What If Facebook Were At Woodstock

By Rob McCreary

Harvard is among the most selective universities in the world. Gaining admittance is a passport to prosperity and elite networks. The waiting list must be as long as the line at the Apple Store at 9:59am on Saturday morning.  How, then, can ten of the most brilliant and well qualified young people in the world squander a place in the class of 2021 because of highly offensive public opinions?

No Public Record of Stupidity
In 1969 when I was admitted to college there were only a few ways you could reverse the good fortune of your anticipated matriculation. You could fail to graduate from your high school. You could commit a crime.  You could get lost at Yazgur’s farm never to be seen again.  Even if you were expelled from high school you often could still get your final transcript and the colleges were no wiser.  Everyone expected your opinions to be stupid, uninformed and controversial.  Just ask your parents.  But no one had a public record of those opinions.  Mark Zuckerberg changed that with Facebook which started innocently and has morphed into a powerful tool for marketers and an even more powerful enforcer of conformity.  Young people everywhere are trusting the public forum of social media to interpret their changeling character in the best possible light.  This naiveté is startling to me.  In all forms of social media many colleges and universities find a willing enforcer of group thought and political correctness. The Facebook effect is responsible for major changes in how colleges run from the building names on campus to the mascots and even the relationships between men and women.  Social media powers a god squad of self-appointed student judges who wield the power of inclusion to ostracize and create pariahs.  Young people crave inclusion and acceptance; so once you are out, there is little chance to get back in.  Social life is often altered for the outliers.

Dumbest Smart Guys
In 2017 the power of social media is demonstrated by the Harvard admission denials.  The original user group for Harvard incoming freshman was pretty much what Mark Zuckerberg had envisioned with more than 100 incoming freshman exchanging ideas and observations in a social media attempt at getting to know each other.  The 10 offenders must be the dumbest smart people on the planet because they obviously thought their incendiary freedom of expression was protected in the second chatroom where they posted  on horrible topics.  They revealed themselves to the world as bigots, racists, sexists and they paid the price as they should.

Why Go Public
I have avoided Facebook, Instagram, Twitter and most forms of social media because I see it as an intrusion on my privacy.  Why would I voluntarily publish information about me, my family, my friends, my movements, my grandchildren, my religion, my politics and my vacations?  Off the grid is actually far preferable in a world of cyber-crime, social media punishment and banishment, kidnapping and ransom, identity theft, sexual predation, and hacking and phishing.  This is common sense.  When is going public in a cyber world ever better than remaining private?

If Facebook or You Tube had existed in 1969,  the freshman classes of every college on the east coast would have been lighter by at least 10 men and women. Thank goodness for a chance to grow up.

I came upon a child of God
He was walking along the road
And I asked him where are you going
And this he told me
I’m going on down to Yasgur’s farm
I’m going to join in a rock ‘n’ roll band
I’m going to camp out on the land
I’m going to try an’ get my soul free

 

Rob McCrearyWhat If Facebook Were At Woodstock

Truth On A Slow News Day

By Rob McCreary

 

It is always interesting to read The Wall Street Journal (“WSJ”) on days when the NYSE is closed and mainstream business is snoozing.  Memorial Day 2017’s edition contained opinions you never read when the markets are open. While the mainstream bias of WSJ is still squarely in favor of groups who pay them, it was nice to see the other side of the story on a day when few advertisers would be reading.

Illinois Privilege Tax on PE Firms

Illinois is insolvent. It hasn’t passed a budget in two years. It needs revenue to pay for the mismanaged state pension plans and entitlement programs. As Kristina Rasmussen reported in a WSJ article on Memorial Day, May 29 the Illinois mess is as follows:

“Illinois hasn’t had a budget in two years, since the Democrats in Springfield continue to insist on more taxes. The state has $267 billion in unfunded retirement liabilities, a $14 billion backlog of unpaid bills, and a $7 billion projected deficit this fiscal year.”

To address this train wreck The Illinois Senate passed a 20% privilege tax on financial advisors that would apply to hedge fund and private equity managers. That legislation is now in the House of Representatives. If passed, the tax would certainly apply to portfolio company realizations. I am not sure whether it would also be a sur-tax on compensation and whether it would apply to stock brokers and investment managers as well?

Ms. Rasmussen suggests hunting productive people like PE firms will end poorly for Illinois. While it is a great political sport to impose a sur-tax on a small group of high earners, it is usually a fool’s errand. Ms. Rasmussen says PE managers can and will move to tax friendlier states and the multiplier effect will be greater than the legislature ever figured. There are many service jobs that support PE including law, accounting, due diligence, consulting, insurance, and recruiting.

