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Archive for February, 2009

The Death of Capitalism is Greatly Exaggerated

February 23rd, 2009 by Yehuda Fruchter   |   No Comments

With a record number of small companies with solid recurring revenue streams, strong balance sheets, high gross margins, and low cap-ex needs, currently trading at close to or at negative enterprise values, the implication is that economic activity will soon come to a screeching halt.

However, a quick stroll around any city would convince you that there are still human beings in the world and that therefore the economy is still very much alive. Yes, the economy has contracted significantly, and many industries, particularly finance, will continue to decline. However, the vast majority of the economy will not simply disappear. There can be no logical reason for a whole slew of cash-rich companies with no debt, to be considered worthless.

Therefore, my opinion is that, the death of capitalism is surely greatly exaggerated.

With The Market now having given back all of its gains since even before the start of the dual .com and housing bubbles, many equities are undoubtedly at levels that will prove to be excellent long-term buys, unless of course the entire economy does grind to screeching halt. The odds of that happening = Zero.

As mentioned in previous posts the current market meltdown is completely a function of the upcoming start of the TALF and other government programs. These new Fed and Treasury programs, which are aimed at reviving moribund securitization markets, pretty much guarantee hedge funds enormous risk-free profits via non-recourse loans. However, these highly immoral and outright crooked (and yet at the same time necessary) financial subsidy programs have not yet started. Why would funds buy anything prior to receiving a $1 to $2 trillion handout? Hence the meltdown. But, these programs are starting soon, and as the risk-free profits materialize via the TALF and Geithner’s program, stocks will recover strongly for some time (and then of course collapse again).

The Fundamental Instability of Capitalism is Upwards

February 19th, 2009 by Yehuda Fruchter   |   1 Comment

In re-reading Minsky’s fabulous book of essays, “Can It Happen Again”, which deals with the possibility of another Great Depression, I came across this excellent quote which I think conveys a truth that investors need to remember:
“The fundamental instability of capitalism is upwards. “

This touches upon a deep truth of capitalism: Despite short periods of extreme distress, as we find ourselves in now, the economy and most asset prices, in due time, always bounce back.

The reason is simply because it is the job of the Federal Reserve and Treasury, the chief captains of capitalism, to ensure steady inflation, so as to enrich creditors (i.e. banks) and financial speculators, both of whom are needed for a proper functioning of financial markets.

When the current financial crisis deepened late last year, the problem was that the government simply didn’t do enough to placate creditors and financial speculators. In fact, Paulson’s actions were arbitrary and very damaging to many speculators. Both Paulson and, especially the “academic” Bernanke, were operating in the past, with Bernanke making policy decisions based on his interpretation of events from over 70 years ago! Unfortunately, the financial world is quite different now than it was in the Great Depression.

Fortunately, however, Geithner has a better understanding of modern financial markets than either Bernanke and Paulson, and hence his solution, despite its extreme social unfairness, will work over time, notwithstanding enormous short-term pain, as I’ve noted in prior posts.

Basically, as I’ve touched on in the past, Geithner understands that securitization, not classical lending, is the heart of the financial economy and the only way to get those markets humming again is to fork over trillions of dollars of free money (in fancy terms this is called: “non-recourse loans”) to the financial speculators irregardless of the moral implications.

Of course, when you’re about to receive trillions of dollars of free money from the government to speculate in securities, you’re guaranteed to make your opponent pee in their pants, until they sell these securities to you at pennies on the dollar. This explains the current market meltdown, but also provides hope for the future.

Once funds receive Geithner’s two trillion in capital, and they are able to purchase securities at insanely cheap prices, there will be an enormous amount of profit generated by these funds (my estimate is well over $200 billion). This will in turn lead to renewed speculation and a return to the fundamental instability of capitalism: upward prices.

The only issue for smaller investors is the timing of this massive transfer of wealth, which will mark the bottom of this crisis. My belief is that since the crisis is deepening by the day some major deals will happen sooner rather than later, making it a smart move to accumulate cheap equities, especially micro caps selling at negative enterprise values, at this time. I would also note that every major financial crisis ends with a crescendo of fraud discoveries. The sudden daily increase in the SEC’s ponzi scheme list, which now includes Stanford, is therefore a sure sign that the financial crisis is bottoming out.

A Few Long Stock Ideas in the MicroCap Value Space

February 16th, 2009 by Yehuda Fruchter   |   1 Comment

Below are three interesting ideas with the following caveats:
1. If you don’t have the time or inclination to read earnings reports, and react quickly to changing financial circumstances, investing in any stocks I write about will be hazardous to your financial health. I also have no idea which stocks will go up and when.
2. I’m fully prepared to suffer significant losses (sometimes greater than 50%) in a large amount of investments, since I know full well that my few winners will more than make up for the losers, as long as I sell the winners and don’t get greedy. If you don’t plan to diversify widely and cannot handle a complete loss of capital in one particular stock, do not bother to research these ideas.
3. Finally, do not expect any updates on the various stocks. Suffice to say, if the stocks go up to what I deem as fair value, I’ll be selling. If they go down, and fundamentals remain solid, I’ll be buying more.

