SEC: Don’t Mess with Market Mechanics

With the SEC banning naked short-selling of brokerages, Fannie Mae and Freddie Mac, financials have just been given the green-light to continue blaming someone else for their predicament. Banning naked short-selling may seem tempting as it would create short-term stability in the markets and keep Fannie Mae and Freddie Mac from requiring bail-outs. However short-sellers didn’t create the underlying problems in these companies and likewise, banning short-selling won’t make these problems disappear.

Its the first step down a treacherous road as the SEC will soon “draft rules to the same issues across the entire market”. As abhorrent as hoping a company fails may be, the primary reason for the existence of financial markets is to optimize the allocation of capital and short-selling is a crucial part of that. Without short-selling, you’re just encouraging the creation of asset bubbles and making it a lot more difficult a correction to occur. Imaginary creation of wealth can never last and the lack of short-selling will just make the subsequent crash a lot worst.

Short-selling is banned in China, one of the underlying reasons behind the >400% run-up in stock prices, and now the staggering >50% stock market crash. In the long run, banning short selling will only mask the many problems faced by the financial industry. And with the SEC’s track record of dealing with problems, maybe that’s all they want to achieve.

EDIT 16-07-08: Whether it be correlation or just causation, financials have had a huge bounce today, the day after the SEC banned naked short-selling of brokerages.

16-07-08-financials

Life in Equity Research

I’ve been working as an Associate in Equity Research for almost three months and I’m loving every minute of it. The hours are great for a job in high-finance, 12 hours a day, Monday to Friday and the very occasional Saturday. And surprisingly, its never really been that bad. It really does help that not only do I enjoy what I’m doing, but I’ve also been given a huge amount of responsibility so I know what I’m doing is really worthwhile.

Three simple but important things I should keep in mind for any future jobs:

1. Whenever you ask any questions, prepare for it as if you’re going for an interview. That means exploring all avenues and making sure you know the topic inside out. You don’t want to come out sounding like an idiot.

2. Work late hours but more importantly, especially for myself, wake up early. I don’t mind working late, but I do have trouble waking up in the morning so I’ve got to try sleeping earlier and starting work earlier. It’ll be less applicable for investment banking but its always good to get as much sleep as possible. You’ll never know when you need it.

3. Double-check work. It doesn’t matter how confident you are that everything is correct. There is ALWAYS SOMETHING WRONG. It always pays to double-check work. Especially since you do a lot of work when you’re half-asleep. You don’t want spelling, formatting or formula errors in anything you do because you want a record of doing quality work.

And lastly, something that I’ll try to keep in my job next summer. Keep a log book of everything you have learned, and mistakes you have made. Nobody can remember everything (perfect example here) and you don’t want to be making the same mistakes all over again.

So sadly, theres just one more month of this and I’ll be back in school, and there will be regular updates again…

Lehman Brothers going Bankrupt?

The firm told investors that it had not borrowed money from the US Federal Reserve on Tuesday and had liquidity of “well above” $40bn

With the rumors surrounding Lehman Brothers about how they need another 4 billion of capital, you would think coming out to state they have more than 4 times that amount of liquidity would stave a sell-off.

I’m guessing the Bear Stearns debacle is too fresh in everybody’s minds. The last time a CEO came to deny liquidity problems, it promptly went bankrupt in three days.

If you’re an employee you might be thinking of buying puts to hedge the risk of losing your job and your life savings. Perhaps thats why trading of put-options rised to 280,000 contracts, quardruple the 20-day moving average!

Hiatus

Well that back to writing bit didn’t last long. I’ll be working in equity research at a boutique investment bank over the summer so I’ll be on hiatus or at least updating very irregularly until school starts again in September. Can’t exactly publish research for my firm and on my website at the same time…

Market Summary March 31 - April 4th

Market Summary March 31st - April 4th

With markets the way they have been this week, its no longer a surprise to see them move 3 - 4% in a week. What is a surprise is to see the markets close in the positive. Foreshadowing for the rest of Q2? Or will it all end in tears… Things certainly haven’t followed the script this week.

Ben Bernanke finally admitted that a U.S. recession is probable along with the IMF decreasing projected global growth. Treasury secretary Hank Paulson also made a proposal for a new financial regulatory plan in their attempt to prevent the investment banks from ever single-handedly crippling the American economy again. Economic data was rather mixed. The unemployment rate may have been bumped up to 5.1% with nonfarm payrolls plunging by 80,000 but ISM non-manufacturing and manufacturing have both increased.