Trump Will Prevail in Travel Ban

Until Memorial Day I had never read anywhere (including law school commentary) that President Trump will win if the US Supreme Court agrees to review the recent Fourth Circuit Court of Appeals legal decision declaring the President’s revised travel ban is illegal. According to the WSJ authors, David B. Rivkin, Jr. and Lee A. Casey a reversal is a sure thing:

“In ruling against the order last week, the Fourth U.S. Circuit Court of Appeals defied Supreme Court precedent and engaged the judicial branch in areas of policy that the Constitution plainly reserves to the president and Congress. The high court should reverse the decision.”

The story reviews legal precedent and concludes that the Circuit Court has clearly politicized its decision:

“It is therefore difficult to avoid the conclusion that the Fourth Circuit and the other courts that have stayed Mr. Trump’s executive orders on immigration are engaged in the judicial equivalent of the “resistance” to his presidency. Judges are, in effect, punishing the American electorate for having chosen the wrong president. That is not the judiciary’s role.”

Greedy CEO Stock Options

The Monday Memorial Day edition also slammed Patrick Drahi, CEO of Altice, for rearranging his compensation plan to provide more upside after his shareholders complained. You never read an article in the WSJ that slams executive compensation. In this case it was neither an American CEO nor an American company. The target was an Amsterdam based company’s leader about which the WSJ reported on the stock options as follows:

“Such a payout is a powerful incentive, but it is doubtful Mr. Drahi needs it. Never mind his outstanding stock options under separate agreements, which are collectively worth €55 million at the current share price; he already owns 59% of Altice—a stake worth about €19 billion today. If the share price triples, his stake is worth another €38 billion ($43 billion). This is surely incentive enough.”

The article incorrectly states that stock options are a way to give executives “skin in the game”.  As I have written before, stock options are a one way bet with the shareholders money and do nothing to align manager and owner. The article finally corrects itself and concludes that some managers like Mark Zuckerberg and John Malone do not need options because they are already aligned to shareholders through massive personal holdings.

In the PE world incentive options are typically granted only to managers who have already invested side by side and at the same price as the PE fund and share downside risk. The point about stock options is they have no downside. If you miss a plan, you don’t lose your own money.

Get Ready for the Next Holiday

Make Sure You Read the July 4th edition of The Wall Street Journal for all the news you can’t see on a real news day.

 

 

 

Rob McCrearyTruth On A Slow News Day

Buffet May Be Clearing Out The Competition

By Rob McCreary

Most of us who have been investing for a long time know what kind of investor we are. Some of us are growth investors, some are growth at a reasonable price and some of us are unabashed chickens -also known by the more prestigious pedigree of “value investors”. Given the unrelenting rise of stocks of all types from 2009 to 2017 as shown in the chart below, most chicken investors are having trouble channeling Graham or Dodd or, for that matter, scratching up an investment idea:

I took some comfort in a recent Barron’s interview of Bruce Greenwald by Leslie Norton called “Channeling Graham and Dodd in Today’s Market”. Professor Greenwald teaches Finance and Asset Management at Columbia and is the author of the popular “Value Investing: From Graham to Buffet and Beyond” which will see a second edition in 2018. When Mr. Greenwald took over the value investing course in 1991, he likened his quest to “an anthropologist trying to save a dying language”. Of course, Warren Buffet changed all that by reinterpreting the Dead Sea scrolls of Graham and Dodd in the modern vocabulary of his Coca-Cola investment and his home spun annual reports about Mr. Market.

Greenwald’s Secret Sauce

Interestingly, even in 2017 Professor Greenwald suggests that good value investors should start with a company’ balance sheet as its first indicator of value not the discounted cash flow model which has many opportunities for bad assumptions. Why the balance sheet? First it can tell you where the intrinsic bottom value lies by looking at liquidation value and also where the top intrinsic value lies in the cost of reproducing the assets that comprise that balance sheet. For example, The Wizard of Omaha would have found a pretty paltry downside balance sheet liquidation value for Coke (a few mixers) but a remarkably high replacement value for the Coke formulation which actually began with a small dose of a popular narcotic-cocaine.

Discounted Cash Flow Models Are a Deceit

Professor Greenwald then instructs that only after looking at the balance sheet should you look at the company’s earnings power TODAY (not the future) and ask how protected that earnings power really is? This reminds me a little bit of drafting fantasy baseball hitters based on how well they are protected by the hitters before and after them which could lead to The Encarnacion Effect where you actually pick a stock in major decline but well protected by Fransico Lindor and Carlos Santana. Nonetheless, I get his idea.

Professor Greenwald also wonders how value investing can have any place in a market that is primed by Fed monetary policy and tilted in favor of passive momentum investing. He is right that any card carrying value investor just cannot wrap his arms around Facebook, Amazon, Netflix and Google. They defy gravity buoyed by the human propensity to believe in cheerful forecasts. If Brexit and the Trump victory proved one thing to me, forecasters don’t have a clue, but humans are wired to believe in hopeful outcomes so experts stay employed. The main culprit in his estimation is discounted cash flow models built on faulty optimistic assumptions.

