Everyone knows about the tooth fairy. Who as a child did not place a tooth under their pillow and wake up with a shiny quarter instead? Of course discovering that there really is no tooth farily is not as big a deal as learning there is no Santa Claus. Really, that particluar belief was not that important.
But when it comes to the CDS fairy, there are a lot of members of the financial community who are in complete denial. The way it works is, you go to sleep with a lot of risk managment problems and capital requirments under your pillow, wrapped in a piece of tissue paper or maybe sealed in an envelope, and when you wake up they have been replaced by nice shiny profits from CDS. It happens like clockwork, and has been going on for years.
Listen up. There is no CDS fairy. CDS is a zero sum game, whatever one player wins another must lose. The only way you can continue to claim that everybody is making money is by continuing to increase nontional amounts and premiums, an ongoing Ponzi scheme. They don't create price discovery for bonds, they create manipulation of bond spreads.
I don't know why you don't listen to Uncle Warren and Uncle George, they both say CDS are weapons of destruction but you sit there sucking your thumb and believing the CDS fairy will solve all your risk management problems and your capital requirements and your need for trading profits to mask the credit losses and you have peed and pooped your pants again and made a mess.
There is no CDS fairy.
Stocks that are frequently sold short are labeled as "hard to borrow." Legally, in order to short a stock, it is necessary first to borrow it. When there is too much demand, the stock becomes hard to borrow.
A frequent result is so-called "buy ins," mostly at the end of the day. Those who have made naked short sales must locate stock to borrow or buy the shares to deliver. The result, prices run up rapidly for a half hour or so, then fall back to where they were before. It's like a mini short squeeze, and short-sellers regard it as a cost of doing business.
I have been buying John Hancock Bank and Thrift Opportunity (BTO), a mutual fund that specializes in banks, mostly regional, and thrifts, with the idea of letting someone else do the stock picking but playing for a bottom in bank stocks, if there is one. So Thursday last week I went to buy a few more shares and my brokerage software informed me my BTO is "hard to borrow."
I was a little surprised - the fund now trades at an 18.8% discount to NAV, so my thinking has been that I have 12 or 13% built in when the discount gets back to a more normal level, as well as the expected recovery in the prices of the bank stocks in the fund's portfolio. I couldn't fully grasp why anyone would want to borrow a fund that trades at a large discount to NAV, in order to sell the whole for less than the sum of the parts. I guess it's simple, they have been making money doing it, or otherwise they would give it up.
I asked my brokerage rep to comment, he didn't have much to add, yup, theyr'e doing it. Looking at BTO's holdings, they had some names I have heard of and some names I'm not familiar with - but there were an awful lot of them and I would assume they put some thought into the selection.
This is less upsetting than for example when short-sellers attack an individual stock that may be subject to rating agency downgrades based on nothing more than the share price, with triggers activating collateral calls and destroying credit and tipping over the apple cart on some derivatives somewhere. It's not possible for short-sellers to do any permanent damage to a mutual fund. All they can do is drive the price down lower, increase the discount to NAV.
To me, this is a symptom of a negative bubble - a short-seller by definition is selling this fund for about 12% less than it is worth, based solely on the belief that the downward march of doom must continue indefinitely. Eventually it will end as all bubbles do, suddenly, and with pain for the greatest fools.
What got me started was reading MBIA (MBI) CEO Jay Brown's comments to Hank Paulson on the potential usefulness of the TARP Guarantee Program. Brown is on the topic of synthetic CDOs, kind of esoteric and not something I had given too much thought to. I was aware that some investors might prefer their exposure to certain asset classes in synthetic form, much as James Bond preferred his martinis shaken, not stirred. A matter of taste, really, and not that important.
Here is what Brown had to say:
We believe that it is critical that eligible collateral be in securitized or certificated form. Neither "whole loans" nor synthetic exposure on a referenced basis should be accepted. More specifically, synthetic exposure is a position taken in credit default swap form where the party does not have an insurable interest in the underlying asset, but rather only references an asset through their derivative, hence suffering from an inability to deliver under the Direct Purchase Program of TARP...
The volume of synthetic assets created, transacted and insured among market participants could easily overwhelm the capacity of this program. In addition, guaranteeing positions in these contracts has no direct impact on the real economy. When these contracts settle in the ordinary course or as a result of losses in the reference portfolios, no wealth is created or destroyed - it is merely a "zero sum" game. MBIA has been a participant in this part of the market, guaranteeing over $100 billion of such contracts. Nevertheless, we strongly urge that the Treasury avoid extending the Guarantee Program to synthetically referenced assets. If the performance of underlying mortgages improves, the synthetic assets and derivatives based on them will take care of themselves.
First, as a shareholder I was not pleased. Readers are familiar with my concerns about "naked" CDS, that is, CDS that are not supported by an insurable interest. I believe these deals may create moral hazard. Eric Dinallo, NY State Superintendent of Insurance, in an effort to bring some degree of regulation to the CDS market, determined that CDS are insurance when supported by an insurable interest. "Naked" CDS in his analysis fall into two classes, grey area cases where there might be some social benefit, and unregulated gambling.
MBIA will not be providing future protection in CDS form, and from the tone of the above I doubt they will provide any form of credit insurance in the absence of an insurable interest, going forward. As an investor, I am sorry that they got involved in the zero sum game, but I have been hopeful that in the absence of collateral requirements they can wait this one out.
