Sunday, 20 March 2011


A bank can trade at a premium to NAV, why?

because it can do things that as an investor you really can't; underwriting, m&a advice, borrow from the discount window, get bailed out, etc.

Imagine a bank, but without those pesky staff eating up costs, or costly office space, or the headache of having branches. Being a shareholder would be great, you'd be the one getting the bonus!

This was Tetragon Financial Group's pitch when they were listing this vehicle in 2007. The Raven was more than a little surprised that the bankers' could keep a straight face and although being on quite good terms with the chap at DB pitching this idea, he couldn't stop himself from laughing and hanging up when it was suggested that this should list at 1.3x book, "after all banks trade at a premium to that".

There were several features that made the TFG structure appealing at that time, however it was the funding that stood out; they highlighted that they had good terms to secure locked up funding from a couple of banks.. "evergreen loans" or something equally twee.

What really stank however was the idea that historical default and recovery rates were appropriate for the underlying paper, exactly the same argument as subprime, the banks making these loans and selling them were holding little interest in them, so clearly they would be of a worse quality than they had been when they were left holding the paper, for sure they weren't going to be better! The idea that the loans would be of a superior quality because they weren't making them for a relationship was utter drivel, the bank was still making them, and taking an investment banking fee, except now they didn't have to hold them.

The real sticking point is valuation. With a bank, they can grow their assets and revenue streams, they can provide services and run a business and as an equity holder that is your business, however much the folks on Goldman's renumeration committee think otherwise.

With TFG you don't have that, sure your assets can compound, but none of the growth in the business is yours, that all goes to the managers, who get paid as asset managers with a fixed contract that as a shareholder would be very hard for you to terminate. So in reality you're just an investor in a fund, except you're a permanent investor, you're signing up to paying those management and performance fees forever!!

One would have thought that the issue and frustration of gating would have made investors more cautious, especially to the idea of locking yourself into a credit fund.

So where should this trade to relative to NAV?

Well nobody should pay a premium to buy assets in a vehicle.

But we can see that you are contracted in to pay 1.5% management fee, and 25% performance fee above libor+2.25%. That 1.5% is guaranteed, so take it off as an annuity; that's 35% thank you very much. ie a muliptle of 0.65x book.

Currently NAV is ~ $10 per share.

It doesn't even take a Hedge Fund Manager on 1.5 and 25 to work out that a share price of $6.50 is 'fair value'.

Friday, 18 March 2011

buying puts as protection.

Buying options does not reduce your risk.

It substitutes some risks for others, you reduce your immediate price sensitivity and replace it with time sensitivity that is less intuitive and harder to manage for a normal portfolio manager. The lottery like returns tend to mean that buyers emotionally remember their winners rather than the thousands of small losers.

Selling options does increase your risk.

It introduces risk and pays a slight premium for doing so. Unless you have a very long time span, and enormous amount of wealth or are trading with OPM in a diversified and institutional setting, you are not going to capture that risk premium, and if you are a retail investor your commish will have turned that premium into a discount quicker than you can say inverted skew.

Howard Lindzon made a comment today (actually in Feb, have been meaning to finish this for a while) that is perhaps prescient; "after the run up maybe its time to look at buying some puts for protection". Having looked at this problem from more than a few angles while running a "tail risk protection book" for a two billion dollar multi strategy fund its one that has given the Raven a few black eyes and hopefully some robust insight.

Its almost always about the timing.

If you buy a boat load of at the money (ATM) puts and the market pukes, you're going to make money. The issue is that if you've got timing like that, well then who needs puts, just short the bugger and get your beach shorts ready because you're not going to have to work hard again.

The reason you buy puts its two fold; 1) not to get your face torn off by the market roofing it 2) which is very similar to (1) but to stop yourself getting stoppped out on a short. or 3) for implicit leverage, which is actually 1&2 together.

So you've skipped to the conclusion, bought your puts, and have been wearing your lucky underpants for the last month, the market is 5% higher and your puts are worth the square root of not a lot, the market actually does crack and you're mentally banking it, those puts must be worth something now, right? for some reason hitting shift-F9 is making no difference to your pnl??? WTF? what went wrong?