Value Grounded In What You Are Today

Value investors are more focused on what the company can do for me today. Professor Greenwald thinks those “today” insights are honed by industry specialization, a fixation on free cash flow generation as a percent of reported net income (Apple) and aftermarket service dominance (Deere). Would you believe that Apple was trading at less than 6x Enterprise Value to EBITDA and only 10-11x its unlevered free cash flow just one year ago? The only question a value investor had to ask then about Apple is how likely is abandonment of that device by that community? I defaulted to asking family and friends about Apple and they all said that substitution is too painful. Samsung reinforced that opinion recently when its phone was banned by the US Airline industry for catching on fire.

Buffet Says Don’t Try This Yourself

Professor Greenwald is also suspicious of Warren Buffet’s warning that only 1 % of the investor population has the skills to be an active manager. He seems to understand that “the nightmare scenario for value investors isn’t passive investing; it’s everybody takes a value approach”. As a value investor I feel pretty safe for the foreseeable future now that Warren Buffet has scared everyone away. Nonetheless, I still am searching for the next Coke in that pile of unloved equities even as my robo funds and ETFs are chunking out pretty good FANG dominated returns.

Rob McCrearyBuffet May Be Clearing Out The Competition

Ballmer’s Gift: “Just The Facts, Maam”

By Rob McCreary

Few businessmen make outright gifts to the American people. John D. Rockefeller gave his estate in Maine to the National Parks to create what is now one of my favorite venues, Acadia National Park.  The views of the Atlantic Ocean from Rockefeller’s carriage roads are simply breathtaking and certainly worthy of a place on your bucket list. Recently, Steve Ballmer, former CEO of Microsoft, published the first ever Annual Report and 10K on American federal, state and local government. While he did not match the natural majesty of Rockefeller’s gift, in many ways his compendium of government information is possibly more valuable, coming at a time when no one knows the truth and powerful forces are attempting to bend reality to their own agenda.

Mr. Ballmer personally underwrote the project which took several years and more than $15 million. He explains the purpose of his Annual Report and 10K as follows:

“USA Facts is a new data-driven portrait of the American population, our government’s finances, and government’s impact on society. We are a non-partisan, not-for-profit civic initiative and have no political agenda or commercial motive. We provide this information as a free public service and are committed to maintaining and expanding it in the future.”

Interestingly, the New York Times’ Andrew Ross Sorkin really likes the project and for the first time in years I can provide a quote that is actually balanced:

“In an age of fake news and questions about how politicians and others manipulate data to fit their biases, Mr. Ballmer’s project may serve as a powerful antidote. Using his website, USAFacts.org, a person could look up just about anything:  How much revenue do airports take in and spend? What percentage of overall tax revenue is paid by corporations? At the very least, it could settle a lot of bets made during public policy debates at the dinner table.”

When you read it, you will like it too. What struck me about the 162 page Annual Report for the year ended September 30,2014 was how we have improved as a country in only a few objective measures over the measurement periods. On a positive note, I was stunned to learn the average net worth of the bottom 20% of the US population was $86,000.

Like many of you, fake news has been making me anxious. I have stopped listening to all network news and am increasingly suspicious of iconic brands like The New York Times, The Washington Post and The Wall Street Journal. They broadcast in loud and urgent tones suggesting end of days mostly to promote only one way of thinking.  It is nice to read the government’s own facts and form your own opinion. Here are some examples comparing 2014 to 1980 unless otherwise indicated:

  • Persons in jail grew from 184,000 in 1980 to 1.6 million in 2014
  • Married Parents dropped from 40.6% to 29.4%
  • The poverty rate is about the same while aid to disadvantaged  is up 3.4x
  • Obesity increased from 16.8% to 29.8% of the population
  • Average household debt rose from $51,000 to $117,000
  • 6.5 million young adults (25-34yrs) live at home
  • Federal, state and local governments have a combined negative net worth of $5.3 trillion
  • Hate crimes based on race declined from 5,396 in 1996 to 2568 in 2014
  • Religious hate crimes were unchanged for the same period

I urge you all just to browse through this wonderful gift to America. It sure beats all the fake news on TV. It may lift your spirits (race relations) or depress you (governmental deficits) but for the first time in a long while you will be thinking for yourself.

Rob McCrearyBallmer’s Gift: “Just The Facts, Maam”

Bezos Rocked Me Like Muhammad Ali

By Rob McCreary

I have a great high school friend who knows how to motivate me. When I was editor of the high school newspaper he would always provoke me to write controversial editorials by posing the unanswerable question knowing, full well, I would be crazy to find an answer.

Fast forward to our respective retirement transitions and he is doing it again, but this time he is suggesting answers to tough questions. I guess that is maturity-his not mine. The letter he sent me was from Amazon’s 2016 Annual Report entitled “Jeff, what does Day 2 look like?”

