The Weekend Review: Three From Barron's

It has been a while since I've done a "weekend review," but Saturday's Barron's had so much fun and meaty stuff in it the time has come.

1. When Growth is Artificial by Vito Racanelli

Mr. Racanelli's article raises two interesting questions: (1) the implications of stock buybacks on EPS and market signaling specifically; and (2) the impact of the LBO/private equity boom on the future of equity returns generally. Some extracts relating to his stock buyback arguments provide both a historical perspective and short-term effects:

The current magnitude of equity shrinkage hasn't been seen in the past 16 years, says Francois Trahan, a senior managing director at International Strategy & Investment Group. This is generally a bullish sign. But the naysayers, and there are a few still around, note that stock buybacks also juice earnings-per-share growth artificially.

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ISI's Trahan figures that about 3.5 percentage points of that 5% is due simply to a lower share count, or a lower denominator, not higher profits. Short term, buybacks are investor friendly, but it's not a commitment to the longer term. "Ideally," you'd like to see that cash go to raising dividends, he says.

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A dividend increase better aligns management's interest with shareholders'. The market knows that EPS increases are declining, but perhaps it doesn't get that "the total amount of earnings available for shareholders is decreasing," he says.

I've written quite a bit about mis-communications and falsehoods concerning stock buybacks. And while this article doesn't portray buybacks in a totally adverse light, it does go to the issue of the impact of buybacks on EPS. Which to me is a necessary but insufficient treatment of the topic. Sure, buybacks can impact EPS (positively or negatively, depending on the after-tax cost of capital used to implement the buyback and net margin), but the more salient point is the execution of sound corporate finance policies. Is the excess cash that management deems to be available for a buyback cyclical or sustained in nature? If the excess cash is cyclical, and if sufficiently attractive organic investment opportunities are not present, then a targeted stock buyback is what I would want as a shareholder. However, if the excess cash position is deemend to be sustained, then I agree with Mr. Trahan of ISI's contention that a change in dividend policy is a more effective means of aligning management and shareholder interests. But an isolated discussion around the impact on EPS strikes me as a waste of time; we all know that the accrual accounting system is overly complex, game-able and broken, and that operating cash flow generation is where it's at. So a discussion of buybacks without seamless integration into overall corporate finance policy is both short-sited and missing the point, IMHO.

But equity -- like matter -- can't be destroyed, only changed into another form. Those ubiquitous LBO firms will have to sell that equity back to the public a few years down the road to realize their investments, notes John Goetz, research director at Pzena Investment Management, in a recent report.

The current LBO boom will create a subsequent explosion in initial public offerings, pushing lots of new stock from debt-laden companies onto the market, he writes. "Any time investment dollars rush in one direction, in this case private equity, future returns will, by definition, be lower."

Now this is an interesting point. Private equity is also something I've written about a lot, and the fact that PE firms are spreading their tentacles and moving into other non-LBO asset classes to soak up their assets. There is no question that a pipeline of IPOs will fill over the next 1-3 years, placing downward pressure on expected equity returns as the supply/demand imbalance flips. We can already see this happening as the private equity and hedge fund firms themselves prepare to go public, because why would they want to be at the rump end of the IPO wave? Better to be on the front when supply is short and demand is dear. They are traders, remember. They've got your number.

2. Brokers Spruce up Their Systems by Theresa Carey

In the wake of the sale of Stockpickr to TheStreet.com (which I blogged about last week), there has been increasing attention paid to the application of Web 2.0 technologies to the investing arena. Ms. Carey provides another example of an interesting company applying such principles to the building of a robust trading and investment platform: 

TRADEKING (www.tradeking.com) is just one of several firms branching out from existing product offerings. It is enhancing its social-networking capabilities to promote collaborative learning and community sharing. Think of them as the financial equivalent of Websites like MySpace and FaceBook -- allowing members to post a profile and blog about trading. Participants can also interact online via live chat rooms and instant messaging.

"People socially network about investments in the real world. It's a natural extension to have these conversations amplified through technology," says Donato Montanaro Jr., CEO of TradeKing.

One new wrinkle known as Certified Trades allows members who are also clients to publish their verified trade history. That way, when you're reading a blog on the site, you can tell who's actually making the trades that they're talking about -- helping you avoid possible touters and pump-and-dump schemes.

TradeKing is one of many new companies working to integrate social networking into the investment process, albeit with a higher level of professionalism, transparency and trust then many of the social-networking-for-stock-picking start-ups that came on the scene last summer. As noted in my earlier post on the topic, I am excited to see the wave of new companies hit the market at the intersection of trading and social networking yet with a control/transparency overlay that makes such models increasingly compelling. 2007 will be the year of massive evolution in this space, to be sure.

