Standard Chartered's Trip to Inland China

As much as I try to focus on the numbers and relatively high level macro stuff, I also appreciate it whenever I get sent some research that involves analysts actually getting off their desks and checking things out. Maybe it’s just the Peter Lynch mentality I grew up idolizing.

Anyhow, really enjoyable and insightful piece from Emerging Market Credit specialists at Standard Chartered on their recent trip to inland China. Thought I would share it.

On Levered ETFs, Personal Responsibility, and Having Enough Rope With Which To Hang One's Self

My boy Felix Salmon has a curious post up this evening, wherein he says anyone who isn’t a (professional?) day-trader should be barred from trading levered ETFs, and that the SEC needs to protect these people (from themselves).  I like Felix, but he is seldom (as) off the mark on anything as he is here.  His post ignores both existing regulatory practice and the – bear with me here – relatively simple workings of levered ETFs.  Allow me to explain…

Levered ETF’s like TBT (which Felix mentions) – or my two favorites, FAS and FAZ – have embedded leverage, that is, they are designed to produce 3x (for FAS/FAZ) the daily return of a basket of stocks/index (or the inverse thereof, in the case of FAZ).  The key word here is “daily.”  Daily, as in, if the index gains 1% ON THE DAY, the levered ETF will (er, is designed to) return 3%, and the inverse ETF -3%.  EACH DAY.  Not over-time, EACH. DAY.  This is spelled out in extremely plain language in various places, for example, on the Direxion (the sponsor for the ETF) website, under the column “daily target.”  The detailed page for each specific ETF, for example FAS, says in the very first paragraph:

Fund Objective

The Financial Bull 3X ETF seeks daily investment results, before fees and expenses, of 300% of the price performance of the Russell 1000® Financial Services Index (“Financial Index”).

This is repeated in several other places, including the fund prospectus, and after it became apparent retail investors had no idea what they were getting in, various additional disclosure from brokerage firms before executing buy orders for these securities.  Still, despite the myriad painfully clear explanations of how these securities work, retail “investors” put their capital at-risk without doing even the most basic and cursory “research.”  To many of these “investors,” (3x) leveraged ETF’s are somehow supposed to produce the > daily return of the underlying index.

I constructed an example case a few years ago to illustrate what happens here, and how such misunderstanding causes ignorant, naive, and frankly masochistic “investors” to potentially bet the farm on a volatile security they do not understand.  Imagine the possible returns for the index are {+-5%, 10%}, arbitrarily assigned over 10 trading days (two calendar weeks).  Investors in a levered 3x ETF based upon this index often imagine their returns will look like the yellow-ish line in the below chart, while in reality, they’ll look more like the light blue line.

Even though the underlying index has a positive return over the 10-day period (a little over 2.5%), the 3X levered ETF has a negative return, and if the position is sold (by choice, by fed call, it matters not), the “investor” will end up losing money, up to almost half of their initial investment!  If investors got into the inverse ETF based upon the same index, with the same daily returns, the yellow-ish line represents what they’d be expecting, while again, the blue line represents what they’d actually see:

Notice how it is entirely possible for both the levered etf and inverse etf to produce negative returns over multi-day holding periods.  Remember, this is when the trend over time is a slight uptick in the value of the index with (admittedly) volatile daily returns.  When markets move generally in one direction or another – either up or down – it can have profound effects on levered ETF’s because of how they’re designed.  In generally rising markets, inverse ETF’s will approach zero over time because subsequent returns are compounded on a lower-and-lower base.  In falling markets, bull leveraged ETF’s will exhibit similar behavior.

If we look at FAZ – the 3X inverse financials ETF – over the past two years compared with the Financial Sector Spyder, XLF, when stocks – especially financial ones – experienced a significant rally, we can see that FAZ has decreased in value as we’d expect, with the value approaching zero (i.e. the loss approaching 100%):

As should be extremely obvious at this point, understanding how these ETF’s work is not rocket science, and it does not take much time/effort to do.  If you do a quick google search for “how do leveraged etfs work” returns a large number of posts, most of which answer the question with little ambiguity.

Let me put this as nicely as possible: You have to be self-defeatingly ignorant/naive/lazy to trade these things without learning about them.  If you have an internet connection, you’d actually have to go out of your way not to pick-up some basic knowledge about how leveraged ETF’s work just by sheer happenstance.  The information is EVERYWHERE, easy to find, and just as easy to understand for anyone capable of opening a brokerage account and executing a trade.  Additionally, buy orders for these securities require express (at some broker/dealers, from the branch-manager) approval, and must be marked as unsolicited, i.e. brokers cannot sell clients on the idea of buying leveraged ETFs.  Clients can only buy them by their own volition, and only after receiving an explicit disclosure warning of the potential to lose a substantial portion of their investment.

