The Goldman Debacle - Part II

In my last post I used a casino analogy to describe the background of the SEC case against Goldman Sachs. Hopefully the analogy made the fundamental issue at hand a little clearer without the Wall Street jargon that confuses most of us common folk. But now that you understand the circumstances, you may notice the holes in the case and the somewhat flawed logic that the SEC is using to build what I think is a house of cards case.

It Can’t Be That Easy

First, let me tell you where I think the SEC’s case has merit. Basically, what the SEC is saying is that GS did not live up to its fiduciary duties by notifying investors that John Paulsen was shorting the mortgages in the CDO that it sold its investors. In a general sense, I think they’re right. GS, as the broker, should disclose as much relevant information as possible to its investors to ensure they’re interests are being served. And if it is apparent that GS violated this responsibility, they should certainly be punished for it.

That’s it. That’s the only area where I think this case has merit. Now, with that out of the way, let’s discuss where it doesn’t have merit. I think the biggest flaw in the SEC’s logic is that they’re saying that GS should have disclosed the person on the other side of the trade (i.e. Paulsen).

Stop right there and think about that. Say you were the casino in my example. When you see those gamblers come and bet money, isn’t there an assumption that those gamblers know that there’s someone on the other side betting against them. In any gamble, whether in a casino or Wall Street, there are two sides to every gamble. In the casino, we call that the ‘house’. On wall street, it could be anyone that feels the opposite of what your bet is.

In other words, every time you bet on an asset, whether it’s a CDO or a stock or you double down on a hand of Texas Hold ‘Em, there is an implicit counter-bet. If everybody felt that the mortgages in the CDO would go up like the investors that bought them did, why would anyone sell them? Furthermore, does it provide any additional value to the buyer if they were explicitly told who the counter-party on the CDO is? I don’t think so. When I buy a stock, I know someone is selling it to me. Will it change my decision if I knew who is selling the stock I’m buying? If I’ve done my proper due diligence, it shouldn’t

The bottom line here is that I feel that Goldman did not have a fiduciary responsibility in not disclosing that John Paulsen is betting against those mortgages because it wasn’t relevant information that the buyers needed to know – it’s just not common practice on Wall St. to do that. Furthermore, the fact that the actual buyers of the CDO were banks who are sophisticated enough investors to perform the necessary due diligence only reinforces this notion.

Where Do We Go From Here?

Honestly, I think the SEC’s case against GS is a witch-hunt to a large extent. The SEC has come under a great deal of scrutiny lately for allowing the financial collapse to occur under their watch, and, unfortunately, I think this case is them trying to pander to the public and Washington that they are still relevant. Hopefully, in time this case will be dropped. However, I think the more likely scenario is they’ll settle with GS out of court and we can move on.

What are your thoughts?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

The Goldman Debacle - Part I

Well folks, here we go. The fallout from the housing crisis is beginning to hit the biggest players in the industry. A few days ago, the SEC (the government organization tasked with policing the financial industry) formally filed a civil lawsuit against what was until then perceived to be the proverbial Iron Man on Wall Street – Goldman Sachs. In the lawsuit, the SEC basically accuses GS of intentionally misleading clients who invested in a product that the bank sold them. The ramifications of this can potentially be huge, and this is likely only the first shoe to drop in a series of lawsuits. But I wanted to take a look at exactly what’s going on, how I think it’ll play out, and, in true InvestingDecoded fashion, how you can potentially profit from it.

Place Your Bets

Exactly what events allegedly transpired to put GS in this situation is kind of tricky to explain. What I’d like to do is set up the scenario without using financial jargon that’ll just end up confusing most people. Let’s set up a real world scenario that parallels the SEC allegations:

Say you own a casino, and a man, let’s call him Mr. Paulsen, comes to your casino and asks you to put a specific model slot machine into this casino. The slot machine Mr. Paulsen is asking to put in the casino is well known to gamblers at the casino as it has historically given healthy pay-outs. Basically everyone who plays on that model slot machine has been winning money. But Mr. Paulsen thinks differently – he thinks that the slot machines are overrated and will eventually stop paying out healthy gains and gamblers will lose money. So he asks you to put the slot machine into your casino so he can get as many gamblers possible playing on it and make money once it stops paying out the cash.