But the 100 billion from one company, at stake in a zero-sum game, with no direct impact in the real economy, got me thinking: what is this stuff, how much of it is there, and what if it does have an impact in the real world economy? What was the involvement of other companies in the financial sector? Then I went on to other interests.
Today in the WSJ we learn that AIG had about 10 billion of this stuff. The Maiden Lane III facility, which is supposed to buy the assets underlying AIG's troubled Super Senior CDO portfolio, has a problem: the insured party does not own them - the exposure was in synthetic form. The WSJ article mentions "Abacus" and Goldman Sachs: a search of the terms reveals the following from a Moody's downgrade announcement: "Abacus 2005-CB1 is a synthetic collateralized debt obligation (CDO) that closed on Dec. 7, 2005 created to enter into credit default swaps with Goldman Sachs Capital Markets." Making bets with Goldman Sachs hasn't been profitable to anyone, as far as I can see, it's like betting against the house, the odds are in their favor. Why it would be a suitable investment for anyone is beyond me.
Personally, I prefer to take my exposure to certain asset classes in natural form: "no synthetic, please."
Part of everybody's set of investment beliefs, either consciuos or unconscious, is the idea that the market always comes back - after a bottom, there will be new heights to scale, higher than anything which preceded it.
Few hold such beliefs for individual stocks, having noticed over the years that large and profitable companies can disappear in a flood of red ink, litigation, and disappointment.
But for the market as a whole, most of us believe in our hearts that it always come back: first it goes down, then it goes up, but it always goes higher in the long run. If that does not play out as projected over the next 20 years, there are going to be a lot of disappointed retirees, myself among them.
Mr. Market has an opinion, I think. He studies the words and actions of those who are supposed to protect us from a meltdown, a global economic catastrophe, and takes a guess at whether the nostrums, remedies and panaceas actual or proposed will have the intended effect of getting everything back on track again. If the actions work, the market will go back up, same as it ever did. If they don't, it will just keep getting worse, forever.
Right now, Mr. Market is not sure...
I am mildly hopeful, based primarily on the Federal Reserves suggesting that they have more arrows in their quiver, above and beyond simple rate cuts.
Comments: View Comments | Thursday December 4, 2008
Pericom Semiconductor (PSEM) is a high tech value play - the company has a genuine technological business with real sales and income, but also features a lot of cash and investment securities. At Friday's close of 5.41 it is trading at less than its tangible book value of 7.98. TTM P/E checks in at 8.5. At these prices, it is safe to buy and hold, waiting for the recovery in semiconductors, whenever that may occur. I have had good results investing along these lines, specifically back after the tech crash.
Overview - Pericom specializes in serial connectivity. Their website includes an Investor Fact Sheet http://www.pericom.com/pdf/fact/PSEM_financial_facts_Q109.pdf. R&D amounts to about 10% of sales and produces 6-8 new products in a typical quarter. They do business with the likes of Hewlett Packard (HPQ) and Dell (DELL). Five year revenue growth has been 18% (GARP too!) and margins have improved in recent years.
It trades just slightly above the per share value of its cash plus short term and long term investments. Cash and investments is in excess of operating capital needs and could be used for a nice special dividend, or to repurchase shares, never a bad idea when a company's share price falls below tangible book. The company has a repurchase authorization outstanding. Acquisitions are possible: management looks at deals as they become aware of them.
Strategy - From the 2Q 08 transcript: "For the last few years, we've focused our efforts on enabling the transition from parallel to serial connectivity in computer, communication, and consumer electronics systems. This has helped us achieve a unique position compared to many other semiconductor companies. We've achieved success so far on providing high-speed serial protocol solutions for digital video, auto-mobility devices, and high-performance PCs and servers, end markets that we believe will continue to grow at a healthy rate."
"Given the tangible productivity benefits from faster high-quality connectivity, we believe our products provide cost-effective differentiating solutions to key OEMs. We believe this has been a key factor for our continued growth in the current market."
Growth and Margins - up to the end of the most recent quarter, management had been able to increase revenues faster than SG&A, meanwhile increasing gross margin. Net income as a percentage of revenue increased from 5.5% for fiscal 2006 to 10.22% for fiscal 2008. Revenues increased 16.5% and 32.7% year over year during the same time span.
Weak Guidance - After reporting a very respectable 1st quarter 2009, guidance is weak, based on a sudden slowdown in bookings and lack of visibility. This, together with the overall poor performance of the equity markets, tanked the stock. 2nd quarter guidance works out to revenues of 38 million and EPS of .09, vs. 44 million and .15 for the quarter just ended. Looking back over the punishing 2001-2003 period, it appears management kept expenses in line and R&D intact, so I expect they can manage through the coming downturn: they have the resources.
Target - over the past ten years, PSEM has always traded at above 1.5 P/B at some point during the year, and is now at a ten year low on that metric. Using P/S, a midpoint target would be 20 per share, using P/B, a midpoint would be 12. Assuming some kind of economic recovery, my two year target would be 12. Under favorable economic conditions, that target would be around 20 per share.
I have opened up a starter position and plan to monitor quarterly, looking for management to control expenses, maintain R&D, and implement their strategy successfully. If and when visibility and outlook improve, or if prices drop without cause, I will attempt to enlarge the position at a favorable price.
Saturday November 22, 2008
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