The Float

M&A, Private Equity, and Shrinking Equity Supply

Back in April, we noted the bullish trend of share buybacks, acquisitions, and private equity reducing the supply of stock trading in the market. This hits close to home here at The Float because the float itself is getting smaller...and, all else equal, this reduction in supply will tend to push stock prices higher.

At Reuters (itself the object of a likely-to-close $17.5 billion acquisition by Thomson Financial), Kristina Cooke notes that recently announced deals would reduce the S&P 500's market cap by roughly 2 percent--and unleash a "wave of cash to be reinvested as the total supply of equities shrinks."

Then this morning: News that Microsoft will acquire Seattle's aQuantive for roughly $6 billion (an 85 percent premium over yesterday's closing price in AQNT), which comes on the heels of Google's recent purchase of DoubleClick for $3.1 billion and other M&A activity in the online advertising space.

Short term, these supply-demand trends are clearly bullish, but as Tim Woolston of Boston Advisors LLC says in the Reuters piece, "Wall Street, like nature, abhors a vacuum. If there is a perception that too much stock is being removed from the market, I think the IPO market will ramp up."

When will the torrid pace of M&A, buybacks, and private equity buyouts begin to slow? What will trigger the slowdown? With credit readily and cheaply available and corporate balance sheets flush with cash, we don't pretend to know. But at some point, somewhere, something's going to go haywire.

All (or at least most) of this activity may be rational in the micro sense that each deal is sensible enough in and of itself (repurchased shares seem cheap, private equity funds are loaded, interest rates remain low, liquidity is abundant, and most buyout targets are profitable, unlike the cash-hemorrhaging disasters snapped up by big technology firms in the late-1990s). Taking a broader macro view, however, the whole phenomenon feels a little frenzied. And frenzies are typically great fun for everyone...until they aren't.

One indicator of the torrid pace: The incredible number of posts at the WSJ's "Deal Journal" blog, where Dana Cimilluca wonders out loud this morning if Microsoft's aQuantive acquisition might be remembered as marking the top of the M&A frenzy.

UPDATE: We've added more on this topic Monday morning.

Sources

Kristina Cooke, "Mergers could take 2.0 pct bite out of S&P 500," Reuters, May 17, 2007

"Microsoft pays 85 pct premium to buy aQuantive," Reuters, May 18, 2007

Slay the Right Dragon

Last weekend's Wall Street Journal featured one of the most important stories you'll ever read. It's about the cost of living in retirement and its subtitle gives away the punchline: "Expenses in later life are proving to be bigger and more unpredictable than many retirees anticipated."

Take a look at the charts to the right. Most retirees find themselves spending as much as or more than they did during their working years. Why? As one of the Journal's interview subjects put it, "Inflation and vacations eat up the former mortgage and car payments."

This could hardly be more important. As more and more Boomers retire every year, the entire society will have to grapple with the disconnects between what people think they need in retirement, what they actually need, and what they have to get themselves through it. At stake: Living standards, intergenerational equity, government solvency, economic competitiveness, and general social stability.

As Nick Murray put it recently (sorry, no link available), there's a simple, powerful, daunting reality underlying all this: Every year, everything you buy costs more. Okay, maybe not everything. HD entertainment systems and computer processing power might get cheaper over time. But food, energy, health care, travel, entertainment...the things retirees want and need the most...they get more expensive every year.

What does inflation mean for retirees and those who would like to become retirees sooner rather than later? It means the single most important risk they face is purchasing power risk. That's pretty important, so let's repeat it, and let's put it in bold, bright red letters, with the three magic words in italics for double-down emphasis: The single most important financial risk in retirement is purchasing power risk.

The incredibly nasty bear market of 2000-2002 left millions of investors with an understandable fear of a different kind of risk: principal risk, or the risk of losing money in a general market decline. That's no trivial concern, of course, and investors' legitimate anxiety about principal risk is the single best reason to hold a diversified mix of major asset classes and rebalance that portfolio intelligently as market conditions change.

But on any meaningful time horizon, principal risk pales in comparison to purchasing power risk. In fact, across the 20 to 40 years most Americans will spend in retirement, principal risk becomes vanishingly small. Purchasing power risk, on the other hand, is pretty much a sure thing. It's not a possibility; it's a brutal, life-changing certainty.

This is a hard truth, and an important one: Inflation will destroy retirees' purchasing power...unless they're willing to assume the risk of short-term "losses" that characterize equity-focused portfolios (we put the term in quotation marks because declines in a portfolio's market value aren't losses until they're realized, just as increased portfolio values aren't gains until they're realized).

Let's put this another way. Scarred by memories of a bursting stock market bubble, millions of investors remain relatively risk-averse even today. Fears of principal loss are understandable, but, like many emotion-driven instincts, investors' fears betray them...because they fear the wrong thing. They hope to slay a dragon--the principal risk dragon--that essentially doesn't exist. In the process, they get slayed by the all-too-real purchasing power dragon.