According to Felix, though, more and more-stringent regulation is needed:

Given how many people are clearly Doing It Wrong when it comes to TBT, I think there’s a strong case for the SEC to step in here and take a very hard look at TBT in particular, and levered ETFs in general. If day-traders want to day-trade using ETFs, that’s fine — and they can bring their own leverage, if they’re so inclined. But ETFs with embedded leverage are clearly being bought by people who aren’t day-traders at all, and who have no business buying these securities. It’s the SEC’s job to protect those people. It should get on the case.

Let me again put this as nicely as possible:

Bullshit.

Plain and simple.  The SEC DOES  protect the very people Felix is talking about.  That’s why the sponsors of these funds have to disclose how they work in prospectus form, on their website, etc, in language that is so painfully simple even a 5th grader can understand!  The SEC can’t (currently) make anyone actually read, let alone understand the material contained therein, nor can they require that broker/dealers make sure such is the case.  You know what that is?  Because regulations assume that as mature adults, “investors” have enough judgment to be able to read information made available to them, and to use said information to make informed decisions.

Felix’s argument effectively says that because some boisterous, over-confident, naive people choose to dive head-first into the shallow end of the pool before looking down to see the 1-foot-high letters on the edge indicating how deep the water is, we should keep everyone but the Olympic swimmers out of the pool.

Ultimately, the question we must ask ourselves is whether we want regulators to protect us from predatory and unethical behavior from issuers, brokers, and other Wall Street interests seeking to profit from illegal asymmetric information, or do we want them to protect us from our own laziness, naivete, and ineptitude.

If you support the former, then you should dismiss Felix’s argument as itself naive and unrealistic, and enjoy your freedom – but not the obligation – to invest in a variety of securities, using any strategy/approach you deem appropriate for your situation.  If the latter, just don’t come whining to me when the only thing in which you’re allowed to invest is a T-bill, causing your assets to grow at a much lower rate, and you’re forced to work until you’re 87 before you can afford to retire.

How Ford And The New York Times Lie To You

UPDATED (see bottom): On Tuesday, Ford released Q1 results.  Here is the New York Times’ take, emphasis mine:

DEARBORN, Mich. — The Ford Motor Company on Tuesday reported its best first-quarter earnings since 1998, even as its sales shift to smaller, more fuel-efficient cars.

Ford earned $2.55 billion in the quarter, a 22 percent increase from the period a year ago and the strongest evidence yet of its transformation from a company dependent on big trucks into one that can generate significant profit selling cars of all sizes.

The old Ford lost money on many of its cars, counting on sales of more expensive trucks to stay in the black. Today’s Ford, however, is able to persuade many of the drivers who buy its subcompact, the Fiesta, to save on gasoline to also spend thousands of dollars on amenities like heated leather seats.

I pulled up Ford’s 8-k that corresponds with this earnings release.  The word “small” is mentioned exactly once, in the “first quarter highlights,” in the bullet point “Unveiled Ford B-MAX small car and Ranger Wildtrak pickup at the 2011 Geneva Motor Show.”  Neither amenities nor heated leather seats are mentioned at all.  “Fiesta” is mentioned only thrice (and only in that same section):

  • Posted 16% increase in U.S. sales due to strong demand for fuel-efficient products such as Fiesta, Fusion, Edge, Escape, Explorer and F-Series.
  • Increased Asia Pacific Africa share to 2.4%, fueled by Fiesta, Focus, Figo and Ranger; China sales increased 18%, India up 115%
  • Fiesta became the first in its segment to earn top safety ratings in the world’s largest markets — the U.S., Europe, and China

Continue reading

How Much Is Donald Trump Really Worth?

This is a question I have never really pondered for more than 5 seconds, because frankly, I don’t care, or at least I didn’t until I read this Forbes article that explained how they go about estimating his worth.

For our upcoming Celebrities issue, FORBES estimates Donald’s licensing income to be approximately $60 million. This includes earnings from books, ties, cuff links, mattresses, speeches, Apprentice producer fees and royalties, and earnings from the Miss USA, Miss Teen USA and Miss Universe. This does not include any of the licensing deals from real estate, which we are in the process of investigating. By such estimate, Donald’s brand is worth $120 million. Note that the number will likely rise by a few hundred million when we account for his real estate licensing earnings.

