It was odd to read the article by Andrew Ross Sorkin today in the WSJ. In it he talks about how all the major investment banks “missed the red flags” around Groupon as the company selected bankers for their planned IPO. He mentioned the balance sheet, the sales model and the fact that insiders already cashed out. Much of this was already discussed and written about when the filing came out and subsequent events made the story even more distressing.

Investment banking is purely about transactions

Mr. Sorkin is an experienced journalist and the WSJ certainly should know their way around Wall Street. What’s going on? Investment banks are hired to support a transaction. It’s true they sometimes call their services “advisory” when it comes to M&A but they only get paid when transactions happen and their fee is based on the size of the deal. It’s not hard to imagine what their motivations and priorities are. They get paid the same for good deals and bad deals.

Of course banks care about their brand and prestige. Goldman has standards. However those standards are driven by the market rather than from within. In other words if the market will accept it and thinks it’s good, Goldman is happy to get the print and take the fee.

All this is especially true during the “bake-off” portion of the IPO process. At this stage a company like Groupon invites all the banks to come and do a dog and pony show with the senior management team to prove how valuable they would be as an underwriter. They are not in evaluation mode, they are in selling mode.

Much like a courtship the banks are invited by the company to “show how much they love them.” Only one suitor gets to be the lead bank (although in large deals there can be two or three) and the rest settle for placement that earns then a nice fee for which they will do zero work. And I can tell you it is zero. (The research analysts at those firms will eventually have to provide stock coverage (buy, hold or even sell which never happens) but the bankers and the distribution network does nothing if they are not the lead bank.)

A key part of the process is where each banks provides a “valuation estimate” for where the shares should be priced and expect to trade. This is the most absurd part of the process because the banks all try and find the highest number. They do need some justification which typically involves sending associates out looking for “companies that have something in common with this one and trade at or have traded at obscene valuations.” They put these in a sheet and find the metric that will create the highest valuation. Banks don’t spend anytime on how much *they* would pay to buy stock in the company. Thanks to the new regulations separating research from banking they can’t even involve the one person or people at their firm that would have worthwhile analysis.

It doesn’t have to be this way

In the “old day” some investment banks like Morgan Stanley tried to maintain high standards that they demanded companies meet before being willing to underwrite an IPO. As they watched other banks run away with deals in the mid-1990′s they changed their approach and created one of the best known “investment banking research analysts” in Mary Meeker.

Before regulations there were some small firms (like SoundView) that actually aligned the interests of the firm with investors in an IPO stock. For example before agreeing to be part of the deal the research analyst had to support a “strong buy” rating on the company with some caveats around pricing. More importantly the compensation of research analysts were tied to deals but subject to company execution. For example if a company came public and either missed published estimates or lowered guidance the analyst would not be paid on the deal. Pretty simple but it made analysts much more certain about their estimates which investors in the company would be relying upon.

The little research investors had back then was all stripped away with the new regulations put in place to “protect them” from the unscrupulous research analysts at other firms (guys like Henry Blodget and a few others at the “bulge brackets”.) It’s not unusual for regulators to get it wrong since they don’t have a deep understanding of the markets they are tasked to regulate. Today investors have to realize that “buyer beware” is just as valid in IPO stocks as it is in most other transactions. It’s unlikely that regulations or markets will get more investor friendly.

Conclusion

This situation is one of the reasons we cover newly-public and even some emerging private companies. There’s opportunity to help investors make decisions and in some cases to exploit solid investment opportunities in the absence of strong independent coverage. Much of our IPO-focused research comes out over at IPO Candy.

I hope the WSJ and Mr. Sorkin can start writing from their knowledge base which should be much deeper around investment banking and Wall Street than this article suggests.

It’s been a rough few years for the US economy. After the financial crisis the structural reforms and government intervention started comparisons between the US and slow-growth, socialist-leaning countries like France. Perish the thought!

But years after stimulus and “recovery” the overall US economy has not added many jobs and just doesn’t feel very robust. Some look abroad to China and feel that their sheer size, growth rate and seeming invincibility will make them the global economic power in the fullness of time.

Big corporations are the problem, not the solution. When it comes to job growth it turns out that small and medium sized businesses create about 120-140% of the new jobs in the US. That tells you something about what big corporations are up to. They are reducing payrolls and moving jobs to “more efficient” providers abroad.

