Patience and Due Diligence

Just How Smart Is Wall Street?

 Posted: August 12, 2011 1:48PM by Stephen D. Simpson, CFA

Individual investors see a steady stream of paeans to Wall Street, praising not only the substantial resources of professional investors, but also suggesting (sometimes subtly, sometimes not) that these professionals are smarter and more capable than the average investor. While there are certainly plenty of columns out there decrying the mistakes of professional investors and pointing out that disciplined individuals can do just as well, the fact remains that the financial media overwhelmingly tilts towards the idea that Wall Street is smarter than you or me.

TUTORIAL: World's Greatest Investors

But is it really? The word "smart" has plenty of definitions, but Wall Street has such a peculiar inability to learn from certain mistakes that it seems worthwhile to question just how smart the Street really is.

They Can't Stay Away From the BubblesNothing of any real size can happen in the investment world without the involvement of institutional investors. So while retail investors are often dismissed as the "dumb" money, it is the professionals who ultimately add the most air to investment bubbles.

It was professionals, not individual investors, who awarded absurd IPO valuations to stocks like TheGlobe.Com, Geocities or eToys.com. Professional investors were also apparently happy to pay upwards of 30 times sales for Cisco (Nasdaq:CSCO), Qualcomm (Nasdaq:QCOM) and JDS Uniphase (Nasdaq:JDSU) back in the bubble days.

Only a few years later, institutions happily dove into the housing bubble. Institutions apparently were not bothered by data that clearly showed affordability was declining at a precipitous rate and that lending standards were abysmally low. In fact, institutions got so casual about the bubble that they happily relied upon models that told them housing prices could never fall - even though there were plenty of examples from outside the U.S. that showed what could happen.

These are only two examples of how the institutional community is all too happy to believe "it's different this time" and "prices couldn't possibly fall from here." The fact is, that the Street is happy to play a game of musical chairs because the players almost always believe they'll find a seat before the music stops … even if years of history suggests otherwise. (Home price appreciation is not assured. For more, see Why Housing Market Bubbles Pop.)

A Few Gaps in Their Due DiligenceAlthough plenty of institutional investors now claim to have spotted the shenanigans at Enron and Worldcom and shorted the stocks, those stocks would have deflated much sooner if all of these people were telling the truth. The fact is, plenty of institutions lost huge amounts of money in names like Enron, Worldcom, CUC/Cendant, Waste Management and so on, when their accounting scandals finally became unsupportable. In fact, when Enron blew up, well-regarded names like Alliance Capital Management, Janus, Putnam, Barclays and Fidelity owned about 20% of the stock in total, and most major firms held some number of shares.

Even in the wake of scandal after scandal, institutions have apparently not filled all the gaps in their due diligence. During the housing bubble and crash, institutions were largely blind to the balance sheet time bombs of financial companies like Washington Mutual and AIG (NYSE:AIG), to say nothing of their off-balance sheet liabilities. Even in the last few months, John Paulson reportedly lost millions of dollars on his position in Sino-Forest when evidence finally arose that the company may have grossly overstated its asset base. Likewise, plenty of other smart money investors have gotten caught up in other Chinese debacles. (For more, see Hedge Fund Due Diligence.)

Overconfidence, Especially in Their Own ModelsHowever smart Wall Street professionals are, it doesn't shield them from overconfidence in their abilities and their models. Time and time again some sharp-eyed professionals will spot a profitable anomaly in the markets - junk bonds or Latin American sovereign bonds that price in too much risk of default, undervalued mortgage bonds, unexploited absolute return strategies and so on. In the early days, there are in fact plenty of great opportunities, but eventually word gets out, other investors try to replicate the strategy and investment bankers rush to fill the supply of look-alike products.

The list of well-known implosions goes on and on - from the heyday of junk bond-fueled LBOs to the numerous emerging market sovereign debt debacles to the "see no evil" models of the U.S. housing market. In almost every case, though, the fundamentals change, the experts fail to notice, more leverage gets poured into the process and it all blows up in everyone's collective face.