Puts don't give you the luxury of not having to get the timing right, if anything it complicates your pnl, introuducing even more timing risk and path dependancy. A "good" (read sucessful at selling centipeeds (a trade with lots of legs, which means lots of commission) to his clients) broker will handily pop up and suggest all sorts of options to sell against your put buy in order to reduce the "cost", by which he actually means the cashflow on day one, it certainley doesn't ever reduce the real cost, will show why it doesn't work in another post.

The paths that you will make money buying puts, you'd have made more money being short. The only advantage is that if the market has continued to go up you'll have lost more on your shorts.

So the first exploration in this space was to design a product that the Raven would have liked to buy at a reasonable price, ie some sort of look back put, ie a product that has a payoff equal to the (price at maturity - max price in lookback period). Well how much would that cost? and thinking back to the days of being on an exotic option desk, how would one hedge that with vanilla options? Without getting into too much fancy mathematics, or hedging strategy its just a good idea to think about what sort of paths will generate interesting payoffs;

1) close today is the market high and it sells off from today onwards, well then the price would equal an ATM put today
2) more realistically, the market rises, and then sells off, a basket of put weigted by the probability of that price being the maximum reached and the remaining time to expirary. so clearly the upside probability makes this product more expensive.
3) the best pay off profile would be a long period of a strong uptrend... with a '87 style crash on the expirary date.

Clearly there isn't a static hedge for this position, but its easy to think of a few dynamic strategies that would approximate that payoff, the simplest would be to buy an ATM put and slightly more shorter dated upside calls, using the profit from any move up on the upside calls to roll the strike in the ATM put up. One could also decide to implement a delta hedging scheme, which would be very similar to the portfolio protection scheme's that failed so drastically in '87. Any dynamic strategy in options is a wet dream for your broker, and a killer for your portfolio, you'll pay bucket loads of commission and for very little effect.

Statistically looking back these strategies would have cost about 3.5%, with a maximum upside profit of about 35% for 3 months of protection. The cost of which annualizes but your upside doesn't, so "hedging" your book would cost you 14% a year. One would have to believe the market has the potential to be a lot higher and the potential for it to be a lot lower, or more precisely that there is a large amount of uncertainty for these strategies to be worthwhile. In which case you're actively betting on volatility rather than actually reducing your risk.

The single best way to reduce risk, is to reduce all your positions proportionally.

Wednesday, 16 March 2011


Just two very simple points to make;

1) Before there is a bear market, generally, there have been positive fundamentals in place, ie. good corporate earnings that have been reflected in rising stock prices. Appealing to positive fundamentals is akin to pointing to the rear view mirror and exclaiming that there's straight road behind you, irrelevant if you're driving off the edge of a cliff.

2) Soros is right, the market and economy are reflexive. A fall in stock prices and a rise in credit spreads, will generally be followed by contraction in the economy for three reasons;
  • prices are a good forecast of future results.
  • prices reflect current sentiment, which in turn reflects future marginal economic activity.
  • prices effect the cost of capital which in turn effects spending decisions in the future.

Violent prices moves are only really "irrelevant" if they are corrected quickly.

Friday, 11 March 2011

$WDC risk managing the position

1) obviously we hedge, but what with? why? how do we calculate hedge ratios.
2) we have a stop, but of time or price? and where?
3) what position size is appropriate relative to the rest of the portfolio?
4) is there a good option trade to structure this better?

The most important thing is to be robust. Be roughly right rather than precisely wrong.

The natural hedge would be Seagate. We're betting on improving pricing in the hdd industry, shorting Seagate would remove that factor so a broad sector or index hedge is a better idea.

Calculating beta, ie the correlation between the stock and an index, has plenty of academic page space, the Raven uses his own special sauce, but it doesn't make that much of a difference.

Computer says... 1.5.

The nasdaq is a poor index to use as a hedging tool as it is very concentrated in AAPL.

