receipts.
Message to Gov. Herbert: Offer Mark Zuckerberg a couple hundred million to take up Utah residency, and then tax him...

Gas Prices Up on U.S. Refining Success

Gasoline prices have gone up for 20 consecutive days (although not here in Utah). Two explanations. "Pessimist": Three refineries are offline, Iran tensions and foreign oil prices are up. "Optimist": Gasoline is manufactured from oil. The U.S. has two thing going. Natural gas prices in the U.S. (but not elsewhere) have gone down 80%, so the energy cost of refining has gone down. Also, our refineries have become ultra efficient. We used to be net importers of gasoline. Now we are net exporters. While the rest of the world processes the relatively expensive Brent and Omani crude through high-cost refining, we put the cheaper WTI and heavy crude through a low-cost refining process. We also throw off cheaper ethylene for plastics production. We have become the China of refined energy markets.
Instead of Solyndra, we should reward Apache Corp, Valero and Dow Chemical.

Oscars Report

Sorry. I missed the self-aggrandizing, utterly boring Oscars. Instead I watched the penalty shootout-capped Carling Cup final between Liverpool and Cardiff, and the Spongebob episode in which Patrick proclaims: "the inner machinations of my brain are an enigma". Brilliant stuff, worthy of an award.

Corporate Shenanigans Explain South Korea's Low P/E Ratios

The Economist highlights the problems with South Korean companies' corporate governance. The Korean chaebols (conglomerates) are run like family fiefdoms with cross-shareholding schemes giving the head family disproportionate control over the entire emapire. Two pracetices are mentioned. Tunneling is awarding contracts to copmanies controlled by family members, like the 2007 $1.4 billion Hyundai chairman's contract to his son's Glovis. Propping is giving financial support to non-viable sister companies. So the problem with Korea is not the threat from the North or risky export-driven economic model, but shady business practices at the highest level.
Korea's KOSPI index trades at less than 10 P/E, while Singapore trades at 15. The sad part is that the largest chaebols are world-renowned efficient producers (Hyundai, Samsung). Too bad investing in them means perhaps being stolen from.

Should the Old Retire to Give Jobs to the Young?

The Economist explains that the "lump of labor" argument that the old are taking the jobs of the young is flawed. Early retirement incentives are no solution to high youth unemployment. According to labor demographic data, the ratio of pre-retirement to new workers is fairly constant across high employment and low employment OECD economies. So high elderly employment is not offset by low youth employment, but is actually associated with high youth employment. So the choice is more the following. We can be like Greece, the old retire at 54 and the young are unemployed. Or we can have old people work longer, create jobs for the young, and have a higher pre capita GDP overall.

Executive Overcompensation

Obermatt.com provides a service of evaluating the degree to which CEOs are over- or underpaid. The Economist recently had a good graph of both categories. Obermatt computes the actual compensation and subtracts the economic value added to shareholders by looking at company's financials and stock performance. By this measure, the late Steve Jobs of Apple was grossly underpaid, while Ray Irani of Occidental Petroleum grossly overpaid. We need more of such research and publicity to distinguish those who legally steal from shareholders from those who produce wealth for our society. This is not exact science, but close enough.

The Risk-Free Rate in Finance: Danone Yoghurt?

In finance classes, we teach that the risk-free rate is that on a short-term government security, the T-Bill in the U.S. A WSJ article explains that this may not be so. The Greek bond crisis has exposed many governments as deadbeat borrowers in contrast to many creditworthy corporate borrowers. No surprise: whom do you trust more, Nancy Pelosi and Dominique Strauss-Kahn or Paul Otellini, the CEO of Intel? In the CDS market, one has to pay €391 annually to insure €10 million of Italian government bonds, but only €141 to insure bonds issued by ENI, the Italian oil and gas company. IBM costs $32, while the U.S. Treasury costs $36 to insure. France costs €186 while Danone costs €73. No wonder the French government stopped Kraft from buying Danone, they could not let the crown jewel go.
These days, if someone slips me a Canadian quarter or a Chuck E Cheese's token, I keep it. It is high time for J.P. Morgan and Apple to start printing new dollars with an Apple logo on them, and get rid of the green fake ones Obama is passing for real ones.

Don't Tell Others What To Do: Let China Be China

AFP reported that one of Apple's biggest Chinese subcontractors Hon Hai Precision Industry Co raised monthly factory wages in Shenzhen by up to 25% to 1,800-2,500 yuan ($254-$397). In an unrelated article, the WSJ argues that the rising wages in China are going to complicate the Fed's inflation policies in the future. The U.S. imported $399 bn in Chinese goods in 2011. We could end up with stagflation in the future.
Why do we have occupy-Apple protesters pressuring Apple to stop exploiting Chinese workers and to raise their pay? Don't we want to pay as little as possible for the goodies? Where are the occupy-Saudi-Aramco protesters demanding to pay more for Saudi oil?
What about occupy Ritz-Carlton for exploiting maids? And, what about occupy the U to pay higher tuitions and to end the exploitation of college professors...?