The case of Long Term Capital Management (LTCM), though a 13-year-old story now, is still a great example. Mixing very experienced and successful Wall Street professionals with a small army of PhDs, LTCM used very high amounts of leverage to exploit small inefficiencies in the market. Unfortunately, early success brought more capital into the firm than it could manage, more leverage was employed to squeeze bigger returns out of smaller anomalies, and then suddenly some of the key relationships underpinning its models fell apart. The end result was a spectacular failure - one so large that the federal government stepped in to help the unwinding process from destabilizing the financial markets.

TUTORIAL: Credit Crisis: Historical Crises

The Bottom LineThese are just a few brief examples of the "factory seconds" that Wall Street churns out with surprising regularity. What of the fact that Wall Street routinely puts its faith in the projections and promises of management teams with no record of competence or success? Or what of the fact that Wall Street professionals routinely trust their investors capital with people and instruments that have previously failed?

The fact is, Wall Street is made up of people and people (even well-trained and well-compensated examples) make mistakes. Whether its greed, overconfidence or a sincere belief that it is somehow different this time, Wall Street cannot resist taking a chance on money-making opportunities. The point here is not to bury Wall Street or excoriate its professionals for their mistakes. Rather, the point is that everybody makes mistakes and investors should never be intimated out of their own good judgment and common sense just because the "smart money" thinks differently. (For more on smart money, see On-Balance Volume: The Way To Smart Money.) 

Read more: http://financialedge.investopedia.com/financial-edge/0811/Just-How-Smart-Is-Wall-Street.aspx#ixzz1VKT47J00

How much money punters lost betting on the possibility that the KNM takeover would have gone through at 90 sen a share

Wednesday April 21, 2010

The dangers of offers conditional on due diligence


THE anti-climax that hit investors in KNM Group Bhd after the attempted takeover fell through raises some issues.

For minority shareholders, the KNM case highlights the downside of the takeover route involving buying the assets of listed companies.

Under this route, buyers are allowed to conduct due diligence on the assets they are buying.

In comparison, when a buyer is making a general offer for the shares of a target company, it only has access to publicly available information on the company it is buying.

In such a case, there is more clarity on whether the deal will go through. It all depends on the acceptance level of the target company’s shareholders. There can hardly be a situation where a price is revised downwards.

But in a takeover of assets situation, the buyer can withdraw the offer or lower his price after the due diligence.

On the flip side, deal-makers say the opportunity to conduct due diligence on the assets is one of the main advantages of the assets and liability route of takeovers.

Some buyers tend to opt for this route in cases where the target company has very large operations, such as banks, or has assets in diverse geographical locations, like KNM.

That the threshold of shareholder approval for this type of takeovers may be raised to 75% from a simple majority, does not mean that this takeover route will disappear.

While it may be harder for buyers to take over companies (if the rule change is implemented), this route still remains attractive to buyers because it gives the opportunity for due diligence.

Investors should be aware that there is a chance buyers taking over companies using this method could change their minds after their due diligence, or reduce their prices.

That could be advice too late for those who took the bet that the KNM deal would have been done at the indicative price of 90 sen a share.

But it may be sound advice for investors buying into EON Capital Bhd (EON Cap).

While the RM7.30 per share offer by Hong Leong Bank Bhd (HLB) may look attractive, coupled with the possibility that another bidder could be interested, investors should look at the fundamentals of EON Cap.

That would give them a good indication of how the buyer would assess EON Cap and thereby, the price they would be willing to pay for it, post due diligence.

Some points to ponder can be found in recent analyst reports on EON Cap. For example, EON Cap’s Islamic banking pre-tax profits seem to be on a downtrend, raking in only RM4.9mil in its fourth quarter ended Dec 31, 2009, compared with more than RM30mil the year before.

DBS Vickers Securities had said in an earlier report that EON Cap has some exposure to collateralised debt obligations in the Middle East that could potentially see further provisions. HLB’s due diligence will surely examine this issue thoroughly.