If you like business and want to understand winning organizations, this is an insightful and inspiring message from Amazon’s CEO, Jeff Bezos. He gets business just like Warren Buffet gets the stock market.
Jeff answers his own question like this:

I’ve been reminding people that it’s Day 1 for a couple of decades. I work in an Amazon building named Day 1, and when I moved buildings, I took the name with me. I spend time thinking about this topic. Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1”… at Amazon

We all should be interested in the question of how you fend off Day 2? What are the techniques and tactics? How do you keep the vitality of Day 1, even inside a large organization?
Mr. Bezos recommends a “starter pack” of essentials for Day 1 defense:

• Customer obsession;
• Skeptical view of proxies;
• Eager adoption of external trends; and
• High Velocity decision making

Customer Obsession

“There are many advantages to a customer-centric approach, but here’s the big one: customers are always beautifully, wonderfully dissatisfied, even when they report being happy and business is great. Even when they don’t yet know it, customers want something better, and your desire to delight customers will drive you to invent on their behalf. No customer ever asked Amazon to create the Prime membership program, but it sure turns out they wanted it, and I could give you many such examples.”

Resist Proxies

This intrigued me, what does Mr. Bezos mean by proxies? He can’t be talking about those mind-numbing, single spaced documents I get from my broker? Not really. He suggests that taking comfort in process may be a proxy and can be“dangerous, subtle and very Day 2.” He suggests that market research and customer surveys can become proxies for customers:
I’m not against beta testing or surveys. But you, the product or service owner, must understand the customer, have a vision, and love the offering. Then, beta testing and research can help you find your blind spots. A remarkable customer experience starts with heart, intuition, curiosity, play, guts, taste. You won’t find any of it in a survey.

Embrace External Trends

Mr. Bezos says that spotting big trends is easy but they are hard to adopt. He points to machine learning and artificial intelligence as one such trend that affects Amazon. That Amazon beat Apple, Google, Microsoft and Samsung with Echo and Alexa is just like four successive Ali jabs followed by his signature uppercut. This is especially true for Google which is reputed to have a huge lead in voice recognition and artificial intelligence.

“At Amazon, we’ve been engaged in the practical application of machine learning for many years now. Some of this work is highly visible: our autonomous Prime Air delivery drones; the Amazon Go convenience store that uses machine vision to eliminate checkout lines; and Alexa, 1 our cloud-based AI assistant. (We still struggle to keep Echo in stock, despite our best efforts. A high-quality problem, but a problem. We’re working on it.)”

High Velocity Decisions

Mr. Bezos respects Day 2 competitors for making high quality decisions, but suggests they make them way too slowly. He sees the Day 1 culture as having four horsemen of innovation:

• Differentiate between reversible and irreversible decisions – so what if your wrong;
• Being slow is worse than being wrong – don’t wait for all the information;
• Disagree and commit; and
• Escalate misaligned viewpoints.

Check Out His Stock Price

Mr. Bezos closes his letter with an invitation to read his 1997 Letter to Shareholders. He believed then, as he clearly believes now, that taking the long view to profitability is the right business model. While Amazon is still chasing its first profitable year, it is clearly not being penalized by an unusual business model.

Rob McCrearyBezos Rocked Me Like Muhammad Ali

Kashkari and Dimon Debate Too Big To Fail

By Rob McCreary

I was inspired by another archived podcast I heard on Planet Money about former Goldman Sachs partner Neel Kashkari. As interim Assistant Secretary of the Treasury For Financial Stability, Mr. Kashkari is best known for overseeing the TARP program in 2008 and 2009 under his former boss, Hank Paulson. Mr. Kashkari is now President of the Minneapolis Federal Reserve. Neel grew up in Stow Ohio and attended Western Reserve Academy in Hudson. According to Wikipedia, Neel’s grades were not good enough to apply to top tier universities. He made up for that later by attending the Wharton School of the University of Pennsylvania.

We all owe Neel a debt of gratitude. He correctly surmised in 2008 that the US Banking system would fail if TARP funds were not administered to replace worthless residential mortgages (a gift from Barney Frank and Fannie Mae) with liquid treasury securities. He oversaw the process by which the banking system was recapitalized and determined which banks got relief and how much. He was close enough to the potential meltdown to understand the real pressure points of the banking system.

Kashkari and Dimon Disagree

Recently, Mr. Kashkari challenged Jamie Dimon about his assertion that “Too Big to Fail” restrictions were curtailing loan growth at JP Morgan Chase. While Mr. Dimon may be right about bank balance sheets improving under Dodd-Frank, he has a hard time explaining why he has used billions of bank capital for stock buybacks instead of loans. According to Charley Crowley and our friends at Boenning & Scattergood, a well-regarded investment banking firm serving the middle market financial services industry, there has been meaningful balance sheet progress under Dodd-Frank with tangible capital as a percentage of total assets moving from a low of 4.28% in 2008 to 8.50% in 2016. This is as high as I ever remember.