A Step Backwards on MTM Accounting

The WSJ reported that Goldman Sachs and Morgan Stanley will switch from marking-to-market to historical-cost accounting of their $100 billion corporate loan portfolios. This is allowed since both are bank holding companies. The move is motivated by lower capital requirements and less earnings volatility. Great! So we are going to pretend that $100 bn defaultable loans which may be worth $80 bn are worth $100 bn so that we don't have to hold capital against them. We are also going to manipulate earnings writing the loans up against losses and down against gains. But wait! All commercial banks already do this kind of manipulation, so GS and MS are simply joining the crowd. No wonder hundreds of thousands of homes sit empty with banks unwilling to sell them at a loss to avoid marking to market. The insanity of government regulation is infinite.

SWIFT to Ban Iran

Prodded by the U.S., the European Union may ban Iran from SWIFT, the Society for Worldwide Interbank Financial Telecommunication. SWIFT is the world-ex-U.S. equivalent of Fedwire and CHIPS combined, carrying wire transfers between most of the largest banks in the world. CHIPS in the U.S transfers over $1 trillion a day, SWIFT even more? Any institution banned from SWIFT would have a hard time moving money around and paying for things. Smugglish lots of cash in suitcases is not easy, so this is the ultimate sanction that will have a real effect.

Nassim Taleb's Black Swan Investing

First read about the Black Swan theory of human development on Wikipedia. Then you may want to read the short summary here.  And then, if you have time and patience to listen to an epistemologist / essayist, listen to the inverview with N. Taleb.
Applied to investing, the main idea is that we underestimate how fat the tails of "extreme" events are. Instead of avoiding losses from extreme events, diversifying and hoping, you should position yourself to profit from them, because they are not rare, they are just unpredictable. You should espouse risk, bet on new ideas, start new companies, be a venture capitalist. Be long out-of-the-money options, real and financial.

Monti Beats Papademos in Greco-Roman Wrestling

Greece and Italy are often lumped together when discussing the European debt crisis, but they are not the same.
Greece is facing a €14.5 billion repayment on March 20 (the annual government receipts are €32 bn). The 10-year Greek debt is trading at 31.2% (!) over German 10-year Bunds (at 1.91%). Unemployment is over 20%. Unions announced a 48-hour strike, and the prime minister Papademos has to threaten to resign to get the Parliament to listen.
Greeks make olives. And goat cheese.
S&P downgraded 34 Italian banks today, but no one listens to S&P anymore. The prime minister Mario Monti is a smart economist and a good politician. He is pushing through spending and labor market reforms. The 10-year Italian debt is trading at 5.62%, only 3.71% over German Bunds, the 2-year debt at 3.22%.
Italians make cars, consumer white goods, precision machine tools, high fashion and optical accessories, wines and branded food products. Italy earns $46 billion annually from tourism. Lombardy (Milan) is as rich a place as any in Northern Europe.
Italy has won four soccer World Cups (second only to Brazil). Greece has won none.
No contest, ciao.

Health Insurance is Consumption not Insurance?

In today's WSJ, in the context of the recent contraceptives mandate, John Cochrane touches upon why health isurance is not insurance at all. Insurance involves paying a small premium to receive a large payout from a small probability event. The large payout comes from the pooling effect of the few that will be hurt and the many that will not. Health service is not a small probability event. Everybody needs health services every day, just like they need food. Some need more, some need less, just like food. Without it people die, just like without food. We don't have food insurance, we have food stamps for the very poor. Otherwise everyone has to pay for themselves.
The real trouble with health insurance may stem from the fact that in the U.S. we get it from our employers. The employer expense is tax deductible - no incentive to save. The insurance is not portable - no preexisting conditions coverage. The co-pays are super low - no incentive to check the doctor's bill.
The other trouble comes from the fact that we, Americans, choose to spend our money on other forms of consumption, rather than health care: video games, cell phones, caramel lattes.
Adding benefits to health care plans means pooling the consumption cost, ie shifting the cost from the small group that will consume the benefits to the rest of us. This applies to all health services: contraceptives, diabetes, cancer treatments, cholesterol screening. Perhaps that is what we want in our rich society, but then what about other "essential" things: dental services, eye care, driving skills, education, beach vacations?
Once you accept health care as consumption, the real question left is how to ensure innovation and efficiency-driven cost reduction through competition. What do you think, patient?

Canada Issues a Yankee Bond

On Tuesday, AAA-rated Canada sold USD3 billion five-year Yankee bonds yielding 0.888%. Canada is the country to the north of us.

