The Daily Reckoning PRESENTS: When desperately seeking alpha, the average investor will buy just about anything…even if that means overpaying. This week, Bill Bonner examines the gall of the private equity industry, and how it compares to that of the hedge fund industry. Read on…
God must love typical investors; he created so many of them. But he cursed the poor yahoos to mediocrity. They can’t get ‘alpha’ (above market performance), say the theorists, because they can never know as much as the market itself.
For the average investor, it is true; he can do no better than average. Match his little wits against ‘the market’? Don’t make us laugh.
You can hear a lot of laughing in the City and on Wall Street lately. And this week, the cynical cackles came from the Blackstone Group, which offered to sell common investors 10% of the company for $4 billion.
Here we back-track for a moment with an observation: The major decision that any stock market investor has to make is which line of guff to fall for. Any of them will ruin you – but some faster and more thoroughly than others.
One of the finest pieces of guff ever – the Efficient Market Hypothesis – is probably one of the least harmful. EMH tells us that market prices incorporate all the information available at any given moment – infinitely more information than any individual investor could hope to assimilate. Logically (if idiotically) any extra value an investor sees in a share is thus incorrect, compared to the price actually set by the all-seeing market.
It is impossible to beat the market, declares EMH. Of course, it is not true. But it also may not be true that you will go to jail if you kill someone. Still, it’s not a bad idea to believe it.
Meanwhile, for 20 years, Blackstone Group has been doing to the market approximately what Tyson did to Holyfield. It’s profits in 2006 reached $2.27 billion, more than double that of the previous year.
Obviously, the professors of EMH got it wrong somewhere.
While the academics say you can’t beat the market, the financial industry makes it sound as though you almost can’t help beating it. For a fee, mutual funds, account managers, stockbrokers, hedge funds and private equity groups offer to help you trounce the average investor.
Of course, that’s the business we’re in, too, here at the Daily Reckoning. But our pitch is extremely modest: If you don’t like our ideas and suggestions, you can ask for a refund.
Compare that to the chutzpah of the hedge fund industry, which charges 2% of capital and 20% of performance. If the professors are right, investors who go into hedge funds are morons. If the results are purely random – as EMH insists – they’re just giving away their money. If the returns bounced up 100% one year and down 50% the next, over a decade, almost all your money would be taken away in fees.
But then, the chutzpah seemed to reach a peak when hedge funds began offering shares to the public. If a hedge fund manager really could get enough ‘alpha’ to justify the fees, why would he want to give it away to perfect strangers? Hedge fund managers can do math. They wouldn’t sell shares of their own fund unless they could get a premium. As we explained earlier this week, either the public was willing to pay more for alpha than alpha was worth, or, there really wasn’t any alpha at all.
It turned out that hedge fund alpha had vanished. No one seemed to know where it went, but when they toted up hedge fund performance, over the last two years, they found that they were no better than the average mutual fund…and no better than the average, mediocrity-chasing lumpen investor.
Then, alpha was spotted hanging around with Private Equity capital, which soon became the hottest thing on Wall Street.
And now comes the pitch:
“Pssst,” says the Blackstone Group. “You still want alpha? Buy our shares.”
Is the Blackstone Group a religious or charitable order? Not so far as we have heard. If they have any alpha, they are not going to give it away. Already, they give investors in their private funds about the same deal as the hedge funds – 2 and 20, 2% of capital, 20% of profits. And now, like the hedge funds, they are proposing to sell their moneymaking magic to the poor fellows in the public market.
Exactly what public investors will get, we don’t know. It’s a private company. And the prospectus for its new offer is not out yet.
What we know is that private equities, like hedge funds, have taken on a speculative mentality. Deals are put together…then flipped from one PE firm to another. The objects of their attention – actual, profit-making companies – are loaded down with debt so the private equity investors can take out the profits. And then, the deals are sold back to the public – at a big premium. As more and more money chases quick profit, standards slip; the deals degenerate…from super-prime to subprime. Until investors come to their senses.