Well, you as the casino owner agree to do it. But before you do that, you want to make sure the slot machine isn’t broken or tampered with. You hire an outside contractor to come inspect the casino to make sure it’s OK. But the vendor, NOT knowing that Mr. Paulsen is convinced the machine will stop paying out, OK’s the slot machine assuming there’s no conflict of interest between Mr. Paulsen and the players.

So you put the slot machine on your casino floor and gamblers clamor to play on it. But you don’t tell them something key – the person who asked you to put the machine there is convinced that you’re going to lose money. Now, as a gambler if the guy who had the clout to get that slot machine on the floor is convinced that the slot machine is overrated an will eventually stop paying out, wouldn’t you think twice about playing on the machine? However, as the casino owner, you don’t disclose this fact to the players. All you do is put a sign on the slot machine saying it was inspected by a third party and it works fine.

Low and behold, the machine stops paying out. Gamblers keep playing and keep losing money and walk away empty-handed. In the mean time, Mr. Paulsen reaps in the rewards from the gambler’s money, on the order of $1 Billion, and you the casino owner keep a share for your services.

This, in a very small nutshell, is what happened in this case. But the casino is Goldman Sachs, the slot machine is Collatorized Debt Obligation (basically a package of mortgages that investors can buy/sell, see past posts for more details) and the gamblers are investors. Furthermore, Mr. Paulsen is actually John Paulsen, a hedge fund manager who correctly bet against the housing market in 2007 and made billions of dollars. What Mr. Paulsen did was ask GS to create a CDO with mortgages that he thought were not as strong as they were perceived to be. He did this by analyzing the quality of these mortgages and comparing them to the credit rating given to them by the big credit rating agencies. The ones that the thought were literally overrated he wanted GS to put in the CDO. GS then hired ACA Management as an independent reviewer of the assets in the CDO (i.e. the independent contractor in the analogy). ACA was tasked to review the mortgages Mr. Paulsen requested to be put in the CDO. But what ACA didn’t know was that Paulsen was holding a short position on those very mortgages.

GS then took the CDO and sold it to investors (mostly foreign governments and banks). But GS didn’t disclose the fact that the person who selected the mortgages in the CDO thinks they’re going to collapse. Do you see the issue here? The bottom line, the SEC is accusing GS of creating a product and selling it to investors while not disclosing the entire story.

You might be thinking that this is a grey area of disclosure, and you’d be correct in thinking this. In my next post, we’ll discuss the holes in the SEC’s case, and how I think the story will play out.

What are your thoughts?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

Another Big Airline Merger?

That's right, folks. Here we go again. The rumor mill on Wall St. is buzzing with yet another big airline merger. After the surprisingly successful merger with Delta and Northwest, it looks like United and US Airways are discussing tying the knot...again. The combination would create the world's second largest airline (behind the aforementioned Delta/Northwest combination) with large operations in virtually every corner of the country (San Fran, Phoenix, DC, Chicago, Philly). But, at the same time, I think it might cause some headaches as well.

History Repeating Itself

This isn't the first time United and US Air have tried to get together. In 2001, the two airlines had a merger agreement that was shot down by the US Justice Dept. on antitrust grounds (ironically enough, both airlines declared bankruptcy a couple of years later). Nonetheless, the two airlines do have some synergies that make a merger sensible. A complimentary route structure, a decent amount of fleet overlap, and the same alliance affiliation would all make a merger makes sense. Furthermore, US Airways has a history of financial under performance and, to shareholders, it may make good sense to combine with a bigger competitors.

Industry Tailwinds

Another good argument for industry consolidation is pricing power. There were two major components of pain for the airline industry this decade which resulted in billions of dollars in loses - higher costs (mainly due to oil prices rising) and lower ticket prices. Because of the huge expansions over the years, the major airlines needed to lower prices to compete. The conslidation of a United/US Air would reduce this competition and allow airlines to increase revenue.

Of course, this is a double-edge sword. Increased pricing power means higher fares for you and me. As much as it might be painful, in my mind it's an inevitability that has already begun.

But of Course There's a Twist

Although there does appear to be serious merger discussion between the two carriers. There are thoughts that United is talking to US Air as a negotiation tactic with another airline - Continental. United has also been courting Continental for a some time now, but the Houston based carrier has refuted offers. The prevailing thought is United is hoping to bring Continental back to the table when it feels that it might be at a disadvantage with a United/US Air tie up.