Volcker Rule

A smart student asked me last week what I thought of the Volcker Rule which disallows regulated banks from engaging in proprietary trading. Europeans loved it at first. They hate it now, because it may stop U.S. banks from buying European sovereign debt. Our dollars are all of a sudden not so undesirable. Gisele Bundchen is probably taking them, even though a few years ago she wanted to be paid in euros...
Anyway, I don't know if there is any problem with the Volcker rule, but there is moral hazard in banking regulation itself. Imagine the world where banks are not regulated at all. Before depositing our hard-earned money in a bank, you and I would investigate whether the bank is safe and how leveraged it is. The bank would have to earn our trust and keep perhaps as much as 20-50% of the deposits on hand. In the world of regulated and deposit-insured banks, we don't investigate. Our depostis are safe, because the government insures them. That is, the risk is transferred completely to the tax payer. The bank, to earn profits, levers up 20-30 times and engages in risky lending and trading. It is the regulation itself that makes banks risky. The Volcker Rule is an over-regulation solution to an over-regulation problem.

Dividend Stocks Are Not The Answer

The WSJ yesterday ran an article exlaining that switching to high dividend stocks is not the same as using bonds in a portfolio. A stock is a stock. You may be getting a 3% dividend yield, but the stock can crash 30%. The movement in the bond's price is constrained by the present value equation and is likely to be limited to a few percent, if that. The dividend strategy has been touted recently as the "solution" to the interest rate risk of intermediate-to-long term bonds. Many yield-starved investors have been drawn to this idea without perhaps realizing the full risk of these "safe" stocks. If yield is your objective, how about shorter maturity bonds with almost no price risk?

Europe Solves the Debt Problem

Last month, European leaders agreed to a new limit of structural deficit at 0.5% of GDP and reaffirmed the total debt burden limit at 60% of GDP. As the WSJ article explains - especially telling is the Target Practice graph, only Estonia, Luxembourg and Finland currently meet the criteria, the rest of the European countries would need a hundred years and a miracle to get there. France's deficit is at 5.5% and debt at 85% GDP; Italy's at 3.4% and 120%, Germany's at 1.4% and 82%. The only thing spoiling my Schadenfreude is that Illinois, California and New Jersey are in as much trouble as southern Europeans and the Feds are pushing our debt into the 80-90% range.
Let us do a rough calculation. Greece has €350 billion in debt. At 10%, that means €35 billion in annual interest payments. Total government revenues are €32 billion (expenditures €45 billion). So if you shut down the country completely, you don't have enough money to pay interest for one year. Europeans claimed that default was out of the question....  

Useful Websites with Financial Info

Here are some sites for people new to financial markets. These are as easy to read as it gets when it comes to learning about the what, who and why. Avoid popular sites, TV networks, political sites, you only get the day's spin and entertainment.

Economic info:
www.briefing.com click on economic calendars, expand this week, click on line items to learn about
http://www.marketwatch.com/economy-politics/calendars/economic
Mutual funds:
https://personal.vanguard.com/us/funds/vanguard/all?sort=name&sortorder=asc
search using different criteria, then go back and see ETFs
Bonds:
http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/ for the yield curve
www.investinginbonds.com an ugly website, but it has the actual individual bond trades for the day
http://www.ft.com/markets/capital-markets  bond news from the Financial Times
ETFs:
http://finance.yahoo.com/  click on ETFs under Investing
http://etfdailynews.com/       http://www.marketwatch.com/tools/etfs/html-news.asp
Commodities:
http://www.commodityonline.com/      http://www.bloomberg.com/news/commodities/
Front pages of newspapers:
http://www.ft.com/home/us     http://www.nytimes.com/     http://www.economist.com/
http://online.wsj.com/home-page    http://www.reuters.com/
Back door to several useful links:
http://www.site-by-site.com/usa/cef/  click on derivatives exchanges, bonds, and others

Driving a Prius Does Not Make You Green

Read in WSJ It's Too Easy Being Green; In case WSJ removed the link here it is

A brilliant article in the WSJ. Driving a Prius, flying a 787 or A380 to New Zealand, relieving traffic congestion, eating locally grown tomatoes does not make you green. In fact, it encourages more driving, flying, inefficient food delivery. Only NOT driving at all, NOT flying, NOT eating, NOT showering, NOT using a ski lift, NOT using cellphone towers makes you green.
NOT CONSUMING is green, but very boring.
Are you latte-drinking REI-clad Subaru-driving coexist facebookers willing NOT to consume?
I think not.
Before recycling became free in Salt Lake County, very few houses in my neghborhood had the blue recycling bins. Now every Tuesday morning, before they get into their giant Suburbans, my neighbors put out bins hugely overflowing with plastic wrapping from Wal-Mart and cardboard boxes from Costco. Some have more than one. Success of recycling.
See Wilson's link to http://www.youtube.com/watch?v=badoMjA_rW0