The effect of inflation on purchasing power--in other words, on a retiree's standard of living--isn't as sudden or jarring as abrupt downturns in the equity markets. And that's exactly what makes inflation so pernicious. It's slow and it's not always obvious, but it's as certain as the sun rising in the East.

Let's be clear here. We do not think inflation-fearing investors should load up with equity-only portfolios. But we do think that millions of investors should take purchasing power risk seriously, which does imply more equity-focused portfolios than our (generally unwise) conventional wisdom seems to suggest.

Let's summarize the key factors in all this.

• Tens of millions of Americans will retire in the coming years, and most of them still feel the scar tissue from the bear market of 2000-2002
• The same is true of many millions who retired before the bubble burst
• Understandably, that experience has left investors fearful of principal loss
• Nevertheless, principal loss is relatively unlikely over any investor's retirement years, and extremely unlikely over the 20 to 40 years most Americans will spend in retirement
• Meanwhile, over such a multi-decade period, even low or moderate inflation can--and in too many cases will--destroy the purchasing power of portfolios designed to minimize principal risk
• Investors who want to maintain their standards of living in retirement must accept some risk of short-term portfolio volatility to do so
• Equity-focused portfolios should always be anchored by inexpensive, tax-efficient, diversified investment vehicles such as exchange-traded funds or index mutual funds
• For many Americans, the only practical alternative to equity-focused asset allocation will be to continue working for several additional years or, worse, to return to work out of necessity after a few years in retirement
• Getting all this right may require the right kind of professional help

That last point is immensely important, because it's far too easy for investors to fall into bad habits, to be ruled by their emotions (fear, greed, overconfidence, revulsion, uncertainty, &c.), and to suffer the consequences of undisciplined investing. Relative to the effects of emotional decision-making, a good advisor's annual fee will pay for itself several times over. That said, expenses do matter and should be minimized wherever possible in the context of a disciplined investment program.

We understand why investors fear principal risk more than purchasing power risk. It's more visceral (sort of like fearing flying more than driving, when the former is much safer than the latter) and seemingly easier to avoid (just don't fly!). But both kinds of risk are important and investors need to understand the difference--and the tradeoff--between them. (To beat the metaphor into submission: There may be an occasional pocket of turbulence along the way, but getting where you want to go in retirement will probably require some flying.)

Source

Kelly Greene, "Spending & Spending Some More," Wall Street Journal, May 12-13, 2007 (subscription required)

Lending Standards Tightening Up

A few weeks back, we argued (here and here) that tighter lending standards would drive further weakness in residential real estate. Persistently low interest rates have helped prop the sector up, but for every marginal buyer who can't meet lenders' new criteria, we'll see incrementally weaker demand. And this goes well beyond the now-familiar "subprime" market. From Ruth Simon's piece in yesterday's Wall Street Journal:

Tighter lending standards are adding pressure to an already soft housing market. Last week, the National Association of Realtors forecast the first annual decline in the median price of an existing home since the group began tracking home prices in the late 1960s, in part because mortgages are more difficult to get.

Here's another key passage from Simon:

The increased attention to appraisals and other underwriting policies follows a period when lenders made it increasingly easier for borrowers to get a mortgage. Often borrowers didn't have to document their incomes or assets, even if they had relatively low credit scores.

Looser standards weren't much of a problem when home prices were climbing. But as the housing market has cooled, more borrowers are winding up in trouble. The mortgage delinquency rate climbed to 2.87% in the first quarter from a recent low of 2.03% in late 2005, according to Equifax Inc. and Moody's Economy Inc.

Simon's work appeared on page D1. Back on page A2, Sudeep Reddy noted that only 15% of the 73 banks responding to a recent Federal Reserve survey reported imposing tighter standards on borrowers with strong credit scores. Roughly 56% of responding banks indicated they had tightened standards for subprime loans. Both numbers are enough to change the game on the margin, and we expect to see further tightening of credit as housing price weakness continues.

Reddy also reported that the Chief Economist of the Mortgage Bankers Association expects home-purchase and refinancing activity to fall in 2007 by 7% and 10%, respectively--and then stay "fairly flat for the next couple of years."

Bottom line: Low rates, rising prices, and lax lending standards created an upward spiral in housing for several years. Rates are still relatively low, but in many markets prices are flat or falling, inventories are exceptionally high, and lending standards are tightening up. Taken together, these macro factors point to continuing weakness in residential real estate.