In other words...stay tuned!

How to Trade Through This

I've said in the past and I'll say it again...I never recommend investing in airlines long-term. However, in this case, I do think there are some opportunities for TRADING through this news (i.e. short term investing of 6 months or less). But I wouldn't buy any of the names involved in the mergers here, there's others that I think can benefit:

1. Alaska Airlines - The airline's size and market niche make it a perfect takeover candidate - especially for American Airlines. Another big merger might force AMR to make a move as well, and Alaska could be a great catch.
2. JetBlue - The airline has had some rough patches, but pricing power could bring some positive upside for the airline.
   

The airline industry is extremely dynamic and full of surprises. Stay tuned to InvestingDecoded for the latest updates and what they mean to you. Of course, you might also get some ideas on how to invest in it.

What are your thoughts?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

A Portfolio for the New World of Health Care

As I’m sure you’ve already heard – the landmark Health Care reform legislation was recently signed into law by President Obama. Regardless of your viewpoints on this reform (and I’m sure everyone has their own opinions), this is arguably the most impactful piece of legislation of our time, and with it comes major changes to the companies involved in healthcare. As I’ve said before, with change comes opportunities, and in true InvestindDecoded fashion, I wanted to discuss what investing opportunities this legislation brings about.

The Low-Down

A few months ago, I wrote about the reform when it was still in its negotiation stages. At the time, I gave my viewpoint on how you could invest in the reform. Now that we have an idea of what the final legislation will look like, I will revisit those predictions and see if they still hold up. Before we can do that, however, let’s take a look at some of the key points of the legislation:

· The primary goal of the legislation is to provide affordable health coverage to some 32 million additional Americans.

· State-based insurance exchanges will be created to enable the uninsured, small businesses, and self-employed to create ‘groups’ through which they can purchase insurance at a lower cost than if they tried to purchase it individually.

· Most larger businesses (those with 50 or more employees) will be fined $2,000 employee/year for not providing coverage for all employees.

· Uninsured individuals who do not purchase coverage will be fined $695/year.

· There will be cuts made to Medicare reimbursement but additional coverage made for Medicaid.

· Insurance companies will no longer be able to deny coverage based on pre-existing conditions or drop coverage for members who get sick.

Winners and Losers

Overall I think that this final legislation is not all that different from the proposed legislation I discussed a few months earlier. There seems to be some distinct winners and losers and, although many of the winners have already seen their stock prices rise significantly, I still think there’s long-term upsides.

Winners

· Pharmacy Benefit Managers – In my mind, these guys are the real winners here…big winners. My prediction is that there will be serious emphasis put on cost-containment for health coverage. Now that coverage is more of a commodity and less of a luxury, margins will be squeezed for insurers. Therefore, they will be looking to save every dollar they can. PBM’s are the ideal way to save money on prescription medication for these insurance companies. I think names like Express Scripts and Medco will see some serious upside. However, one that I think will be the clear winner in all this is CVS Caremark, who I think will win on both the PBM and Retail pharmacy side.

· Pharmaceutical Companies – Drug companies came away like bandits in this legislation (I’d say this is thanks to some nifty deal-making with the government early on in the legislative process). These companies will see an influx of 32 million new customers that would previously not buy their products. On the other hand, they have come back with token concessions as payment for the new demand. Right now, there doesn’t seem to be a single big winner. A pharma ETF would be a perfect investment here.

Losers

· Health insurance Companies – The health insurance industry has just been turned on its head. These sweeping reforms will impact the likes of WellPoint, Aetna, CIGNA, United Healthcare, etc. drastically. The first challenge I see for them is increased cost due to the types of members they will now have to insure (i.e. those who are extremely sick and would otherwise not be able to get coverage). Furthermore, they will face increased competitive pressures due to the exchanges that were set up as well as opening up the market to more competition that was done through previous legislation. Yes there are now 32 million new potential customers. But I think the pricing pressure and increased cost structure will their once-lofty margins and, consequently, shrink profits.