In 1989, it was junk bond dealers with alpha in their pockets who were in need of wising up. Then, Ohio Mattress was being taken private by a buyout firm just at the time Drexel Burnham collapsed. Lenders got worried…then frightened. All of a sudden, the easy credit that made the deal possible disappeared. First Boston, one of the lenders, reached into its pocket and…lo…no more alpha. The deal fell apart and the bank was so destabilized, it was later sold to Credit Suisse.
Junk bond investors learned such a valuable lesson, it took them almost 10 years to forget it.
The Daily Reckoning
March 29, 2007
Editor’s Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).
In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below:
Inflation is the “greater risk,” said Ben Bernanke earlier this week.
Greater than what? Greater than deflation, we presume he meant.
“Still,” continued the chairman of the world’s largest banking cartel, “uncertainties have arisen, and therefore a little more flexibility may be desirable.”
The main uncertainty that has arisen concerns the aforementioned deflation.
Look at what happened to Japan when its expansion turned into a contraction: The land of the rising sun didn’t see daylight for nearly 17 years. Those poor sumo wrestlers and manga artists were bumping around in the dark.
Seventeen years is nothing unusual for the downside of a major financial cycle. And that’s why Ben Bernanke – who thinks we are still in an expansion – will do all he can to make sure it continues.
Today were are talking about Economic cycles – the final one of our 5 Big E’s – the inescapable, ineluctable, irreducible trends of our time. Up and down, in and out…life and death…day and night…dust to dust…inflation and deflation…boom and bust…ashes to ashes.
Even ol’ sol itself will someday burn out. There isn’t anything that doesn’t follow a cyclical pattern.
Even our Big E’s.
Energy is going up. The Exodus of money and power swings from West to East. The Experimental, faith-backed dollar is going the way of all paper money – to Hell. And the Empire is peaking out (about which, there is a little more below).
But where is the Economic cycle today? And where are you in it?
The Fed’s main man thinks we are still in the expansion stage of the credit cycle…and maybe he is right. The cycles can take a long time.
Stocks peaked in the United States in ’29 and didn’t hit a final bottom until after WWII…and then they began a major boom that lasted from ’49 to ’68 – almost 20 years. But, the cycle turned again. From ’68 to ’82 stocks went down.
Then, in January 2000, the Dow registered a new, record high – 11 times higher than the low recorded in August of ’82.
A flood of liquidity pushed many financial assets to unreal new highs. From 2000 to 2007, total credit market debt increased five times faster than GDP. That tide of money washed almost everything up.
But tides ebb and flow too, and the last seven years have seen little real stock appreciation. In fact, in real terms, the Dow has lost ground.
We look out the window and see mixed signals…eddies…crosscurrents…backwashes… It’s hard to know which way the water is going.
Big Ben says it is still coming in.
But maybe not.
Our old friend John Mauldin:
“As I have written for months, the problem is not just in the subprime loans, but extends to the level between prime and subprime, known as Alt-A loans. Alt-A loans were just 5% of the market back in 2002, yet were 20% last year. 81% of those loans were low- or no-documentation loans last year…Roughly 50% of all subprime borrowers in the past two years have provided limited documentation regarding their incomes.
“Remember the study I quoted last week from the Mortgage Asset Research Institute, which looked at low/no-documentation loans? 60% of the borrowers exaggerated their incomes by 50% or more!”
[Slipping standards, dear reader…tisk, tisk.]
“It stands to reason, then, that many borrowers simply will not be able to make their payments when the reset comes due, thus the prediction that as many as 20% of the subprime mortgages written in the last two years will default.
“Indeed, the subprime meltdown is now spreading to other parts of the mortgage and credit markets: Near prime and risky mortgages (option ARMS) are now in trouble and they accounted for over 50% of mortgage originations in 2005-2006; subprime auto loans and subprime credit cards are in trouble; bank loans to home builders are in trouble; and bank lending to non-residential construction will soon also show cracks as the CMBX – the indices showing the cost of insuring against commercial real estate default – has sharply fallen, signaling a much higher risk of default even in this market segment.”