In addition, it expects EON Cap to incur higher credit costs as it may need to bump up its loan loss provisioning, which stood at 84.9% as at September 2009, to the industry norm of closer to 100%.

Another issue that the buyers of EON Cap should pay attention to is the weighty exposure EON Bank has to small and medium enterprise and hire purchase loans, which are deemed riskier than other loan segments.

HLB could also discover that it has to pour in more money into EON Cap in the merger exercise to ensure, for example, that both banking groups enjoy the same credit ratings and best practices and information technology systems at their branches.

This in turn could have an impact on the price the buyer is willing to pay for the asset.

Learning from the experience of KNM, investors should dissect analysts’ target prices of EON Cap to see if these prices are inflated by the potential takeover.

Knowing the fair value of EON Cap, excluding the offer on the table, should help investors know the downside risk to buying into EON Cap today.

Deputy news editor Risen Jayaseelan wonders how much money punters lost betting on the possibility that the KNM takeover would have gone through at 90 sen a share.

http://biz.thestar.com.my/news/story.asp?file=/2010/4/21/business/6097857&sec=business


Read also:

KNM Group: Hold, target price 90 sen

Do not underestimate the value of due diligence

If and when you decide to pursue investing or whatever your fancy, do not underestimate the value of due diligence.

Look through each and every financial statement you can get your hands on, including the detailed notes.

If you just read the annual reports of companies, you will have done more than 98% of investors.

If you read the notes of the financial statements, you will be ahead of 99.5%.

Verify those financial statements, as well as future projections announced by the top executives, by doing your own legwork.

Talk to customers, suppliers, competitors, and anyone else who might affect the company.

Do not invest unless you can say with absolute certainty that you are more knowledgeable about his particular firm than 98% of the analysts!

External growth - Acquisition

What is an acquisition?

Meaning "to gain possession of," the acquisition of all parts of another business is an alternative method to develop or expand your own business.

1.  An acquisition is the most apposite option where you need specialist skills and knowledge or facilities for your own future development.

2.  This is a way of filling "holes" in a company's current or future straegy; it can be very successful as long as there is a good understanding of what the knowledge gaps are and how they cna be filled effectively.

3.  As is the case with mergers, the relevant questions should be asked and answered, and the correct business fit must be achieved.

Most acquisition involve businesses of unequal size with, usually, the larger or more powerful company purchasing or acquiring the smaller.  In recent times, this has not always been the case, and examples can be found of relatively small companies buying out much larger ones, either to obtain resources or to gain additional assets to supplement those currently owned.

Such deals are usually financed quite heavily with loasn and other deals and are often followed by a very vigorous pruning of parts of the acquisition to repay the financing involved.  This is known as asset stripping and is rarely intended to achieve growth of an established business, but rather functions as a financial dealing that will generate cash for further enlargement.

HOSTILE ACQUISITIONS OR TAKEOVERS

Many acquisitions are known as "hostile takeovers" where the management of the company being purchased actively resists the unwanted overtures of the predator company.

When talking about mergers, such phrases as: "teamwork," "sharing," and "mutual benefit" are appropriate; some expressions used when considering hostile takeovers might be:

• "We have bought you."
• "Do as you are told."
• "Our way is best."

One of the keys to success is not to keep the newly purchased company at "arm's length" but to actively create value from the new relationship.   The underlying idea of growth through acquisition is to utilize the resources you targeted at the investigation stage as quickly as possible to enable your own business to grow and flourish. 

Before any acquisition (or merger) it is essential to establish that what you think you are acquiring is real and worthwhile and to use a process such as due diligence.  This includes complete studies of the business you seek to acquire, which should be carried out by specialist, univolved, third parties, who look at every part of the business and report on its viability to meet the requirements you have set before you take irrevocable action.

Using the due diligence procedure to arrive at incisive answers to the many questions needed, to making the decision to acquire, represents the exemplary use of due diligence.