However, Mr. Crowley also sees an unintended consequence of Dodd-Frank being forced small bank consolidation. The little guys simply cannot meet the regulatory hurdles of a 22,000-page attempt to legislate good banking processes. Mr. Crowley explains it as follows:

“One unintended consequence of Dodd-Frank and other aspects of the regulatory pendulum swinging is that consolidation has been very active, and the too-big-to-fail issue has certainly not gone away. Twenty years ago, the top 10 banks controlled an aggregate of 23.6% of the nation’s deposits.  According to the most recent data, it is now 52.9%. Community banks (generally speaking) had virtually nothing to do with the financial and real estate crisis, and yet they have been paying a heavy toll in terms of increased regulatory costs and the presence of ever-stronger competitors.”

Kashkari- 70% Chance of Bank Failure This Century

Neel Kashkari is even more adamant about” Too Big to Fail”. In a recent interview on Fox, he told its viewers that the only way to insure bank safety and soundness is doubling the minimum equity capitalization of large banks. He confirms Mr. Crowley’s belief that a strong banking system is challenged by the consolidation of the smallest banks and the concentration of depositors. His bottom line is “Too Big To Fail” has not been solved. Mr. Kaskari initiated his message for an impressive story on Planet Money in its podcast on May 26, 2016. Mr. Kashkari claims he is not angling for Janet Yellen’s job, but each of his impassioned “Too Big To Fail” speeches have a familiar populist twang. He is channeling the same anger that pogoed Trump to the White House. With Neel’s rising popularity, can we expect Trump is going to dump Janet Yellen and bring in the son of immigrants and a fellow refugee from the fly over zone as the next chairman of the Federal Reserve?

Rob McCrearyKashkari and Dimon Debate Too Big To Fail

A Swing and Miss Business Model

By Rob McCreary

In 2001 and 2009 the investment world was introduced to Nicolas Taleb and his two blockbusters “Fooled By Randomness” and “The Black Swan”. Arguing that some investment styles only work in certain conditions and not to confuse skill with luck, the first book schooled investors to look at a manager’s process not just his results. The second book told the story of explorers in Australia discovering black swans when the prevailing wisdom was that all swans were white. Mr. Taleb introduced us to his investment theory of making small bets on rare and highly unlikely events which is exactly what he did before the correlated market meltdowns in 2008 and 2009. In many ways the venture capital business model is a mini-black swan strategy. VC firms make a series of small bets on emerging business models fully expecting to lose all their investment 70% of the time. Whether it is venture capital or black swan six sigma hedge strategies, the common elements of the business strategy are a multiplicity of bets with a low probability of success, low investment amounts and massively high payouts.

Did Blum Read The Black Swan?

I was really excited last week when I listened to Planet Money’s podcast about Jason Blum entitled “The Business Genius Behind Get Out”. Mr. Blum is a movie producer who has introduced a new business model to Hollywood:

  • produce an endless supply of really low budget films quickly
  • distribute the film only if it has a chance to sell $25 mil of tickets
  • leverage movie industry talent who will trade pay for equity

Take, for example, his first major success which is a horror movie called “Paranormal Activity”. According to Planet Money that movie cost $15,000 to produce but grossed more than $193 million at the box office and generated four sequels. Mr. Blum’s share is estimated to be in excess of $20 million! The really exciting part of the business model is Blum often syndicates risk. If he cannot afford Jennifer Lopez’ salary he will offer her equity. According to “The Hollywood Reporter” in an article by Kim Masters  Mr. Blum “has become as polarizing as he is prosperous” with many of his talented partners feeling unrewarded:

“While Blum has put films into production at lightning speed, there is disappointment from some who have worked on them for below-market prices. Many were well aware of Blum’s successes but also knew that he runs no-frills productions. What they found, at least in some cases, were work conditions worse than they had anticipated and, when the films went unreleased, no worthwhile credit. Still, Blum continues to attract directors — many veterans — with a promise of creative control. Blum takes pride in being straightforward with cast and crew: The productions are bare, the pay is low, and no movie is guaranteed a release.

Some Tape Measure Home Runs

There are some really great success stories. In addition to “Paranormal Activity” there are at least 6 movies where the multiple of invested capital is at least 25x. According to Ms. Masters these are some of the big winners:

“Paramount Studios, faced with increased pressure to cut bloat and release more profitable films, salivate over the three franchises Blum has launched in the past four years: Insidious (a $1.5 million price tag) grossed $97 million worldwide; Sinister ($3 million) grossed $77.7 million; and The Purge ($3 million) grossed $89.3 million.”

To Live With The Classes, Sell to the Masses

Most interesting for me, however, is Mr. Blum’s profits waterfall. According to “The Hollywood Reporter” many of the actors and technical talent who produce these low budget films take significant reductions in their normal compensation in return for big shares of the outlier profit returns. It appears that the intermediate returns (2-10x) are often shared with the director and actors. Of course, as a good self-promoter Mr. Blum gets 12.5% of the first dollar gross which is significantly greater than “even A -list producers get”.