All this suggests that consumers have less money to spend. And that means deflation…
Yes, it seems that even the market in hogs is deflating.
The Street.com reports:
“Thirty-day delinquencies (and loss trends) in Harley-Davidson’s receivables book offer a clear picture that credit-quality issues are broadening… a pattern of deterioration that we first began to see in subprime mortgage loans during the first half of 2006.
Harley-Davidson’s 30-Day Delinquencies
Source: Lehman Bros.
“…Harley’s finance subsidiary (HDFS) funded almost half of Harley-Davidson’s motorcycle loans. Like subprime mortgage loans, HDFS’ hog loans are pooled and securitized to institutional buyers. Unfortunately – in credit trends and terms – HDFS is also beginning to look more and more like New Century…”
Chris Gaffney, reporting from the EverBank world currency trading desk in St. Louis…
“Today is a big data day in the United States, as we will get reports on inflation, consumer confidence, and spending. This data will be closely watched, since it will provide indications on the outlook for the FOMC’s interest rate decision next month.”
For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig
And now, more views:
*** And now, dear, dear long-suffering reader, our political ruminations finally come CLOSE to the end.
Why has collectivism – not individualism – triumphed almost everywhere, we ask? Individualism – a genuinely free market – clearly delivers more goods and services than a collectivized economy. People may not really care about liberty, but surely they care about money?
Why is it that even in the U.S. of A, where getting rich is practically the national religion, the government intervenes (in the name of the people, of course) in countless ways – from fixing key lending rates to setting the terms of employment contracts.
Part of the answer comes to us from Helmut Shoeck, who wrote a book 40 years ago called, Envy. Money isn’t everything, said Shoeck. In fact, in some ways it is less than nothing. People envy people who are richer than they are mostly because it confers status…not because it has any inherent benefits.
This comes from the peculiar nature of wealth. After you have the basics – adequate food, clothing, healthcare and shelter, wealth only matters in a relative way. Even if you are a multi-millionaire, for instance, you will be relatively poor in a neighborhood of billionaires. Since it is relative wealth that counts, you will be almost as satisfied – and maybe even more satisfied – to see your neighbors taken down a notch than to see yourself with a few more million.
Envy is such a powerful emotion that all societies eventually have to deal with it. In primitive societies, a rich chief might have been required to host a giant banquet. In the Middle Ages, laws were enacted forbidding people from showing off their wealth – the sumptuary laws. People were given a place, or rank, in society and expected to dress accordingly. Sometimes they forced everyone to wear the same drab clothes – as in China during the Mao years – and sometimes they just took everyone’s property away – as in most communist counties. In the West, taxes were imposed. Britain and the Scandinavian countries even had marginal income tax rates over 100% for a while.
People seem to hate the idea that their neighbors are having a better time in life than they are. It makes them favor controls, regulations, taxes…in short, it makes them favor a collectivist society.
But there is another important reason why individualism is rare and fleeting in the world.
And we will tell you about it, next week…
*** The trouble with democracy is that its politicians are too popular. A good husband, we recall mentioning yesterday, shouldn’t notice when his wife gets fat. But a free man should keep a close eye on his governors…and keep a pot of tar bubbling, just in case. Better yet…a noose.
An angry mob might run the king’s governors out of town on a rail…or even cut off the king’s head. But voters are reluctant to hang a man they just elected.
Too bad. Some of them have it coming.
[Ed. Note: As you know, dear reader, Bill has much to say on this, and many other topics. And now you can actually hear his opinions live, as he will be a key speaker at our Agora Investment Symposium in Vancouver, British Columbia. For details, call Barb at Agora Travel at 800-926-6575.]
*** And this from colleague, Dan Ferris:
“Just finished reading an interesting stock-market study – ‘Sometimes The Worst Are First’ – in Fortune. It shows that companies in the bottom half of Fortune’s Most Admired Companies surveys have outperformed those at the top of the list, consistently. ‘From 1983 to 2006, the mean annualized return of the less admired companies was 17.8%, beating the more admired group’s 15.4% return.'”