I’m not going to dispute that $60 million number because again, I don’t care that much.  What I would like to dispute is how they get from $60 million/year in non-real estate licensing income to a $120 million valuation for the brand.  This is not exactly rocket science.  If you look at the $60 million as a simple stream of cash flows, pick a discount rate, and say it lasts 10 years (not totally unreasonable), and discount it back to present value, the value of the brand is around $350-$400 million.  If you jack the discount rate up to 15%, assume each successive year that his licensing revenue is going to drop by 25% (I think an extreme assumption), that annuity stream is still worth over $225 million!  Even if we only assume cash flows will last for 5 years instead of 10 (using the same, very conservative assumptions), the value of the $60 million/year comes out to over $130 million!

Where Forbes gets $120 million from $60 million/year is really beyond me.  I’m not an intellectual property valuation expert, but if I could buy all the licensing rights to The Donald’s various crap collections for $120 million – and I can’t believe I’m actually saying this – I’d jump at the chance!

This is to say nothing of his various real estate holdings and real-estate licensing income.  I’m not even going to attempt to ballpark either of those numbers, since they are not easy to find, and taking Donald’s word for it would be akin to taking ethics advice from Charles Rangel. The numbers may sound good, but they might be completely made-up.

UPDATE: A comment on Business Insider brought up that this quick back of the envelope number crunching exercise doesn’t consider taxes.  I left them out because I assume the licensing revenue comes into a corporate (or several), which is not necessarily (all) on-shore, making it difficult to estimate the effective tax rate at which the income is subject.

But, for fun, let’s give it a shot and assume the effective tax rate is 25%, and the income declines by the same amount each year, with the same assumptions mentioned above.  Using these numbers, we get a value of $126 million, still above the number used by Forbes, but only slightly.  The point is we can massage the inputs to get any output we want, and unless Forbes starts learning how to be transparent (doubtful), we can do nothing besides question their assumptions and methodology, especially when they seem suspect.

Most Obvious Short Trade Of the Decade: "American Dream @ The Meadowlands" (Née, Xanadu)

This is the ugliest retail space built in the United States since at least the 1960′s.  It is also one of the biggest.  A new deal between the state of New Jersey and a Canadian developer aims to make it even bigger (and less ugly, although that remains to be seen).  In addition to the indoor “ski-slope” (apparently the developers don’t know there are several places to ski outdoors within an hour of Manhattan), the developers want to build an indoor water park and other features not seen outside of Japan since the real estate bubble burst.  Apparently the developers don’t think that traffic will an issue, either.  After all, its not like the NJ Turnpike and Rt 3 (on which I’ve personally ghost-rode my whip) are already packed in bumper-to-bumper traffic at least 6 hours each day or anything…

Remember, this new effort comes after at least two previous ventures have gone bankrupt and/or been foreclosed-upon trying to get the doomed-from-the-start project up and running.   Someone please find out where the debt on this poorly-conceived, horrendously-executed mountain of boom-time excess is trading, or even better, the CDS.  Put me down for lots of protection on those bonds…

Who puts “American Dream” in real estate project’s name?  Seriously.  Especially one with such a star-crossed history as this one.  It’s like they’re actively TRYING to make the project fail!

Wait.  Maybe the developer already IS long CDS…

7Y Auction Results, May Calendar

Today’s 7y auction was largely disappointing, with bonds selling off shortly after the results. Yours truly was expecting indirects around 50, with a bid to cover of 2.81-85, which did not materialize today. The trend in bid to cover continues down, along with a pullback in indirect bidder demand.

Yield: 2.712 vs. 2.895 prev (3/30), Indirects 39.13 vs. 49.41, Bid To Cover: 2.63 vs. 2.79, Coupon: 2.625 vs. 2.875

Updated stats and the tentative May issuance calendar is now posted [GDocs].

This concludes the auctions for the month, enjoy the weekend.

Quote Of The Day, The Bernank Presser Edition

“You seem to believe that when investors are no longer willing to hold a government’s debt, all that needs to be done is to increase the supply and it will sell like hot cakes. We at the IMF—no, make that we on the Planet Earth—have considerable experience suggesting otherwise. We earthlings have found that when a country in fiscal distress tries to escape by printing more money, inflation rises, often uncontrollably. Uncontrolled inflation strangles growth, hurting the entire populace but, especially the indigent. The laws of economics may be different in your part of the gamma quadrant…”

–Ken Rogoff

An Open Letter To Joseph Stiglitz

July, 2002