GM

GM just announced a loss for Q2-2006. However, the major cause was the restructing costs (previous post on GM). The car business itself did better than expected. Non-US did well, but US-cars did better than expected too. The stock chugged up from $26 to $32 over about a week of the announcement.

After the flurry of news about Nissan/Renault’s Goshn meeting Wagoner, things have gone quiet. Reading Jerry Flint’s Forbes article I had a thought: wat if Goshn’s long-term plan is not a Nissan-Renault-GM triumvirate? What if he really wants a GM-Nissan partnership, ditching Renault (and his French government partners) when the time is right?

Updated: Nov 22nd, 2006 – I closed my long GM position today as I don’t expect it to do much in the near future. I started a long GM position by shamelessly and blindly following the Longleaf guys into the stock. I got lucky when Kerkorian agreed with them and when he pushed for a tie up with Nissan. I still think GM is probably a stock for the long haul — the uncertainity comes from not knowing how the 2007 union-contract renewal will turn out.

Today, a negative remark by the UAW president reminded me that I had planned to sell just before people started to take the union seriously. The likely scenario is that the union will be completely uncompromising leading up to June/July 2007, and might even make investors really nervous about the stock. So, that’s the time I’ll get back in; because I believe the union will end up “giving up” far more than most people expect.

Update Jan 2009: I’m glad I got out of GM (at a marginal profit). I gave up on my plan of getting back into GM, as Kerkorian and Nissan walked away.

Option Backdating

The government has filed charges against Brocade for “back-dating” options. If the charges are true, the company clearly violated IRS rules. If tax-evasion was the primary basis of prosecution, I would not be writing about it. However, the government isn’t stressing tax evasion, but “fraud”.

What they did: Here’s a simplified example of what happened at Brocade.

Suppose the share price was $10 on June 30th, but rose to $20 on December 31st. Now, on Dec 31st, the CEO says to an executive Mr. X: “As compensation, the company will give you the option to buy 100 shares for $10 a year from now.” Since the shares are already selling at $20 on Dec 31st, that’s a nicer deal (for the employee) than giving him an option to buy the shares for $20.

If that was all to it, no prosecution would have resulted. Managers are free to make such offers. They can even compensate with shares for 1 cent, or for “free”. On Dec 31st, a manager may give an employee an option to buy the shares at the price they were selling for on June 30th. Where the managers do fall afoul of tax law is when they pretend that they made the offer on June 30th. That is the totality of their “wrong-doing”.

If the company admits that they gave Mr. X options priced at $10 on a date when the shares were already selling for $20, then the government may end up getting more tax (from the company and/or the employee) under today’s rules which give a tax-break to certain specific types of options. So, lying evades tax.

However, the SEC’s case is not about lying to the government. It is accusing the company of fraud for misleading the shareholders and the general investing public. There’s no doubt that such a statement is a lie. However, it is not a material lie to any intelligent investor. The date on which the offer was made makes no difference to the shareholder. (The difference to someone reading the annual statement is that some of the cost is shown in a footnote rather than being shown in the body of the income-statement.) The only underlying fact that really matters is the price of the option.

Take an analogous example. From time to time the government gives tax-breaks for certain types of spending during a specified period. Now, suppose a company gets a tax-break if they buy a machine in one year. Suppose they actually buy the machine in the first week of the next year and change their documents to show that it was bought in the previous year. They are obviously lying to the IRS and evading tax. However, the analogous case would be if the SEC (rather than the IRS) went after the company for lying to its shareholders, because its books reflected this lie (which is immaterial to all but the IRS), which was designed to earn more money (albeit via tax-evasion) for its shareholders.

Yes, managements can sometimes do such things to fool shareholders. When they do so, the shareholders be the one to sue. (If a majority of shareholders think they’ve been wronged, they can also fire the managers.) Prove harm and get recompense… that’s how it should work.