Every venture capitalist in silicon valley would salivate at a 12.5% promoted interest on the first dollar of revenue. Every private equity manager I know would be perfectly happy with taking an outsized performance feature on intermediate returns rather than last dollar participation. What Mr. Blum has stumbled on is a highly scalable industry where profits from the masses intersect with an artistic community where production credit for a big hit may often be more important than making money. I immediately think of adjacent territories for music celebrities like Taylor Swift and fiction writers like J.K. Rowling (Harry Potter) and George Martin ( Game of Thrones). Possibly Jason Blum read page 28 of “The Black Swan”—which by the way was published the year he produced his first movie in 2007– where Dr. Taleb talks about scalable professions and identifies recording artists and movie actors: “You let the sound engineers and projectionists do the work; there is no need to show up at every performance in order to perform.” Before Jason Blum, however, the movie industry was locked into a paradigm where a movie’s worth was often tied to its cost as a weighty indicator of success. Notwithstanding great directors, famous actors and magnificent special effects, there were simply too may “Water Worlds” in Hollywood.

A Swing and Miss Model for the Ages?

Mr. Blum has hit a few Joey Gallo dingers in the last six months. First, he is projected to gross $200 million on “Split” which cost only $9million to produce (20x) and maybe as much as $175 million on “Get Out” which cost only $4.5 million to produce (30x). It has probably dawned on Mr. Blum that his business model will invite competition and the barriers to entry cannot be that high. In this case, the first mover advantage might land Jason Blum in the Forbes 500. And while he is obviously hitting a number of impressive home runs, he strikes out 5 times as much as most of the home run hitters in my fantasy baseball league and gets paid even more handsomely for failure than the best clean up hitters. Let me know if you see any more opportunities like this. I am all in.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

Rob McCrearyA Swing and Miss Business Model

Why Not Write an Investment Cookbook?

By Rob McCreary

My wife is a good cook. She claims it is all about following directions and has little to do with inspiration or special talents. While I doubt her modesty I do see her following closely the step by step recipes for dishes from Ina Garten, Giada DeLaurentiis, Mario Batali and James Beard that run from the mundane (roast chicken) to the exotic (Merguez). It is a miracle to me that these recipes produce superb food every time.

It made me wonder why there is not a definitive cookbook for investing like the “Good Housekeeping Guide To Asset Classes”? Maybe it is because investing is not like cooking? Maybe it is because the common ingredients are not available to all? Or, possibly, it is because the investment world is all about fee for service and there is little sharing of investment secrets?

Who Will Publish “Joy of Investing”

There are great investment books and articles. There are also letters to shareholders and investors. You occasionally get a glimpse of the mindset of the most successful hedge fund managers like Ray Dalio (Bridgewater Pure Alpha) and George Soros (Quantum Endowment Fund), Peter Lynch (One Up On Wall Street), Graham Dodd (Security Analysis), Seth Klarman (Margin of Safety) Lawrence Cunningham (The Essays of Warren Buffet), Robert Kiyosaki and Sharon Lechter (Rich Dad, Poor Dad), and Robert-J-Shiller (Irrational Exuberance). However, there are no cookbooks for how to invest in high yield securities or when to use mutual funds or ETFs to buy into a sector of the economy. I am still searching for the “Joy of Investing” which would be the investment equivalent to the only cookbook my mother owned (The Joy of Cooking). If you can prepare complex sauces and intricate desserts with step by step direction, why can’t you buy stocks, bonds, investment real estate, mutual funds and ETFs from a Cookbook?

Possibly the intersection of Artificial Intelligence (“AI”) and Supercomputing will provide my answer. If computing power can decode the human genome and beat chess champions consistently, it surely can help me decide what kind of corporate bond to buy? While the vocabulary of the bond world is off-putting to even the most sophisticated investor (duration, yield to worst, and inverted yield curve), I am sure there is a computer somewhere that can tell a 65-year-old with a net worth of $1.0 million comprised of a 401K plan of $250,000, a home worth $300,000, social security monthly benefits of $525 and dividends and interest of $25,000 per year what to do. AI makes it even easier because a computer can interact by voice in the customer interview. I think you may find many fewer high commission products like variable annuities and load mutual funds and more lower fee alternatives like the Vanguard family when “HAL” is doing the investing?

Shovel Ready Project

This would be a perfect public works project. It makes tons of sense rather than making stock brokers fiduciaries. It will actually liberate the retirement generation from the world of high fees for common investment advice. You also see some robo advisers emerging now from companies like Wealthfront and Betterment, but, in general, the world of investments is not like cooking. A hamburger from Wall Street is just going to be much more expensive than one from Michael Symon’s cookbook.

How About a Robo Advisor?