My Reform Portfolio

With all this said, I have a simple portfolio that I’d recommend for reform. Now keep in mind many of these stocks have already had a significant run-up and may experience some near-term weakness (next time listen to my recommendations that first time I make them). But I think long-term there’s still opportunity here. This portfolio will give you a fairly diversified healthcare setup while taking advantage of the true winners (as I predict they will be):

1. 25% - CVS Caremark

2. 25% - PBM ETF (to diversify in case things don’t go well for CVS)

3. 30% - Pharmaceutical ETF

4. 20% - Biotech ETF (to get more leading edge pharmaceutical exposure)

What are your thoughts?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

You Can Now Bet on Movies!

In the spirit of the 82nd Oscars (which I may or may not be watching as I write this post), today I want to discuss a novel new investment vehicle that I recently heard about.

We've discussed Options investing here on InvestingDecoded in the past. The basic idea is that you create a contract whose worth is based on the intrinsic value of a hard asset (i.e. it's value is derived from the value of a hard asset...i.e. a derivative). Recently Cantor Fitzgerald, leading financial services company, announced that it has received approval from the CTFC to create an market exchange for Options based on movies.

Huh?

Known as the Cantor Exchange, this new market will allow investors to bet on the box office success of movies. Investors will be able to invest in options for upcoming film releases. Each options will price at one-millionth of the expected gross ticket sales of the movie 4 weeks after release. That means that if the market is betting a movie is going to make $100 million dollars after 4 weeks in the box office, the option contracts will price at $100. As the expected 4 week gross revenue number changes, the contract price will adjust accordingly.

What's the Impact Here?

The ability to trade the success of movies provides more than just a betting market where you and I can prove how much we know about good movies (although it does that too). The Cantor Exchange will provide a marketplace for moviemakers to hedge their risks when financing movies. There has been a strong and consistent trend in Hollywood to bring out pricier and more extravagent films. Having an exchange where you can gauge the success of a project you've funded gives moviemakers the opportunity to long or short options for their movies. That way they can reduce their exposure if the movie is not a commercial success. This also gives opportunities for low budget filmakers access to more capital as they'll be able to write Option contract for they're films and have access to a greater number of investors through the Cantor Exchange.

But All's Not Well

I think the concept of the Cantor Exchange is really interesting. It's bringing investing principles to filmaking to a level at which it has never been. However, I do see some serious risks with this exchange. One of the most important principles in investing is the equal dissemination of information to all potential investors. In other words, if one investor knows something, all of them should - otherwise you get the chance of insider trading. The risk I see with the Cantor Exchange is that film producers can gauge the potential success of a movie prior to its release and start trading options on it while other investors haven't had the opportunity to see the movie. However, I think that is a very fixable situation. There are very strict regulations on how CEO's of publicly traded companies (as well as others with 'material insider information') can trade the stocks of those companies. These same rules would need to be applied to studios and those at the studios with that type of information. With these rules in place, I think the Cantor Exchange can be a really interesting and lucrative endeavor for all of us individual investors.

Learn more about the Cantor Exchange here

What are your thoughts?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

Clearwire (CLWR) - An Interesting Play

Recently, a friend of mine asked my thoughts on a stock whose products have been getting some strong exposure lately. Clearwire, a growing name in the wireless broadband arena, is attempting a major coup in the broadband internet industry. Through it's Clear brand, it's trying to lure people away from traditional broadband providers (cable, dsl, phone, etc.) into wireless broadband. If you're from Chicago, you've probably seen the ads around the city.

The Technological Advantage

When chatting with my friend about CLWR, the first question I asked was "How do they expect to compete with names like Comcast, AT&T and Verizon? These big names have huge market penetration already and switching costs can be fairly high for something as integral as internet service."

My friend explained that the key with CLWR is it's technological advantage. All of its wireless broadband service is 4G. Clear claims its 4G service is 4X faster than the current 3G used by the major names. CLWR is achieving this by partnering with Sprint's wireless network which has already been implementing the 4G network for over a year now. On the other hand, the big wireless providers (i.e. Verizon and AT&T) are at least 3-6 months behind in implementing 4G.

This technological advantage gives CLWR the edge in providing a better product than its competition which will help it lure customers away. Having fast wireless internet service anywhere in the city at a competitive price can really help CLWR get the market penetration it needs to be successful.