Now on to some ideas:


WWWW: This stock should be familiar to long-time readers, as we made good money investing in WWWW some time ago. The company has gone thru various changes over the past few years (i.e. merger of equals with a former competitor), but has recently settled back to $3. At $3, the company has enterprise value of about $50 million ($34 million in cash and no debt), vs. high-margin, and recurring revenues of about $120 million. I estimate free cash-flow at about $20 million+ a year. The two kickers: the company’s last quarterly report showed a massive accounting loss which masks very strong cash profits, and WWWW has a nice buyback in place. So an investment in WWWW takes advantage of the Market’s propensity to misunderstand accounting earnings reports (overstating both losses on the downside and profits on the upside), coupled with the downside protection of a very low valuation and a corporate buyback.


OPWV: My purchase price in OPWV is actually significantly lower than the current stock price, but I still think that the stock has potentially enormous upside, assuming that certain events take place. OPWV is basically a well-known mobile software company, with a strong balance sheet, that has been a complete dismal failure as far as a business profits and investment returns are concerned. This of course spells huge opportunity, since investors are bound to ignore positive developments in well-known dogs until the stock price has climbed enormously. The positives for OPWV (recently trading for $0.89): A market cap that is still lower than cash on hand valuing the current $200 million or so a year business at less than $0, a business which has finally turned the corner on a cash-flow basis, and a growing interest in mobile plays. In normal times, OPWV would sell for at least 2X EV/Sales, which would equate to a stock price of at least $5. Will it get there? I have no idea. But the odds of such a move, if cash-flow continues to improve, and some deals are announced is higher than the odds of the stock remaining below cash.


CCUR: CCUR is another example of investor bias towards past failures which show strong evidence of improving fortunes. At a recent price of about $3.75, CCUR sports an enterprise value of $4 million, with nearly $28 million in cash and no debt. Sales at the company appear to have consistently been about $70 million a year (50%+ gross margins and little cap-ex). Recently, after years of losses, the company started making money again. I estimate free cash-flow at a little over $4 million a year for a EV/FCF ratio of about 1. In normal times, CCUR would sell for at least 1X EV/Sales, which would equate to a stock price of at least $12. Will it get there? Again, I have no idea. But the downside seems low here and the odds of an upside move seem very high.

Need a Good Recipe for a Political Portfolio? Follow the Chinese

February 14th, 2009 by Yehuda Fruchter   |   No Comments

It’s no secret that Markets have been, and for the foreseeable future will be, held hostage by politicians.

How should an investor design a portfolio in a Market shaped by politicians? I believe we only need to look to the Chinese to find an answer.

An interesting study from 2005, entitled “Behavior and performance of emerging market investors: Evidence from China” (click here to read the full study) found that:

“Chinese investors are trading at a rate almost four times higher than U.S. investors.” Additionally, to the amazement of the researchers (since this data contradicts US findings) the accounts that traded more frequently actually earned higher returns.

So a clear prescription for making money on the new, Washington Wall Street: Trade Aggressively, and Invest Selectively (if ever).

This of course may prove difficult, or nearly impossible, for those not following the Markets on a daily basis, but for those who do, the intellectual justification for aggressive trading is clear.

A politician is by definition a sycophant, which implies that he/she cannot possibly make decisions based upon economic considerations. Constantly shifting “political” concerns always far outweigh any sound economic policies or basic moral values.

This means that in a politically-charged Market, as we find ourselves in today, prices of assets are even further divorced from from any economic fundamentals and become more intertwined with the fickle and ineffective policies of politicians. Hence the need to trade more frequently.

Interestingly, based on anectodal evidence, I think you can see a similar tendency among successful business operators, as distinguished from investors, in politically-corrupt, third-world economies. There is a distinct tendency to stash away gains quickly (preferably in overseas accounts) and reinvest very reluctantly in the local business. This is because these businessmen, even if they are honest, are always entirely uneasy about the potential for some sudden shift in government policy, which could spell ruin to their business and savings.

The safe strategy apparently is simply to take advantage of short-term events, cash out, and then wait for the next favorable opportunity.

Comparing the Two Bailouts: It’s No Contest

February 12th, 2009 by Yehuda Fruchter   |   No Comments

If you need further proof that the largely imaginary financial economy has become the real economy, just compare the two bailouts:

Cost of supposed bailout of the production economy, the “former real economy”, with Obama’s stimulus plan: nearly $800 billion.

Cost of bailout of the financial economy with Bernanke and Geithner: $4 trillion and growing.

Maybe it’s time to consider shrinking the financial economy back to its original purpose of serving the production economy, rather than usurping it.

The problem: We’d have to get rid of most securitization markets, and this would entail a social upheaval of unprecedented scale.

That’s probably why Geithner and Bernanke are intent on saving the securitization markets at all costs, even if that means diverting another $1 trillion to fight the imaginary financial monsters created on Wall Street.

Geithner’s Plan: Quick Take and Strategy

February 10th, 2009 by Yehuda Fruchter   |   No Comments

Here’s my quick take on Geithner’s bailout plan, which is far more important to the Markets than Obama’s stimulus plan.