But what really triggered the market rise this week were the financials. It seems major investors believe the best is over. Lehman and UBS announced plans to raise $4 billion and $15 billion respectively through stock offerings and Citigroup sold $4.5 billion in debt. China’s sovereign wealth fund has also started a $4 billion private-equity fund focused on financials. Hopefully it’ll work out better than last year when they invested in Blackstone and Morgan Stanley.

Market Outlook April 7th - April 11th

We’ll get a glimpse into the reasons behind the Fed’s decisions with FOMC minutes coming out on April 8th. Pending home sales will also indicate how Main Street is faring with the housing market continuing to plummet. GE will report earnings next week and it’ll be interesting to see how the AAA-rated company’s diversification has fared in current economic conditions.

Is Your 401(k) Plan Diversified Enough?

Its no far stretch to say the biggest loser in the Bear Stearns bankruptcy were its employees. 1/3 of the company stock was/is held by Bear Stearns employees who’ve had a substantial amount of their life savings wiped out as well as finding themselves out of job. Clearly, holding company stock results in a rather substantial exposure to idiosyncratic risk, the risk of their stock holdings being reduced to nothing, and the risk that they’ll be out of a job by tomorrow. Since you can’t exactly diversify your job, it’ll make sense to reduce the risk in one’s portfolio.

Unfortunately, that usually doesn’t happen. Participants in 401(k) plans offering employer stock invest on average about 33 percent in company stock. An introductory course in finance will tell you that increasing unsystemic risk, so why do most people expose themselves such risk? Moreso the extremely smart bankers in Bear Stearns? (Although top management has obvious problems with risk management.)

Warren Buffet doesn’t believe in diversification. He’s quoted as saying “Wide diversification is only required when investors do not understand what they are doing.” Working day to day in a company probably provides not only the reassurance that the company won’t go bankrupt tomorrow, but that the company actually has decent prospects and holding the stock might be a rather good idea. To hell with diversification, I know the company, I know what I’m doing and I’ll make a lot more money holding on to the stock.

Unfortunately, bad decisions are made by top management. And no matter how well employees might know and be able to influence the company, their effect is severely limited. They might be working for the company but if half of your life savings are dependent on your top executives not screwing up, you’re still going to be exposed to an inordinate amount of unsystemic risk.

So like Enron before, Bear Stearns is a sad reminder that unless you’re smart enough to be the richest man in the world, it might be a very good idea to just diversify…

Contrarian Indicator: CEOs?

In the current recessionary environment, if a CEO comes out to say that all is well, is that an indicator to short the stock?

On the 31st of January, after a worse than expected quarterly loss, MBIA CEO Gary Dunton came out to say that “We believe that these steps, along with reduced capital requirements resulting from slower business growth, will result in our capital position surpassing rating agency Triple-A requirements … and will allow us to continue serving the needs of our clients and investors”

February 28th, John Stomber, CEO of Carlyle Capital, reported that during the fourth quarter the company’s portfolio stabilized and generated returns consistent with our near term targets, continuing to run the business to preserve the value of our shareholders’ equity and to position the Company to meet our long run objectives of earning an attractive risk adjusted return and paying a consistent dividend in the future.

On March 12th Bear Stearn’s CEO Alan Schwartz came out to say that Bear Stearns would have a profitable 1st Quarter and that the company had a $17 billion cushion against losses.

By March 12th, Carlyle Capital is bankrupt. March 17th, Bear Stearns has been sold to JPMorgan for $240 million. MBIA while still grasping to its AAA foresees further write downs and withdraws from Fitch ratings.

MBIA

Carlyle Capital Corporation

Bear Stearns

Such a situation not only brings up a whole lot of questions surrounding the legality of issuing such statements but the very credibility of company guidance. Is this fraud? Or for conspiracy theorists, is the misinformation deliberate, to allow insiders to get out of positions beforehand?

Either way, in current conditions, it might just be a good idea to start shorting a stock whenever a CEO comes out with “good news”.

The Risk-Reward Ratio in Brokerage Jobs?

I was talking to a Managing Director in Equity Research about the differences between investment banking and equity research and realized that there’s a lot more risk in equity research than investment banking.