The burdens on small businesses though have made it harder to hire. Healthcare costs are substantial and the economy isn’t strong enough to support speculative hiring. Today thousands of college graduates bemoan the lack of $85K annual jobs that will train them to do something useful and wait around for “things to improve.”

Mayor Bloomberg has hit on a perfect opportunity for the US to get back some of the mojo that built the country and made it great. Immigrants have been the key to growth since the US came into being. Our policies are stupid and self-defeating. He lays out a set of proposals that offer the greatest bang for the buck than anything else we have seen in recent memory.

Image via Wikipedia

Changing our policies would allow the best and brightest to come and remain in the US to get a college education and start new companies that will provide the new products and services, jobs, taxes, and investment opportunities that we need. More companies, more jobs, more demand for housing, more prosperity – all for little to no cost for the country.

There’s lots of attention on QE3, near-term job growth, health care, inflation and quarterly numbers. But the real long term growth engine for the US, the thing that makes it different than every other country in the world, is the strength that comes from immigrants that come to build a better life and in turn our economy and country.

Every day the news is filled with the equivalent of whining over entitlements. Meanwhile so many smart, talented and hardworking people in the world have neither freedom nor opportunity. Their attitudes, efforts and impact is sorely needed in this economy right now.

It’s worth taking the time to read or listen to the entire Bloomberg message and also see lots of the information that backs up the merits of the proposal.

[Disclosure: None. I'm not a particular fan of Bloomberg and a registered independent. I like fact-based legislation that still remembers the positive traditions, honor and character of the country. What Bloomberg is talking about here is a great example.]

Related articles

• Hell Yes, Mayor Bloomberg. I’m With You. (techcrunch.com)

A few weeks ago, an inspired email exchange between ourselves and some research partners made it too hard to resist posting Why not just eject Greece?. After that the matter seemed to pass and markets quickly forgot about the problem.

But, given recent events and our little downdraft yesterday, we find ourselves returning to the topic. The other solution we discussed was that Greece should simply sell off some of its islands. Greece has about 6000 islands, most of which are uninhabited but potentially quite valuable.

They are beautiful and a very popular vacation destination for the population of richer countries like German and France. Also, just think about how much Nordic countries might like a warm oasis down south!

Since many of the islands are uninhabited and have no infrastructure, Greece would also stand to gain valuable short and long-term economic growth from the additional infrastructure investments and nearby population growth.

In short, selling off a hundred islands or so would be a huge win-win, and such a number is still a very small fraction of what Greece owns – so they wouldn’t even really need to enact radical reforms since they could finance  future expenses with more island sales.

This strategy would get them through approximately the next 100 years, depending on their economy and the ultimate prices realized from the sales. Of course, I’m sure they would want to draw the line at inhabited islands or, in the very worst case, Crete.

Some have pointed out that this “can never happen” because it’s somehow “wrong” for rich countries to “take advantage” of poor ones. All I can say to that is “WHAT?!” This is a country of adults who can well decide for themselves how to run their country, and they are hardly poor. Add to that the fact that the government engaged in what most agree was fraud in overstating revenue and understating expenses to avoid harsher punishments earlier in the process – so why not?

As we wrote earlier this month, if you want a union of equals then the countries have to take responsibility for their own actions. This is a “crisis” that was brought about by a simple lack of caring, honesty and attention. If there was a natural disaster, of course help should be forthcoming, but I fail to see any compelling reason for there to be in this case.

My business partner is fond of calling Europe “a beautiful museum,” and so it seems fitting that if money needs to be raised, a country like Greece might call on Sotheby’s to showcase and hold a fine auction of a hundred or so of its islands. That way rich individuals, corporations, and countries can bail Greece out cheerfully in exchange for a small piece of waterfront property. (Didn’t America do this once in the 1980′s with Japan?)

Our friends at GaveKal argue that if Greece doesn’t get bailed out, it’s clear that country risk will return to the fore of yesteryear. It’s also been made clear that the Euro will not shelter Europe from any crisis, as it once was thought to be able to do. Given these realities, some major waves of asset pricing will have to roll through the Euro zone before the dust settles.

“Fasten your seatbelts. It’s going to be a bumpy night.” – Margo Channing (Bette Davis) in All About Eve

The market has been acting much as our friends at GaveKal have discussed as prices have “melted up” here in Q4. Fundamentally prospects for better business momentum in 2010 are good and valuations on many stocks we follow still offer reasonable upside.