I was curious about the early days of the Robo Advising Business and defaulted to a source of unbiased financial news, and found it with Arrielle O’Shea from the NerdWallets. In an article published in January 2017, Ms. O’Shea looked at the leaders. She likes Betterment and Wealthfront. As expected there is a group of financial all-stars behind these products. Here is a summary of her product comparison:

Wealthfront is a key force in the online advisor industry, and offers competitive fees, free management of balances under $15,000 (with NerdWallet’s reader promotion) and one of the strongest tax-optimization services available from a robo-advisor. It’s also one of the only online advisors that have remained strictly a robo-advisor, with no human advice offering. The comparison to Betterment — which recently launched two plans that include interaction with human advisors, both with higher management fees and higher account balance requirements — hinges on what kind of advice you’re looking for and which type of account you have. Wealthfront is likely the best choice for taxable accounts and clients who don’t need or want human advisors.”

 Since I always follow my own investment recipe which includes the proscription for “playing with live ammo” I am going to sign up for Wealthfront. I want to see how the computer does against some of my high touch, high fee account managers and whether it can beat my own approach. I will report at a later date, but in a persistent low return environment where fees matter I am betting on the computers to be competitive.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

Rob McCrearyWhy Not Write an Investment Cookbook?

Despite Advantages, Family Offices Won’t Put Us Out of Business

By Rob McCreary

The Wall Street Journal recently focused on the rise of family offices as significant disrupters of the private equity model. In an interesting article by Anupreeta Das and Juliet Chung entitled “New Force on Wall Street: The Family Office” the authors confirm a trend we have been seeing for the last 10 years. Increasingly, wealthy families are collaborating for advantage. That advantage may be direct investments where fees and carried interest are side stepped completely or it may take a form of uncompensated side car investments where the important family uses its networks, wealth and access to assist private equity sponsors. In return for the extra help, these families are often allowed to invest in “friends and family” vehicles or directly into a specific portfolio company without paying management fees or carried interest. As Ms. Das and Chung observed:

“Wealthy families have always found ways to protect and build their money, and the savvier among them have pursued their own business deals, from acquiring farmland to seeding hedge funds to buying companies. Today their ranks are ballooning, and many, put off by the high fees and sometimes weak performances of Wall Street money managers, are shifting to investments they can pursue directly through family offices.”

In October 2014 I wrote a blog entitled “Family Offices Are a Protected Species” about another advantage a family office has; exemption from SEC registration.  As you may recall Dodd Frank requires private equity firms and hedge funds with more than $150 million under management to register with the SEC. This almost always triggers an audit where manager compensation, cybersecurity, valuation of portfolio companies, record keeping practices, governance and self-dealing are scrutinized. The same registration burden, however, does not apply to family offices with a common ancestor even if they hire internal managers who are paid performance compensation. As long as the managers do not own and control the fund they are managing, they can be incented with performance compensation. I guess the logic is that a single investor family office is sophisticated enough to fend for itself and, more importantly, no ERISA governed assets are at risk.

The scale of these disrupters is what caught my attention.  According to the authors, the family assets rival the managed wealth within the entire PE asset class:

“Research shows family offices hold assets of more than $4 trillion. That approaches the cumulative $5.7 trillion of private-equity firms and hedge funds, as estimated by data provider Preqin, though there is overlap because family offices sometimes invest in private-equity and hedge funds.”

Secrecy May Be the Biggest Advantage

The authors also note a big advantage family offices bring to the investment world – SECRECY. Many private or public company management teams do not want the world to know who owns them or if; in fact, there has been a change in ownership at all. In addition, we have seen that certain families like the Koch Brothers have become political targets for their activism. Secrecy about where they are investing removes one less possible objection. It also helps disguise investment themes or strategies. I have always believed that the Wizard of Omaha, Warren Buffet, often shares investment wisdom when he is conditioning the market. For example, he’s often quite bullish on investments like U.S. Air and Salomon Brothers while he is an owner but more whimsical once he has exited.

Family Offices Are Not a Real Threat

However, even with these advantages, the family office has yet to dominate private equity. There may be five big reasons:

  1. Taxation of carried interest
  2. Career path for younger employees
  3. Total compensation
  4. Lack of owner urgency
  5. Alignment for portfolio company managers and rollover owners

No Carry

On the first point it is typically hard to compensate family office managers with anything other than phantom equity because a good company may be owned for multiple generations. Without an exit to set value and create a capital transaction the inside manager may settle for the equivalent of stock appreciation rights. Typically, this phantom equity is treated as ordinary income.

Lateral Employment

On the second point, the family office will never provide the same lateral employment opportunity as a private equity firm in a city with a vibrant practice. For example, Cleveland has a robust PE community where the breakup of a PE firm can lead to multiple new entrants with opportunity to own their own management company, raise capital and recruit managers who are blocked at other firms. That entrepreneurial pull is strong.

Total Compensation

The third disadvantage is total compensation. If the family is supplying the capital, the managers may command a much smaller share of the upside.