We hedge to remove systematic risk, not add idiosyncratic risk, so a better choice would actually be a blend of indices, half spoo half nasdaq, looks robust enough, calculating a new beta to this... computer says..2.4raw 1.95net, the main driver of this high beta is the high volatility of WDC and relatively low volatility of the spoo. This suggests selling $0.97 of spoo and $0.97 of nasdaq for each $1 of wdc.

To be logically consistent we should have a look at the residual chart for $WDC, we at least have a history of the pnl of the trade that we are putting on rather than just looking at an outright chart, or using some rule that we don't have any feeling for.

It also allows us to at least estimate the risk in our hedged trade, as such for a $1 of wdc, we can expect daily moves of $0.04, with the worst daily move of -$0.38. These numbers are meaningless. A dollar of wdc is a dollar that could be lost. Theoretically it is possible to lose more, if the stock dropped to zero and the hedge rallied, but assuming risk of greater than $1 is over cautious and unrealistic. What it means to us is that we need to be cautious and not leverage the position, although many people would say that $1 of wdc and $1.95 of hedges is already leveraged. A reasonable stop would be a loss of 20% in price performance, and a reasonable stop in time would be 3 months.

3) Obviously this depends on what other positions are in the book, risk tolerance etc. What can be said absolutely is an upper limit on the position size, and that placing anything bigger would be a mistake. quarter Kelly betting criterion would suggest nothing greater than 5%. That is an upper bound.

4) Given that this isn't an event driven trade, ie. we are not anticipating a takeover, spinoff, rights issue, etc, then the value of using options is that they give us leverage and the ability to limit our downside. Without even looking at the vol surface, it doesn't make sense that we'd pay a dynamic hedger to take risk for us, when we actively want to take risk in the stock.

However, that might be worth a look later.

Wednesday, 9 March 2011

an awesome HIT..........$WDC reaction

Huge news monday morning, and would have had more to say here if there wasn't the need to trade it. WDC are buying Hitatchi's storage business, the ominous "third player". The stock moved from $30 on Friday to $36 a pretty huge move. Having been short the stock and spent the last two days first buying back the small short and putting on a proper sized long its fair to say this is a game changer.

Removing this pricing pressure from the market has an enormous impact on the multiple that one should value wdc and seagate on. Without the deal the pricing situation was bleak. A large number of units overhanging that didn't seem to get cleared a siutation getting worse because Hitatchi was looking for an exit, and in so doing was trying to push up sales at the expense of margin for a potential IPO.

It was quite plausible that the selling prices could have been knocked down a further 5%. Just using the trailing 12 months, that would have reduced sales from $9.9bn to $9.4bn, and net profit to $0.58bn from $1.09bn. Putting that on a conservative multiple of 8x (which is justified for such a cyclical business) and adding in the $2bn of cash and you were looking at a price of ~ $28, but obviously with a lot more downside if the economy got worse or Hitatchi really started to blow out stock.

Whereas if we put on our rose tinted spectacles and dream, then WDCHIT looks pretty sweet; the combined group would have about $19bn of sales, on an 21% operating margin and all the synergies, and then a move up to a better multiple of lets say 10x and we're looking at $2.6bn net profit a year and a stock price of $100. yes triple.

Being very conservative, lets say a 50% leak, half synergies, 18% margin and the same old multiple 8x and we're at $36. Mid case and we're talking $55.

Lets make it even more simple, there are essentially three cases;
1) deal gets kaboshed - stock drops, $27
2) deal goes through, no synergies, high leak, no multiple expansion $36
3) deal goes through, land of milk and honey, $55

You can play around with probabilities and try to be really smart and work out a finer detail on this, however in the short term one has to recognize that the future has radically changed, and that historically markets don't digest that information quickly.

The same human nature that allows momentum to be a profitable strategy is at work, its hard to buy a stock that has gone up a large amount in a short period of time. Here we see the reason why and that there is a lot more upside potential.

The Raven has bought his position already, but will continue to add if the price action confirms this view.

Tomorrow some more thoughts as to those relative probabilites and how we're going to risk manage our position.

Wednesday, 2 March 2011

Simon Fox - HMV's "Guardian"

CEO of HMV, joined the firm when the stock was at 130p, its now at 15p.