UPDATE: New data indicate the slowest construction permit pace in nearly 10 years. Is that bad news for housing? In the short run, yes, because it implies fewer construction jobs and reduced economic activity in related industries. In the longer run, it's good news. Inventories are simply too high, and the only way to clear the market back to some sort of price-stability equilibrium is to build fewer homes for a while (and list fewer existing ones, of course). The adjustment will be an extended process, and on a micro level some economic dislocation is inevitable. But in a macro sense we think the process can be relatively orderly. This is how markets work. Excess gets wrung out one way or another. And we'd much rather see fewer permits than panic markdowns on existing properties.

Sources

Ruth Simon, "Lenders Get Tougher: Qualifying for a Mortgage Becomes Harder, Even for Applicants With Good Credit, as Banks Probe Deeper Into Personal Finances," Wall Street Journal, May 15, 2007 (subscription required)

Sudeep Reddy, "Credit Standards Rise for Subprime Loans," Wall Street Journal, May 15, 2007 (subscription required)

Joanne Morrison, "April housing starts up but permits down," Reuters, May 16, 2007

In Praise of Bubbles

For a provocative, counter-intuitive take on financial bubbles in American economic history, check out Pop! Why Bubbles are Great for the Economy, a new book from Slate's "Moneybox" columnist Daniel Gross.

Dan's basic claim is that for all the personal, financial, and emotional wreckage bubbles leave behind, they produce something more durable and economically useful. Here are the key paragraphs from a summary essay at Slate:

Looking back through the last 150 years, a familiar pattern emerges. A wonderful new technology or economic idea arrives. A few good years of solid growth help engender a sense that things are different and that new rules apply. Hype and rosy projections—from Irving Fisher's 1929 prediction of a "permanently high plateau" to Dow 36,000­—justify investing at stratospheric levels. The trend, previously confined to the business community, crosses over into popular culture. Everyone's buying stock, investing venture capital, refinancing a mortgage, installing compact fluorescent light bulbs. And then, pop! The bubble bursts, heroes become goats, and bankruptcies spread. As corruption and venality are exposed, self-loathing and recriminations rule the day. (See: subprime lending, spring 2007.) And that's when all the moralizing narratives about the tragedy of bubbles get written.

But this is only half the story! After all, the process of growth and innovation doesn't end when a bubble bursts. The Internet wasn't unplugged and shut down in 2002. In fact, once you gain a little historical distance from bubbles, it is clear that some bubbles—some, not all—leave behind something that is a little bit boring but extremely useful: infrastructure. The bubbles that have left behind commercial infrastructure have been incredibly important contributors to America's remarkable long-term economic performance.

For more, check out the short version at Slate or pick up a copy of the book here.

Cover Story Contrarians

A couple weeks ago, the Economist ran a piece on the dubious record of magazine cover stories (a point we've made ourselves, if a little indirectly). This is important stuff, not just because it's fun to giggle at someone else's bad timing, but because it touches several key issues in behavioral finance and market efficiency.

Here are the key findings of recent academic research on the cover story phenomenon:

Unsurprisingly, the companies that received the most positive coverage had performed well before the stories were published: their share prices had, on average, outperformed the index by 42.7 percent once adjusted for sector and size. Those companies suffering negative coverage, in contrast, had underperformed by 34.6 percent.

After the stories appeared, however, the positions switched. The most negatively portrayed companies managed to beat the market by an average of 12.4 percent, whereas the outperformance of the media darlings fell to just 4.2 percent. This difference is not statistically that significant. What matters is that if news is sufficiently good or bad to catapult a company onto a magazine cover, then it is already reflected in the share price. Or, as the academics put it, "positive stories generally indicate the end of superior performance and negative news generally indicates the end of poor performance."

Here's a little more on what it all means for investors and the capital markets:

This phenomenon is known as "recency bias," the tendency to be excessively affected by the pattern of recent data. Brokers may subconsciously favour "hot stocks" when making recommendations, since they believe clients will also favour such shares. Picking a poor performer might elicit the response: "Why are they recommending this rubbish?"

Indeed that bias, along with other psychological tics identified by academics, may be a reason why markets are ultimately inefficient. There is some evidence that share prices undershoot fair value in the short term (as investors are slow to react to individual pieces of good—or bad—news) but over-react in the medium term (extrapolating present trends, like Buzz Lightyear, to infinity and beyond).

This is important stuff. Here at Interlake, we think markets are pretty darn efficient in the long run--and often inefficient in the short run. As entertaining as they are, magazine covers are more a consequence of short-term inefficiency than a cause. Reporters, editors, and headline writers get a little carried away for the same reasons everyone else does.

Given this view--that markets are generally efficient in the long term and (varyingly) inefficient in the short term--Interlake takes a dual-discipline approach to money management: a combination of index-based asset allocation and absolute-return-seeking active management. We think it's an elegant combination, both ignoring and exploiting magazine covers and other forms of market dysfunction.

Source

"Covered in shame: Investors, like magazines, have a terrible tendency to extrapolate," The Economist, May 3, 2007