As we enter the final few days I expect self-interest among many investment managers will push prices toward the best possible “market to market” at the close on December 31st. With volume light it will be easier to lift prices with concerted buying than usual. 2009 returns should allow many investment managers to post a strong annual return and pocket nice performance-based fees for the first time in a while. It’s also an ideal time to be getting a cash performance bonus as many popular asset classes like real estate are attractive if you have cash.

However after December 31st the motivation for pushing prices higher to maximize current compensation will evaporate and be replaced with speculation about Q4 reports and 2010 guidance updates later in the month. If true it argues for a little pull-back in prices with the first trading day in 2010 and into January depending on likely guidance versus expectations for 2010. (R2 will compile and publish our spreadsheet on that by mid-month.)

On the flip side tax-loss selling also applies to the few names that have lost a great deal of value in 2009, especially given the triple digit gains in so many stocks. In some cases this will push share prices down to levels where I’d add or own shares for a bounce in January.

I’d never pretend to know what the market is going to do in the short term but starting with a scenario helps to manage positions and exposure of a long-term portfolio.

No matter what happens in the last week I think Champagne sales will be healthier this year than last…

The news is simple, in a rush to raise capital and reduce government control (to pay higher compensation) Citibank priced an offering “in the hole” as they say and in the process spooked the treasury out of selling their 34% stake.

We’ve seen most of the informed commentary that suggest the entire episode was “pathetic” and bad for stockholders. Although the transaction process was a mess (isn’t that one of their core businesses?) it’s not the big story.

The fact is the massive Treasury stake is now a major overhang and they have basically said that they are ready to sell but at a slightly higher price than the recent deal. In other words you have a monster seller sitting above the stock waiting for a price.

Now it’s possible that results will continue to improve at Citi and eventually there will be enough demand to “clear out” the supply but we are talking about one hell of a large supply of stock.

There could be some interesting trades here knowing all this. For example selling calls above where the Treasury would want out could be a safe bet given the right options strategy. (See related post on options as a strategic investment.)

[Disclosure: We have no position in Citi.]

We’re listening to the latest economic and market analysis from the smart gents at GaveKal research and during the talk we were reminded of some conditions that existed during the most intense phase of the technology bubble of 1999 and 2000.

It’s obvious that China has been financing US consumption so that they could enjoy the growth that has helped to propel their economy.  Equally true but less obvious is that Germany has been doing the same thing for weaker countries in Europe to the tune of a few percentage points of GDP.

Some may not remember that in 1999 we witnessed some extreme business practices.  A startup company would accept a large investment from a larger company.  At the same time the large company would be come a “marque customer” of the startup.  On top of that cozy mutual reward system the startup would offer the larger company payment terms, basically financing their purchase.

In retrospect it is difficult to imagine that investors tolerated this type of activity.  But tolerate they did and until the dam broke early in 2000 many embraced it with both arms.

Right now this same type of activity is going on with respect to China and the US and Germany and many of the EU countries. Of course the scale of these operations are vastly larger than what happened in the US technology sector back in 1999.  But it has been going on for some time and there is no way to know how long it will continue.  Some have speculated that the Germans tolerate it because the average man on the street doesn’t realize that it is going on and those that do realize it’s a bit like a fatal embrace.  If Germany were to clamp down, their own economy would tank.  The same situation vis a vis China has been discussed ad nauseam.

What should one make of this?  In the short term there doesn’t appear to be much to do about it.  The US and the global economy has stabilized and is recovering.  All economic players are committed to maintain easy money for some time and the current worry is more deflation than inflation.  Nearly all the players have a strong shared interest in maintaining this broadly faith-based system of measures to keep all the plates spinning.

We thought that a piece we published back in April of 2007 “What would Godel do?” was now very much out of date but it may come in handy again.

The U.S. stock market has been described as “painful” by many of our colleagues.  The recent rally left many on the sidelines.  The move up came because “things stopped getting worse at a faster rate” but now it may start to feel that the next stage of “things actually not getting worse and likely to improve” isn’t quite clear enough to support a further rally.

Unfortunately there is no way to predict the short and medium term moves in the market.  We’d love to ignore them but no matter how narrow our stock selection process they get caught up in the tide of market ebbs and flows.

As has been said for a long time, all one needs to understand is fear and greed and know which one is operating at the moment.  But in this market they seem to be hand in hand and in the market every day.  Witness the inflation debate.  While most experts actually agree that there is no real evidence of inflation and cases can (and have been) made by GaveKal, Krugman and others that we will dodge this bullet. We may even do it in a fairly routine and predictable fashion.