The SECis leading this fight, supposedly protecting small investors from evil managers. When Christopher Cox was appointed to head the SEC, some called him a fan of Capitalism and even an Ayn Rand admirer. Instead the ARI’s fears about Cox turned out to be right.

The SEC recently tried to increase their control of hedge-funds; fortunately this was just struck down by a court. Congress passed the ridiculous Sarbanes-Oxley bill. There have been other new “crimes” invented all the time, often applying retroactively! As with Sarbanes-Oxley, as with restrictions on IRA accounts, as with restrictions on consensual adult sex, the government is trying to play big-daddy, protecting the “little guy” against his own possible lack of rationality; as if we’d all be lost without Big Brother!

It’s unfortunate that a large number of people share Cox’s view of Capitalism as a system where the rich guys fleece the poor guys, with generally good results as long as the government keeps a leash on the rich guys. As a result, not only do they not understand the morality of issues related to the SEC, they also do not understand how the U.S. government’s steady erosion of America’s primary competitive advantage hurts them in the long run.

Prognosis:In the case of Brocade, the CEO did not backdate options to himself. He gave these to employees. The jury won’t see a man trying to enrich himself. However, it’s my guess that government chose this case because they have ample evidence to back up the fact that a lie was published. I wonder if a jury can get past that and say: “sorry, come back with an IRS case, if you want us to vote guilty”. (Not that I’d cheer the IRS on, but it’s what I would expect and what Brocade ought to have anticipated.)

Cut down on rules: What the SEC ought to do to say that a company need not specify when an option was granted. The company can give that information to the IRS, but need not give it to the public. The SEC should make a long list of things that a company is notrequired to publish, and then leave it up to the marketplace to figure out what to ask of companies before investing. Consider this, some shareholders may sell a company’s shares if they learn that the CEO is gay. This should not be about prosecuting companies that lie about their CEOs being straight, it is about not forcing companies to state whether their CEO is gay — let the market decide if that information is relevant. Those who think that the market cannot solve this without government help do not understand Capitalism.

Shady managers: Some commentators have sneered at those who complain about the government’s case, asking: would you buy stocks in a company that does this? The truthful answer is that I would not buy shares in a company that engages in stupid tax-evasion tricks like this. Not because I want to pay more taxes, but because I think I’ll end up paying more in the long run. If the IRS did not have their stupid rule in place, this would never have happened in the first place; the managers would have little reason to lie about the date.

Update (Aug 9th, 2006): Shareholders and investors would like to know is a company is lying. A new web-site, called ShareSleuth, promises to unearth such companies. The site is backed by Mark Cuban. The idea is to publish reasons why he has shorted some company’s shares. It’s an interesting model. Still early days; it’ll be interesting to see how it turns out.

Update (Aug 29th): The Barrons Blog, has some more links to articles on option backdating.

PHM

Summary:I ought to buy some PHM; only, not just yet

I like everything I’ve read about Pulte Homes (PHM). Though I did not know it when I bought it, I live in a Pulte home. when I first got interested in PHM, their stock was booming. So, I kept out. In the 2004 Barron’s “Roundtable”, one participant recommend shorting PHM. Turned out he was early. When the 2005 “Roundtable” came around, the stock had not moved significantly up or down. The “guru” reiterated his short and this time it turned out to be good advice. I didn’t take the advice either time. I figured I wanted to buy PHM when it was sufficiently undervalued. Here’s a chart, from Yahoo finance.

Bill Miller and Ruane Cunniff have been buying PHM since early 2005, and it is down about 20% from their purchase price. I don’t understand their timing, except that they were buying @ around 25% off the 52-week high. Still, given that housing had only just begun to slow down they seem to have been early.