But The Stock Can Be a Different Story

One of the first things I learned when I started investing is, often times, comparing a company and its stock can paint two very different pictures. CLWR's product looks promising. They seem to be on the right track of changing the landscape of broadband internet. However, the stock looks more iffy and I'll explain why:

1 - Valuation - CLWR's stock is being very richly valued by investors. The price/sales ratio of 5.79 is almost 5X the industry average. A richly valued stock is usually appropriate for high growth companies like CLWR. But 5X I think is pushing it.
2 - Earnings History - After a fairly stable 2008, earnings for CLWR have been increasingly negative for 2009. This is most likely due to an aggressive expansion strategy. Nonetheless, losses are expected to continue their declaration this year.

However, even with these negative components, all hope's not lost. The company has a strong cash base of $1.96 Billion which is enough to cover all its debts. That helps offset the negative earnings. Furthermore, the recent pulback of the stock price has helped reduce the rich valuations, although it's still on the expensive side. Finally, insider buying/selling is pretty neutral, which helps bring confidence that management isn't at least getting out of the stock.

A Mixed Bag

CLWR has a lot of things going for it at this point. However, at least in the short term, I don't think this is the best time to buy the stock. I see continued downward pressure over the next few months. However, long-term, I definitely see strong growth for the company. Analysts are expecting a 92.7% increase in year-over-year sales growth for 2010. That's a tall order for any company. However, I think CLWR is taking the right steps to get there. Furthermore, I think CLWR can potentially be a takeover target by one of the big guys if they decide they want to get a head start in the 4G business.

Bottom Line

I would buy CLWR for a long-term investment. However, I'd first wait until valuations come more in line. It needs to get down to at least $5.50 before I seriously think about getting in. $5 would be a perfect entry point. From that point, I'd keep a close eye on the revenue growth (not so much profit numbers) and, as long as its consistent and meeting expectations, hold on for the ride upwards!



What are your thoughts?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

2009 Year In Review

2009 has come to an end and, thus, ends the first year of InvestingDecoded. I started this blog to help others learn about investing and try to make sense of something as complex as the stock market. I hope I've been able to make this happen. At the same time, however, InvestingDecoded has helped me learn more about investing for myself. To me, that alone has made the time worthwhile.

Now that the first year is over, it's time to look back. One of the biggest things every investor needs to do a assess his/her performance. InvestingDecoded is no exception. Let's take a look back at topics I've covered and see how the recommendations have performed.

Oil's Rollercoaster Ride

Early last year, I wrote a series of detailed posts about the oil industry. We discussed how the oil complex functioned and the price drivers. One of the big recommendations I made was a call on oil prices. When I originally wrote the post, oil was hovering around $35 a barrel. I wrote that the $35 price was artificially low and, eventually, prices would rebound. At the end of 2009, oil was trading at close to $80, slightly above my estimate of the mid-70s. If you had invested in oil when I recommended it, it would have been a fruitful investment.

The Banking Crisis

InvestingDecoded also had a series of banking related posts. Here, we peformed a detailed analysis on the balance sheet of various banks. From there, I ranked what I felt were the best banks to invest in, with Wells Fargo coming out the winner. Looking back at this prediction, it seems that I was likely somewhat off. WFC has slightly underperformed the overall industry ETF (graph below). Although I'm still convinced the bank has good days ahead of it, many of the pureplay investment banks (e.g. Goldman Sachs) have performed better.


International Telecom Getting the Job Done

One of my more direct recommendations last year was Millicom International. The emerging market cell phone company was trading in the 40's. Now trading in the mid-70s, Millicom has shown it's quality as a company and a stock. I still think the company has room to grow to the 100+/share once global growth really picks up.

Other Names

Some of the other names I discussed were companies like Ford and Citigroup. Since those recommendations were made later in the year, it's hard to assess their success. Ford, however, looks like it's doing very well. I personally have made a nice 70% return on it and have cashed out some profits. Citigroup is having some issues, but it wasn't a outright recommendation when I had discussed it. Time will tell how both these once-powerhouses come through in this recovery

2009 was one of the most interesting years to be an investor. You could have made a lot of money if you took some risks. At the same time, you could've lost a lot as well. 2010 I think will be less volatile, but it will set the tone for the next few years. I'll keep on making recommendations in 2010. Here's to all of us having some success :-)


What are your thoughts?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.