All that reasoning doesn’t matter of course.  We actually read a piece today from a sell-side firm (we will leave out their name to protect the innocent – there must be some there right?) that actually brought the hyperinflation of Nazi Germany into the argument.  Seriously?!?  Yes they did!

Now their piece goes on to say that their analysis suggests that we remain in a structural period of tame inflation and they don’t think that would change.  But of course this shows up later in the piece, after the up front fear stoking comment about Nazi German hyperinflation.

This is what makes a market. That’s all fine and good but the schizophrenia in evidence makes it very hard to manage portfolios.   It demands a daily analysis, affirmations and adjustments along with a healthy dose of risk management.

We are dealing with some pre-summer positions that will have to be closed or inoculated against losses.  Palm is launching the Pre this weekend and thankfully Mr. Mossberg has weighed in with a pretty positive review.  He rightly points out that the applications are missing and just a few days later Apple will be updating their iPhone which may kill off some Pre enthusiasm.  Others have all given Pre a pretty positive review so the stock may continue to act well into the weekend.  In the short term however it may well have run the course until more carriers come online and we see how the WebOS develops as a platform.  It’s hard to have a reliable IV on Palm but $15 is reasonable at the high end.

Nvidia had a positive but muted reaction to the ION newsflow out of Computex this week.  After hitting a high of $11.20 or so it has settled back to just above $10.  Investors are still very worried about margins and remain very much in a “show me” state of thinking for the most part.   However the company has their analyst meeting on the 16th where we expect mostly more of the same from management but an incrementally positive reception from analysts who continue to “dig in” to the story more and more.  IV on NVDA is $15.

The Apple story plays out just as it should and there are few surprises there.  This is a massively over-covered stock to be sure so doesn’t require much work beyond knowing where the IV belongs.  Right now we are at $150 and are sticking with it until after the summer.

Emerging markets have had a great run.  The group we bought (China, Brazil, Canada) is up 25% but should continue to do well (perhaps not as well) for the rest of the year so not much reason to reevaluate at this point.

Although our decision could change at any time our plan is to move from 25% cash, 75% long and 20% short to 50%/50%/15% by the Summer and keep a watchful eye on what still feels like an unsettled market.

[Disclosure: Research 2.0 has positioned in all the securities above that would be described as net long although some have options and other short components involved.]

I can’t quite figure out why the government and people in general are eager to enact new rules like the uptick rule and individual stock circuit breakers to combat short-selling as if it’s an evil thing.

I do understand how aggressive short selling can disrupt a situation where leverage is used or other forced actions are required based on price action and valuation changes.  I’d say these situations need to be dealt with fundamentally and not by trying to protect something which is obviously unstable by limiting the ability of the markets to correct it.

Here are the reasons that this line of attack seems unreasonable:

1. Short sellers are fairly small in relation to markets overall.  While they can be felt in focused areas, funds available for short-selling are small in relation to pool of assets that can make long investments.  Short selling can make a real impact when it is focused and especially where markets are thin.  But they are far too small to be labeled as being a major part of the problem.  They may have been a catalyst to accelerate or cause some bad structures to tumble but they are not strong enough in and of themselves to be a primary factor.

2. There are a variety of reasons to sell short, most of them are neutral or positive, not evil.  For example we use short positions as a way to lessen our market and sector risk against our long portfolio.  It stabilizes our overall equity value and allows us to further enhance our returns based on good stock selection.  For example one would want a long postion in Apple based on their strong fundamentals but a year ago the stock was hovering between $160 and $180.  So even though a long position in AAPL is “correct” from a research standpoint (at least ours) the valuation and market risk means that today you are down materially if you didn’t take some risk-limiting or buffering action.  Most efficient asset allocations would include short selling or short positions as part of an overall strategy.

3. Options and derivatives are another way to have a short position. One can sell calls, buy puts or enter elaborate combinations of contracts to effectively establish a “synthetic short” anyway.  If you’re large enough, brokers like Goldman Sachs or JP Morgan can even create a special contract for you that isn’t even traded in the public market.   So focusing on just one method of being short (shorting selling the stock) seems odd.

4. What about rules on the other side of the ledger?  What about funds that buy stocks, especially thin ones, at the end of the quarter to enhance quarterly returns?  What about investors and sometimes managements that target a stock with a large short position and intentionally try and “squeeze the shorts” to goose the price of a stock?  There are just as many abuses by unscrupulous types on the long side as the short side.  Spreading a false positive rumor can be just as effective (and illegal) as spreading a negative one and being positioned to make profits from the likely market reaction.