3. A Legend Lashes Out by Lawrence Strauss

Michael Steinhardt is a legend and for good reason: his returns rocked and he is widely acknowledged as one of the greatest traders of all time. And Mr. Strauss does a good job getting Mr. Steinhardt to reminisce a bit about his time in the hedge fund business, comment on where he sees the industry today and to distill what, in fact, hedge funds should be about: the ultimate alignment of investors' interests with those of the GP in the unerring quest for alpha:

MICHAEL STEINHARDT, WHO LAUNCHED his hedge-fund firm 40 years ago and quickly became an industry giant, doesn't think much of some of the people making huge fortunes in the business today.

Back when he started, he says, hedge-fund chiefs were members of "a very limited, elite group that had mystery and excitement and élan. Now, it's all about making money for the managers." Steinhardt, who routinely made 20%-plus annually for his investors, adds that a lot of his modern counterparts are far better at gathering assets -- a key factor for their pay -- than they are at generating investment gains. "If I made 11% in a year, I'd be committing hara-kiri. These guys make 11% in a year and they are overjoyed."

He's even more critical of mutual funds, whose collective performance he denounces as a "disgrace."

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With managers now collecting management fees of 1% to 2% -- or even higher -- on billions of dollars, "they are extraordinarily well-compensated," says Steinhardt. "I used to say that I should not make a dime unless my investors made a dime, and the 1% [management fee] was supposed to be enough just to pay expenses." However, he adds, "This is a free market" and investors sign up "of their own free will. So one shouldn't feel sorry for them."

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Steinhardt liked to make contrarian calls and to invest in just a small number of stocks, especially those not well-covered on Wall Street. "You're not going to bring anything to the party on IBM," says Lattanzio. "They will tell the same thing to everybody. It doesn't mean it's a bad investment. But he liked to find things that were different." And, he adds, Steinhardt "was very good at understanding if there was an edge there."

There is not much more to say except that I couldn't agree more with Mr. Steinhardt. A supply/demand imbalance has skewed the game to the point where motivations between investors and GPs aren't always aligned? Why? High management fees. How important is true alpha if there is more risk to the GP of losing assets by pursuing true value-added ideas (which entails risk and necessitates true hedging) versus doing just ok, capturing a stratospheric management fee and large absolute performance fees due to high assets under management?

Sure, one can argue that truly great managers will always have the competitive fire to pursue alpha with laser focus, regardless of management fees. But how many mediocre managers are out there running $3-$10+ billion in assets and getting richer than Steinhardt, Robertson and the like who couldn't carry their jockstrap in the investment game? Quite a few, for sure. And this is what sucks about the hedge fund business. Not the pay of whose who truly deserve it. But the pay of those who truly don't. But we live in (and should live in) a market-driven world, and for those who can reap these rewards due to massive flows into the asset class without being truly great, enjoy. Because the day will come when the pendulum will swing in the other direction, and at that point, may the force be with you and may you have taken your chips off the table. Because markets like these don't last forever.

Comments

[Yaser Anwar]

With all due respect to Mr. Steinhardt and the column, it doesn't really tell us something we don't know. Does it sound better coming from a legend? Probably.

Over the years, the top HFMs of the 80-90s (and still on top of the food chain) i.e. Soros, Tudor, their clients risk appetites have changed to "low volatility and double digit returns" from "home runs and swinging for the fences (in a calculated manner of course)".

I think part of the problem also stems from the fact that they've got a lot more of their own wealth in the funds now, which might be leading to a more cautionary approach.

That said, the latest I.I. and MARHedge surveys show the increase in allocation , from Pensions, to Alternative Assets, and a good portion of this influx of capital will be in the new marketing gimmick "managed accounts". So long Alpha, hello Beta!

[Roger]

Drew, awesome comment. You are so right. Yours is a "forest for the trees" comment - and the forest is the disaster that pension fund deficits represent. You can already see pension funds desperately chasing returns via alternative assets, which will invariably end in tears. Management of long-dated liabaility pools requires rigorous, long-term thinking, precisely the opposite of short-term, jump-on-the-bandwagon behavior which one can feel rippling through the pension fund community. Hopefully this will change after a few keen knocks on the head, which will invariably be suffered by short-term oriented managers of long-term liability pools. It will be an interesting movie to watch. Unless you happen to be a U.S. taxpayer, and therefore a guarantor via the PBCC.

[Drew Robertson]

Don't get too upset by these lucky schmuck hedge fund mgrs. They're just going with the flow. The flow pushed by desperate pension funds and insurance companies who have no fishing idea how to balance their obligations 10-20 years out with the expected returns they anticipate from index funds and fixed income "investments". What should they do? That's a more interesting and consequential problem than membership dues at Stanwich CC.