VALUING THE ACQUISITION

There are several valuation methods that can be used, and it is always best to seek professional expert advice before making the final decision.  You will need to consider many relevant factors to obtain an overview of how healthy the business might be, these include:

• The history of the business
• The current performance
• The financial situation
• The condition of the premises
• Intangible assets
• Employees

Once you have considered all of these factors, you can then decide

• how much you think the business is worth, and
• how much you are prepared to offer, if you decide to proceed.

THE FINANCIAL STRUCTURE OF AN ACQUISITION IS:

Company "C" shares ----> ----> ----> Company "A" shares ---->> Larger company "A" shares

Those that went with Madoff chose faith over evidence

Who isn't a Madoff victim? The list is telling.
Although many smart people seem to have been taken in, one expert argues that anyone who really did their homework would have seen the warning signs.
By Nicholas Varchaver
Last Updated: December 17, 2008: 10:14 AM ET

Untangling Madoff's web
More Videos
Financial frauds ruin lives

NEW YORK (Fortune) -- As the number of victims of Bernard Madoff, the criminally charged founder of the investment firm that bears his name, seems to multiply with the speed and force of a hurricane, certain types of investors seem to be absent -- so far, anyway -- from the casualty list.
That's no accident, argues James Hedges IV of LJH Global Investments, a boutique firm that invests in hedge funds and private equity for high-net-worth families. In other words, score one for the big institutions that stick to standard rules rather than allowing their managers to invest on personal connections or hunches.
"There's no Duke Endowment [among the list of Madoff investors]," Hedges says. "There's no Harvard management, there's no Yale, there's no Penn, there's no Weyerhauser, no State of Texas or Virginia Retirement system."
The reason is simple, in Hedges' view. Letting Madoff manage your money "wouldn't pass an institutional-quality due diligence process," he says. "Because when you get to page two of your 30-page due diligence questionnaire, you've already tripped eight alarms and said 'I'm out of here.' "
In short, in Hedges' opinion, any sophisticated entity that actually did its homework would have seen the warning signs.
Hedges got the chance to see those signs up close: In 1997, when he was advising the Bessemer Trust, the giant wealth manager, he visited Bernard Madoff to discuss investing with Madoff's firm.
"I found him stylistically like a lot of traders: fast-talking, distractable, not remarkable," Hedges says of Madoff. But during their two-hour meeting, Hedges says, "there was one red flag after another."
For starters, he couldn't grasp Madoff's investing strategy. "I kept saying, 'you've got to explain it to me like I'm in first grade,' " he says. To no avail.
Then there was the fact that Madoff was charging no fees other than trading commissions: "The notion that something is fee-less -- which is what they largely proferred -- is too good to be true."
The fact that Madoff's operation was audited by a microscopic accounting firm also worried him. "He was also so secretive about his asset base -- that was another red flag."
In the end, Hedges was uncomfortable and Bessemer decided not to let Madoff manage any of its money.
In Hedges' view, those that went with Madoff chose faith over evidence. "You've got people who

• were disintermediated [i.e., didn't have a professional representative], or
• unsophisticated, or
• went in through a personal relationship.

That's what a con man is -- a confidence man is somebody that engenders a relationship and then subsequently lures somebody into doing something that they shouldn't do." (According to the federal criminal complaint against him, Madoff has confessed that he ran a "giant Ponzi scheme." His lawyer, Ira Sorkin, declined to comment.)
Certainly many of the institutions that turned to Madoff will challenge Hedges' views, as many will face litigation from their own clients. So far, two of the large fund-of-funds with the largest sums under Madoff's control, Tremont and Fairfield Greenwich, have already asserted that they conducted extensive due diligence before investing. Many others will take the same position.
Should Hedges' opinion be borne out and corporate and state pension funds remain absent from the roster of Madoff victims -- of course, there will be many more names added to the list -- it will only heighten the Madoff tragedy. Because, in the end, it would show that this was one investing disaster that could easily have been avoided.
First Published: December 16, 2008: 5:51 PM ET