At today’s prices, PHM is extremely tempting. If it paid a higher dividend I might have bought and waited. However,

• I’m still not convinced we’ve seen the worst of the home-sales situation. There has been a slow downward drift, but no capitulation. The financial press and its readers know that a slow-down in housing is here, but the “man on the street” does not.
• The Fed is most likely not yet done with raising rates, so mortgage rates probably have a little rise left in them

In a recent WSJ interview, Ken Heebner (of CGM Realty) said he thought housing still had some downside to it. He said that sellers are offering incentives and are also in the stubborn stage where they are hoping to get a price for which sellers aren’t available. The next stage ought to see a capitulation in the form of significant price falls in selected markets. This, in turn, should put pressure on the new-home builders.

So, even though PHM is extremely tempting (at a PE around 5!) I am going to hold off for a little while more. If PHM ($29 today) does break out and head near $32, I might lose patience and buy it.

Update (July 22): PHM went down to $27, and it took a lot of will-power not to buy some. I’m pretty sure it’s a bargain at this price if one buys with a 5 to 10 year perspective. Problem is that housing still has not hit bottom, and I cannot believe that all the bad news is priced in … it seldom is.

Update (Aug 11): Toll Brothers has said that orders are down 47%. Meanwhile apartments are doing better than in the last few years. Forbes reports that “Through June 30, Economy.com shows housing sales have fallen 8.2% to 5.81 million from 6.33 million last year.” Bottomline: The cycle unfolds predictably (in terms of direction if not size and duration).

Update: See follow-up post here.

Whither Rates

Summary: The Fed is probably going to raise rates another 50 basis point during the second half of 2007, after which it will probably start a multi-year descent.

Here’s a graph that shows the Fed Funds rate and the 30-Year mortgage rate from 1972 to mid-2006.

• There has rarely been a time in this period where the rise in Fed Funds rate has not been accompanied by a rise in Mortgage rates.
• The duration for which the Fed has raised rates has varied considerably, but the current uptrend has been slightly above average, in terms of duration and quantity of increase. Therefore, by “naive” historical pattern, one would expect the Fed to pause and begin to let rates go back down again.
• Given that the Fed has a new Chairman, he wants to prove himself good at controlling inlfation and also wants to show that he does not stifle growth. However, with current ideology what it is, the chances are that if he has to err, it will be on the side of wanting to control inflation. The current ideology would therefore point to a little more of a raise, until the economy actually squeals just a little bit.
• In 2000, the Fed took the rate just above 6%, to “kill the bubble”. Chances are it will want to stop shy of that, since it’s hard to see that the Fed perceives as much of a bubble today as in 2000.
• The net of this would be an expectation that the Fed will raise rates another 50 basis points over the latter half of this year (perhaps with a skipped meeting during which they will pasue). Then, they will probably pause again and go back to dropping rates.
• The speed at which they resume dropping rates would depend on whether something hits, particularly on how housing fairs in some of the frothy markets.

Update (July 28th): We’re about a week away from the next FOMC meeting. In the meanwhile, Bernarnke spoke about a slowing economy, causing people to speculate that he’s predicting a “soft landing”. While today’s GDP figures point to slower GDP and housing, they also point to a high (2.9%) jump in “core inflation”. From the Fed’s perspective, sticking with an August 8th hike, despite the slowing GDP will demonstrate their inflation-hawkinshness for good. I’m guessing they opt for a raise, rather than pausing this time and raising at the next meeting (which in their view would demonstrate that they are “reluctant raisers”).

Update Aug 04: PIMCO thinks the Fed is almost done, and see rates being eased in 2007. Also, in the morning, the jobs data came in lower than expected, with the official unemployment number going from 4.6% back to 4.8%. The market zoomed up briefly in an almost knee-jerk “ah! they will not raise rates” fashion. However, it was short-lived. In a couple of hours, it was going back down… not sure why.

Update Aug 9th 2006: In the end, the Fed did not raise rates. After an extremelt short and weak upturn, the market sunk. I figure that people realize that the rate cut is coming and has simply been postponed. So, rather than a quick end to the uptrend in rates, they see a longer, drawn out (though less steep) trend. In essence, the misery has been prolonged.