I’ve always assumed that there was a proportionate risk to reward ratio for most brokerage jobs. Sales and trading with a large inherent risk (losing your job if you don’t do well) would have the largest possible rewards (large juicy bonuses). On the other hand you have investment banking which is considerably more risk averse (you can’t single handedly lose $7.2 billion), thus having a smaller compensation range.

But this seems to stop holding true for equity research. You’re putting your neck on the line when releasing analyst reports. These reports should be right more often than not. If not, it won’t take long to be out of a job… Thats definitely a lot more pressure than filling in commas and double-checking models in investment banking.

Yet investment bankers get paid a lot more. Why? There’s probably some reward that is more intangible than cold hard cash so I added working hours to the mix.

Even though they’re both brokerage jobs, its probably unfair to be comparing research with investment banking since the jobs aren’t that similar. One could just like doing stock analysis rather than endless DCF models. And of course theres a lot more involved than hours and compensation. But from a purely financial point of view, it certainly makes the risk reward graph look a lot more logical.

EDIT: Goldman Sachs’ chief investment strategist (Equity Research), Abby Cohen has just been demoted for painfully wrong predictions… It just goes to prove that equity research seems to have a disproportional risk to its reward…

A New Chinese Stock Exchange?

The long list of stock exchanges in the U.S. is slowly being whittled down to a few. With the NASDAQ and NYSE slowly acquiring smaller stock exchanges, the trend seems to be heading towards larger and fewer stock exchanges.

So whats happening in China? Bucking the trend, Shenzhen is starting a new stock exchange for small and medium sized start-ups. The timing seems even stranger when one considers the 21.2% YTD drop the Shanghai Composite Index has undergone and the possible decline in growth the whole world might be heading into.

So what does exactly does this bring to China? As a stock exchange focused on start-ups, it would be encouraging entrepreneurship and creativity, making it a lot easier to get funding. The strange timing might even be a blessing in disguise. The huge potential of start-ups come with a very large downside, much more than the blue-caps at the Shanghai Stock Exchange. Fears of a slowdown in Chinese growth may prevent over-exuberant valuations and help protect investors.

At this point of time, manufacturing still accounts for approximately 50% of China’s GDP. In order to make a step up, China needs to move towards a knowledge-based economy, coming up with the ideas rather than manufacturing the ideas of others. Increasing access and improving the ease of obtaining funds will only expedite this process, advancing China’s growth potential.

Is 2008 the year Webzen finally fulfills its potential?

Webzen is a Korean video game developer and publisher specializing in Massively Multi-player Online Games (MMOG). Its games are played in China, Korea, Taiwan, Japan, the Philippines, the U.S. and Vietnam.

Unfortunately, Webzen hasn’t lived up to its hype. From its high of $12.68 in 2004, Webzen has dropped to its current price of $3.39. Its only real success to date has been MU, a MMOG released in 2003. The company’s newest MMOG, Soul Ultimate Nation, has been underwhelming with game revenues already decreasing… Company revenues have actually decreased both domestically and overseas and net income was negative in both 2006 and 2007.

With net income for fiscal year 2008 projected to be US$4.26 million, the company has a Forward Price-Earnings (F P/E) ratio of 32.4. A seemingly expensive valuation when comparing it to other Asian video game developers such as Shanda Interactive Entertainment (P/E ratio of 12.39), Giant Interactive Group (P/E ratio of 14.12). So what exactly has Webzen going for it?

As you can probably already guess, 2008 is crucial for Webzen with the company releasing both Huxley and All Points Bulletin (APB). Huxley is an internally developed MMOG that has won numerous accolades from IGN and E3. APB on the other hand is developed by David Jones, creator of the Grand Theft Auto series. APB is plays like an online version of Grand Theft Auto and with over sixty-five million copies of Grand Theft Auto sold, APB seems almost certain to succeed.

Webzen also has a strategic partnership with The9, an online game operator of MMOGs such as World of Warcraft in China, perfectly placing Webzen to continue expansion in the Chinese online gaming market. It is estimated that revenue from the Chinese online gaming industry will grow by 30% annually to US$3.5 billion in 2011.

By no means is investing in Webzen without risk. An expensive valuation coupled with a company that has failed to consistently generate profit after eight years of operations means that there is significant potential downside for the stock. However, I am confident that 2008 will be a turning point for the company. Video game publishers only need one brilliant game to turn the company’s fortunes around. Webzen might just have two.

Disclaimer: Author does not hold Webzen at time of publication