Urgency

The fourth disadvantage is urgency. In the PE model in order to raise successive funds you must demonstrate an ability to realize returns in all markets. This means deploying capital, growing companies and having successful exits in all markets. Many PE firms have proven they can repeat the formula over 50 years and as many as 9-10 funds. The family office already has uber wealth and often does not have to deploy capital for self-preservation.

No Second Bite

While a family office can offer immortality for a patriarchal business and continuing employment for loyal employees, it struggles to provide long term gain opportunities for management that has not had a “pay day” as well as owners who want a “second bite” of the apple. The alignment of managers and former owners is a powerful inducement as well as an important risk mitigant that you are buying a business that is running out of gas.

In short, I really don’t know any PE managers who would quit their job to work for a family office. Until that happens the private equity firms will win the recruitment war.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC
March 22, 2017

Rob McCrearyDespite Advantages, Family Offices Won’t Put Us Out of Business

$30 Trillion of Debt Doesn’t Worry Anyone

By Rob McCreary

Every year the US Government releases its Annual Report to its citizens. It is always interesting to see where we stand. Chart 4 below shows a 2016 balance sheet for the U.S. government. The assets are $3.4 trillion comprised mostly of student loans. The liabilities are $22.75 trillion comprised of two thirds federal debt (principal and accrued interest) and one third federal employee and veterans’ benefits. If I were Secretary of Treasury, Jacob Lew, I might have discounted that student loan asset inasmuch as most of that receivable is either in arrears or non-performing. I also wonder why the government does not treat Medicare, Medicaid and Social Security Benefits as a debt net of the corresponding trust fund asset. The explanation is that $5.5 trillion trust fund liabilities are off the “big balance sheet” because they are offset by assets on Agency balance sheets. I guess they wash which means that all these programs are fully funded?  In fact, agency debt is de facto guaranteed by the taxpayers.  So I don’t understand why they don’t just consolidate into the US balance sheet and round it up to $30 trillion?

When Will We See Profits from Operations

The U.S. Balance Sheet might be a little frightening but the trend line for receipts and disbursements should induce panic. The chart below is a little hard to interpret, but I can help. I have been looking at this report long enough that I actually get it now. The BLACK LINE is total receipts. The Color Bars add up to total non interest spending on categories like defense, Social Security, Medicare and Medicaid. The blue line is historical and projected total spending (which includes interest) from 1980 to 2090.  In a sleight of color, Mr. Lew shows the real problem in white hoping that it will be ignored.

Prior to the crash of 2008, receipts and non interest spending were pretty closely matched with a wonderful period prior to the dot com crash where receipts even exceeded total spending including interest! During the last 8 years receipts plunged and non interest spending hemorrhaged, Thank goodness we have the world’s reserve currency and were able to control interest costs. Of course, we see a projection that by 2020 we will be back in balance with no primary deficit.

If one of our managers gave us this kind of rosy projection, we might ask to see the historical trend line supporting that wonderful future and we might also ask what is the interest rate assumption underlying the growth in net interest expense.

 Look At the Net Operating Deficit

As shown below the government managers want us to believe they were on the right path for a believable turnaround until last year. The budget deficit fell from $1.089 trillion in 2012 to $438 billion in 2015. In 2016, however, the budget deficit spiked to $587 billion on the back of a 50% increase in net operating costs. In another interesting sleight of color, Mr. Lew portrays the budget deficit in red and the net operating deficit in white. In fact, the budgeting process for this management team is worthless and we as owners should just look at the net operating deficit. Our managers have overspent their income in every year since 2012 and they doubled the loss from 2015 to 2016. Since 2012 they have cumulative net operating losses of $4.45 trillion. So why would we believe anything in the projection from this management team about the future primary deficit and return to normalcy by 2020.

Interest Is Toxic

An even more important question is the cost of debt. Every year I look for the assumptions underlying the projected cost of capital and cannot find the assumption. This is a really important variable especially in a rising rate environment where the cost of funding accrued interest will keep rising. If we ever return to a 1980 environment where the cost of 10 year government debt was  close to 20%, our creditors will basically own America.

Why Don’t We Care?

When I talk to even the most sophisticated financial people about this debt trap I get a lot of eye rolling and yawns. It dawned on me that no one cares. Is it the law of large numbers? Is it a “kick the can down the road?” Is it confidence in our ability to reschedule the debt because the U.S. Dollar is the reserve currency? Is it because the politicians plan on swapping the Grand Canyon for Chinese debt? Or is it because we are all hooked on this heroin masquerading as legitimate finance? Maybe it is an intellectual recognition that $30 Trillion of debt is a problem – BUT NOT MY PROBLEM.

My finance teachers always taught there are only 3 things you can do with debt, default on it, render it worthless by printing money or hyper-inflating or rescheduling it. There is one thing for sure that distinguishes governments from its citizens, they will never pay it back!!!!

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

March 7, 2017

Rob McCreary$30 Trillion of Debt Doesn’t Worry Anyone