Geithner : This bank mess is too difficult for the government to handle. Let’s give it over to the hedge funds and private equity guys and let them sort it out.

Result: Great deal for the funds. Terrible deal for the banks. Terrible deal for consumers. Bank stocks will collapse. Banks will be owned by hedge funds and private equity in a few years. Long SKF, for a trade. (you cannot invest in these short ETF’s long-term, and shorting in general is not a long-term investment strategy) .

Long-term (three years out), ignoring the complete corruption inherent in this idea, this is a great plan, as it gets rid of the banks in a secretive way, behind closed-door negotiations with hedge funds. The toxic securities mess will be cleaned up over time.

Short-term this will bring great pain onto the existing banks with toxic assets.

Bottom-line: I am long SKF and will hold it now, as many bank stocks will collapse further as they are restructured by private funds. I don’t think the SKF will be as volatile as it has been in the past (which has hurt it’s performance – these ETF’s are the daily inverse – so volatility eats away at returns), since the Geithner plan will stick. But, as mentioned above, SKF is only a trading vehicle and mainly for day trades.

Real Banks Don’t Lend Money

February 9th, 2009 by Yehuda Fruchter   |   No Comments

Politicians continue to criticize the banks for not lending money. But what they fail to understand (or don’t want the average person to understand), is that “Real” banks do not lend money. Real banks securitize. And with most securitization markets still slow, or dead, is it any wonder lending has slowed?

As many bankers long ago realized, pure lending is a boring, and a very limited business. Quite, simply you make money on the interest spread, and the size of the loan has to be related in a very strict way to the underlying business. For example, it’s simply not possible to lend one entity billions and billions of dollars, if the company has a mere $10 million in sales. In other words, traditional lending is constrained by growth in the production economy. It’s hard to get outrageously rich by lending money in the traditional way. There are strict physical and mathematical boundaries.

Enter securitization.


The Holy Grail of Securitization and the Potential Unlimited Wealth it Creates

If a bank securitizes a loan, however, then it can create an unlimited amount of capital off of even a tiny loan.

Since the loan is now security, like any other, it can fluctuate and therefore many people will be enticed into trading the security. This generates trading fees, and commissions. Even better, you can hire all sorts of smart people to develop valuation models for these imaginary securities, assigning them basically any price you choose and thereby generating astronomical asset management fees, and capital gains off of the securities you trade.

More importantly, with the magic of securitization, you can create an almost infinite amount of securities. There’s a security that represents the loan, there’s a security which represents the security which represents the loan, there’s a security which represents a bunch of similar securities, there’s insurance on the security, and so on ad infinitum. An infinite amount of securities adds more trading fees, commissions, asset management fees, capital gains, legal fees, etc.

In sum, with securitization the only limit on capital formation is your imagination. The underlying growth or size of the production economy, which the security was originally supposed to represent, bears no relationship to the size and growth of all the securities that are created. There are no physical or mathematical barriers to growth.

Securitization is therefore the path to outrageous wealth. It’s the holy grail of finance and the entire economy that lives off of finance, e.g. law firms, real estate, etc.

Is it any wonder that banks are not lending?

Without a sustainable revival in all security markets, lending will not resume in a meaningful way.

Financial Frankenstein: Why the Government Stimulus Won’t Help Us Contain the Financial Monster

February 9th, 2009 by Yehuda Fruchter   |   No Comments

Perhaps the best analogy for the current financial crisis is Mary Shelley’s Frankenstein. Like, Victor Frankenstein, despite our initially benevolent motives, we have lost control of our creation, and have unleashed a monster.

Our monstrous creation in this case is the “imaginary” financial economy with all its tradeable paper. Originally designed to simply drive the real economy, the financial economy, thru the alchemy of securitization, has grown so large as to become the real, and true, economy.

The fact that the dollar volume in the stock market alone (which is really a small slice of the financial economy), is nearly triple the US GDP should drive home the realization that the real economy is the financial economy.

The non-financial company, or the “production” economy for lack of a better term, may employ more people, but it is no longer the real economy. More importantly, in a slight twist of fate, the “production” economy is now completely dependent on the financial economy in a myriad of ways, like 401-K’s, insurance plans, home ownership and other savings schemes. Even the mighty Google, can’t shake off the financial economy, as evidenced by their need to reprice all their employee’s options following the drop in GOOG’s stock price.

Once one comprehends the sheer enormous size and influence of the financial economy, it should seem obvious that spending nearly a trillion dollars in the “production” economy cannot possibly solve our financial crisis. The idea may have made sense decades ago, when the financial economy was much smaller in the size (and seemingly smaller than the production economy), but at this point, based on strict mathematics, there is simply no way the “production” economy can possibly bail out the now much larger financial economy. It’s the classic case of putting the cart before the horse.

What to do? The Frankenstein myth offers little consolation or advice. Once the monster is created, and reaches a certain level of self-awareness, there is no return. You either kill the monster, or create a new one.

The stimulus plan takes neither approach. Which is why, I’d sell into this stimulus rally and remain cautious.