Update Oct 17th 2006: The Fed is in “pause mode” now, waiting to see what happens next. If inflation stays high for too long or goes further up, they might tighten again. On the other hand, if inflation seems low and the economy begins to slow (e.g. driven by below-inflation house-values) the Fed may start a lowering phase. Today, Goldman Sachs predicted that by the end of next year (i.e. end 2007) the Fed rate will drop from the current 5.25% to 4%. On the other hand, J.P.Morgan predicted that it will rise to 6%. (via Bloomberg)

New Home Sales: The affect of Mortgage rates

Summary: Short term rises in mortgage rates slow or cut the rate of new home sales. Presumably, as long as mortgage rates are trending upward, stocks of home-builders will remain under pressure. The longer-term trend in home-sales is open to question.

Relationship: There are five periods of rising rates. Episodes 1 and 2 saw a distinct rate increase and a distinct drop in new home sales. The larger rate saw the bigger drop in new-home sales. Episodes 3, 4 and 5 saw small rate increases, accompanied by levelling off of previously-climbing new home sales. However, the rate increases were temporary and brief. When they ended, new home sales climbed again.

New Home Sales: The other interesting thing about the graph is the way the new-home sales have risen since the early 1990s (i.e. the long term changes). It does not seem unreasonable, when compared to the long-term decline in mortgage rates. Will explore this more in another post. 

Data sources (see hyperlinks) and other such details: The graph shows 30-year Mortgage rates and New Home Sales (in units). The Y-axis scale does not appear meaningful bcause it is not absolute interest rate or absolute sales. Instead, it is the number for each year (rates on July 1st) expressed as a ratio to the average number for the 1972-2005 period. 

Greenmail

“Greenmail” is supposed to be a form of corporate-blackmail. Someone buys a large chunk of a company’s shares, threatens the company with a take-over and ends up getting bought out at a good profit.

Fact is, most of the time, the “greenmailers” do not take anything near a majority stake in the company (more like a 10% share). Fact is, that they threaten managements, not shareholders.

The typical situation is this: the company is in a situation where radically different action by its management can make a huge difference. Existing managements are often sentimentally attached to parts of their business, or to certain ways of doing things. At other times, managements know what they need to do, but simply procrastinate because its a tough decision; then they make a half-hearted effort, “hoping for the best”.

A typical investor, seeing such a management situation, would go elsewhere. Others, however, are more “activist” in their calls for change. The ones who earn the “green-mailer” title are the most ruthless of all. Their attitude is: it’s all dollars and cents. (e.g., T. Boone Pickens, Sir James Goldsmith, Carl Icahn, Kerkorian).

Recently, Carl Icahn bought a stake in AOL and he was on the business news every week explaining why the CEO of AOL (not AOL, but the CEO) was doing such a bad job. Kirk Kerkorian took a large stake in GM last year, and insisted on having a representative on the board. When he got that, the representative — Mr. York — began telling GM what they ought to be doing. This week, Mr. Kerkorian sent GM a letter suggesting that they should tie up with Nissan/Renault. (This might even imply bringing in Mr. Goshn of Nissan as some type of super-boss over Mr. Wagoner.)

In essence, what these so-called “raiders” do is to light a fire under management. Since they do not own a huge chunk, the real threat is that the other big holders — large mutual funds and pension funds — will agree with the raider’s reasoning. The big boys usually stay polite and let the “raider” hold the gun in public. The ultimate threat is not to the company, but to its top-management team: shape up or we’ll find someone else who can run the company.

Added  (Aug 19th): The above does not mean that shareholders should always welcome folks who want to take over the management of their companies.  The WSJ of Aug 19th 2006, had a page-1 story about some shareholders that fight back, with good reason. Here is how it works: a raider targets a firm where management could do better. Instead of selling for a price that is slightly higher than market, and letting the newcomers whip the company into shape, the raid can be a wake up call for shareholders. They can motivate management or bring in new managers and do great things for themselves. If you spruce up that jalopy, you might be able to keep more of the profit for yourself.