There do appear to be areas like fail to deliver and others that make sense to crack down on.  Targeting a type of investment seems just plain wrong if a market is to function properly.  Short sellers contributed to the drop in PALM to $1.20 just a few short months ago.  We were only too pleased to buy stock there thank you very much.  That’s what makes a market.

Speculators and investors long or short are putting their capital at risk.  Their rewards and punishments are meted out by the market.  Bad decisions and management brings one to ruin, good decisions backed up by strong research, valuation analysis and risk management make you rich.  Hasn’t all this already been covered already somewhere like “Markets & Investing 101?”

Not happy to be up on the soapbox so I’ll get off now.

[Disclosure: Research 2.0 maintains a small, actively managed portfolio of technology stocks to put our ongoing research conclusions for validation.  Risk management includes a dynamic adjustment of position sizes and the use of short positions and options.]

Since we’ve always been in technology our paths haven’t crossed much with firms like Berkshire Hathaway.  They have long eschewed investments of a technology sort with the refrain that they focus on “businesses they can understand.”

Few would bother to argue with that stance.  One isn’t likely to outperform by knowing less than others about an industry or an underlying business.  Technology companies also have an extra high-octane component that has to do with the companies positioning and investor perception.   There are often giant disparities between where two very similar companies trade from a valuation standpoint.  It’s not unusual to see one company trading at 1x sales and 12x earnings with another at 5x or even 10x sales and over 50x earnings.  These large gaps exist even when we normalize margins.    Getting these differences right can be as important as understanding the fundamentals about the technology business itself.  Yet another reason to avoid technology investing unless you have a real edge.

Something happened to the boys at Berkshire that we didn’t expect.  They stumbled into the perception problem from another direction – options and derivatives.  The first time this got reported and the stock tanked, we bought shares in $BRK for the very first time.  They rapidly recovered their lost value and we sold due to the large gain in a very short period of time in a market that puts a premium on keeping dry powder around every day.

A few weeks later we read the Berkshire shareholder letter and immediately saw the problem.  Warren Buffet and Charlie Munger certainly understand what they are doing and their newfound exposure to long-term options and derivatives looks like a good decision from a dollars and sense standpoint.  However it’s put a cloud of doubt into the story and creates a risk that long-term core holders in the shares may decide that the company is no longer what they understood.

We’ve observed that options are a real blind spot for many people, no matter how smart they are.  We spent a heated hour or two in the White Horse Tavern in NYC trying to explain them to a friend who had a PhD in physics to no avail.   Since then we’ve worked with scores of analysts and found that many have a hard time getting even the most basic options contracts and stategies.  There’s just something about them (like statistics or chemistry or drawing a horse) that blocks the mind.

Warren took great pains to fully explain their exposure in the shareholder letter and why large fluctuations in stated value and the balance sheet were not “real” in his sense of the word.   The problem is the majority of his shareholders may never be able to fully understand and feel comfortable with the new story.

The real question for us is do they understand the valuation haircut they may have given $BRK thanks to this new facet of market perception?  Unless the situation reverses itself the gains made from these new positions may not be enough to offset lower investor confidence in their asset value and investment approach.

[Research 2.0 has no position in $BRK at the time of this writing.]

Today GaveKal was out with a research note regarding the growth of consumption in Asia.  We won’t regale readers with the entire note but one thing stood out:

Asian consumers generally have space issues and tend to be technology savvy.  These conditions tend to stimulate purchases of technology gadgets as consumers get more disposable income.  

Juxtaposed against the recent market sell-off in technology shares the argument is more compelling.  The fact is that technology companies are generally in much better shape to weather the slow growth since many of them are so cash rich.  (25% of assets in the S&P technology companies are in cash)

So technology stocks look like good medium term call options on global growth and are positioned very well longer term to benefit of increased consumption in Asia. 

The above comments capture the gist of what was said in the note and we would add that a number of very strategic core names like Apple, Adobe, Google and Cisco should probably be bought here on a long term basis.

Overall economic fundamentals and a lack of certainty on future estimates will keep some pressure on these names but owning shares in these franchises when growth and visibility comes back will absolutely be the right thing to do.

Technology innovation and adoption is alive and well.  We are in a short-term pause before what appears to be a major adoption cycle a year or two out.

[Research 2.0 owns shares in the names mentioned above.]