Not to overstate the case, but sharehoders have been decimated, well actually reverse decimated, as they have about 10% of their original investment left.

During his tenure, there has been a different head of the renumeration committee for different years, and a differing method for calculating performance awards, be that by changing the "peer group", the criteria or the conditions. The Raven is sure though that shareholders must be delighted to know that they had to match another firms offer for this superstar, in order to motivate him in his role?! what is 2mm of shares between "partners"?

When he joined in 2007 he had a total compensation of £333k, for 2008 he earned £992k, for 2009 £579k and for 2010 £874k.

What did shareholders earn?
2007 -33%, ouch and the FTSE did what?
2008 +29% almost back to break even yah, definitely worth a million quid...
2009  +3% still not at break even... hmmmm half a million?
2010 -44% almost a million again?
2011???? -82% and what will be looking at??

Thank goodness ITV didn't land this superstar, the Raven was long ITV, that would have been pretty nasty.

It is "interesting" though that a company losing nearly all of its shareholders' value has a CEO that also find the time to join the board of the Guardian, and the Chairman, to top that decided that joining M&S might be a good idea, only to discover that perhaps he didn't actually have enough time for both roles.

Just to put it into perspective, since he joined the firm shareholders have lost half a billion pounds, and the CEO has made £3mm but feels that he needs to be incentivized to turn the company around rather than jumping ship? Shareholders should have made him walk the plank.

Tuesday, 1 March 2011

HMV warning

Thanks Robert Swannell, are you going to pay HMV shareholders a golden parachute?

trading update

can't believe the guy rocks up and leaves after such a short period of time when the firm was already in a difficult position. Its not even being a mercenary, and the excuse is very poor.

net debt of £130mm is worse than the City was forecasting, its a little worse than the Raven was thinking given their update, and leaves less room for further restructuring costs and makes meeting their bank covenants a little harder.

The news in January that credit insurers were restricting insurance to HMV's suppliers should be in the stock price by now. The point the Raven feels the retail market is not pricing in so clearly is that between October 09 and the release of full year results in April 2010, inventories fell from £319mm to £248mm, a reduction of £70mm of stock, roughly one would expect a similar % move this year, and so inventory should fall to ~£234mm ie £68mm, which should mean that HMV naturally should be able to trim payables to £420mm. So in reality the demand for insurance should have been lower over the half.

Bought a few more shares, however its still a tiny position and should HMV fall to zero it would cost less than 1% for the portfolio, which is the maximum risk. Gut feeling that this is going to come with a rights issue that it should be able to get away if it does it sooner rather than later, the worry is that creditors get to extract the value from this firm.

miliband's mistaken

Article in the Times today who's main thrust is that Miliband disagree's with Mandelson that Labour should be comfortable with people getting "filthy rich". That people's income haven't risen in real terms, as real wages are at the same level as they were in 2003. It is unfair that the benefits of growth are accruing to the "filthy rich".

What he doesn't deal with is why the returns accrue to the wealthiest, or in fact why the wealthiest are wealthy. In Miliband's rather simplistic socialist view he neglects how or why wealth is created, it isn't just a process of dumb luck, or inheritence, or just that the wealthiest simply 'own the means of production', its the capital and risk taking create growth, rather than it just being a return on hours of work. Unless there are substantial productivity gains being made by increasing the skill of the labour pool, its logical that a growth generated by investment should increase returns to that capital.

Regardless the figure that is quoted as evidence for his blathering is that real wages will be the same next year as they were in 2003. The Raven has several problems with such a meaningless statistic.
1) wages are only a small part of REAL income for the poorest households, in fact for the poorest 20%, wages only make up a 25% of total consumption. When in real terms government spending has increased massively over that period it makes little sense to point to real wages when arguing about how well the poorest have done
2) "real" wages don't actually capture the benefits of gains from technology. ie. buying a phone in 2003 for the same price as one today would show 0% inflation, where in fact the quality of the product has improved greatly, in which case there is actual deflation.
3) picking two points in time is dishonest, given that real wages increased during the boom and have fallen back in the recession.