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Last week I walked through the volatility environment and our view that, despite signals that VIX might be starting to decline somewhat, it would still remain at nosebleed levels on a historical basis through the coming months.

This week vol. levels again ripped with Thursday’s spike pushing the VIX to close above 80 to a level of 80.86, actually higher than the close on October 28th. Thursday also marked the first time that the VIX has closed higher than the realized 30 day volatility for the cash S&P 500 since Oct. 27th. VIX futures maturing in December and January continued to trail spot levels, hovering near the 50 day moving average. The key takeaways from this market action were changing liquidity patterns and put/call divergence.

Although the aggregate, Index and Equity Put/Call ratios rose sharply in late week sessions, the Index PCR has continued to make lower highs since early October as buyers continue to pay inflated prices for insurance.

Along with a general decline in volume from last month’s historic levels, many market observers noted that a lot of players seemed to be sitting on the sidelines.

Hedge fund redemptions are a large factor in declining volume, but so too are rising yields in the corporate bond market. For the past 5 years, the credit default swap market has been a primary source of trading activity for out-of-the-money equity put options as dealers sought to hedge tails risk on the default insurance they were selling (and arbitrageurs sought to capture spreads between the two markets). With the new reality starting to hammer the bond markets and volume drying up in CDS for names that are in clear danger of default such as auto makers and financials, there is a an asymmetrical impact on liquidity as those players leave the market.

In the thinner market for options on futures the spike had a more pronounced impact as the class of funds known as “premium sellers” found it impossible to get out of the way of runaway trains without causing price spikes late this week. The premium sellers as a class will likely be extinct after this month –one well capitalized manager who is a personal friend of mine (although we are odds intellectually on risk and investment) already registered a draw-down of over 59% in Oct. and will likely be busted out if he remained short volatility into Thursday. Their departure from the scene as cheap sellers of insurance on the S&P and other major indices to market makers will have a direct impact on liquidity in the equity options market.

Taken all together, this creates tremendous opportunities for investors that normally shy away from the options market to capture outsized returns, provided they have the correct investment duration, fundamental conviction and do their homework.

The leveraged matador speculators and arbs are gone, the only providers of liquidity in this market will be people that actually understand the fundamentals of the underlying companies and can properly assess the risk. Those investors will be rewarded handsomely.

As always feel free to contact me with any question about strategies at

Andrew Barber

’09 Theme: License Stability

Some apparel licenses will prove massively unstable in ’09 as licensees pull back on investing in content. Some will miss minimums, and will lose business that some currently think is a lock.

Here’s an issue that people are not focusing on, but should be – the risk associated with stability in cash flows from licensing streams. The apparel industry is riddled with examples whereby content owners license out their brand to others that have more expertise in a specific product area or consumer segment. Standard royalty agreements are usually in the 6-10% range, net of costs allocated by corporate. In other words, what is a smallish revenue event translates to a meaningful EBIT event given 100% incremental margin. With zero capital at risk, such arrangements are almost always ROIC-enhancing.

I have a high degree of confidence that we are entering a phase of the cycle where these licensing relationships will be strained meaningfully. We’d all be irresponsible not to consider the strategic implications.

Think about it like this… Let’s say you are a mid-size company whose EBIT is derived evenly between your own content and content you license from other companies. For the past 7 years, the industry has had every bit of wind at its back (import quota changes, FX, input cost deflation, strong consumer) such that everyone made money – even the marginal players. Now we’re in a multi-year period where the opposite is a reality, and many mid-tier brands will go away. So now your top line is rolling, you’ve underinvested in your brands, flowed through too much FX and sourcing benefit to your bottom line instead of plowing back into your model. So now what? You’re probably cutting costs reactively and irresponsibly to keep your head above water. Do you cut costs out of your own content? Or from what you were allocating toward another company’s content that you licensed and ultimately will return to them? I’d challenge anyone to find me a company that would opt to damage its own content over another’s.

CEOs of companies that license a meaningful proportion of their EBIT (PVH, GES, ICON, to name a few) will argue that there are fixed amounts that partners need to contractually invest each year, which is controlled in part by the company owning the brand. Yes, there are usually fixed dollar amounts or percentages that are required for reinvestment, but that ALL leave plenty of room for unhealthy behavior on the part of the licensee. Remember when Jones Apparel Group said that its Lauren, Ralph, and Polo Jeans business was fine and was ‘locked up’ for years? ‘Nuff said. DCFs don't matter when a business segment you have in your model suddenly ceases to exist.

All it takes is some bad investments (or lack thereof) and a couple of quarters of missed minimums, and the content owners could usually take back the business at will.

The table below shows the percent of EBIT for some major brands derived from licensing. Part two of this analysis will be to drill down which companies have the biggest risk of having business taken away from them for reasons noted. There will be some big winners and big losers beginning in ’09 folks…

Interesting 4Q Comp Diversion

Interesting to see the varied trajectory of comp trends and guidance into 4Q for FL, DKS and HIBB. FL looking washed out, tho I’m starting to like HIBB a lot.

With Dick’s, Hibbett, and Foot Locker all reporting within 24 hours of one another, it was interesting to see the varied trajectory of com trends and guidance into 4Q. Let’s look through 4Q comp guidance on a 1-year basis for a minute. The implied 2-year trend for each company’s 4Q guidance shows that both DKS and HIBB are spot-on with their respective trajectories of -2%. My concern there is that both forecasts suggest a 100-200bp acceleration. FL, on the other hand, is looking for a 300bp deceleration. Yes, it will see a negative FX hit, but not enough to account for such a wide delta from its peers. One thing worth pointing out is that FL’s inventory position remains clean, as it is proactively managing inventories for the first time in at least 3 years from my vantage point.

If you asked me to put on my ‘gaming expectations’ hat, I’m probably going to look toward FL in the upcoming quarter – especially in the face of a 28% decline in the stock on Friday – a disproportionate move in the stock relative to the fundamentals.

Looking out over the next year, however, I’m starting to like HIBB – a lot. Stay tuned for more on that one…

Quote Of The Week: Captain Jack Sparrow

"Have you not. It's very kind of you. But it would seem that as I possess a ship and you don't you're the ones in need of rescuing and I'm not sure that I'm in the mood."
-Captain Jack Sparrow

This quote from Disney’s ‘Pirates Of The Caribbean’ provides a metaphor for “The New Reality.” At a few points in time this week, the S&P500 was down -52% from its 2007 peak, Somali Pirates were holding the Saudi's for ransom, the “Pandit Bandit” was pleading for Citigroup’s mercy, and Big Auto was begging for a government bailout.

“The New Reality” of global trade is quite simply that he with the cash (and the ship) will take what he wants, on his terms, and at his price. Argh!

Chart Of The Week: The Queen Mary

This is one of the most poignant charts in my notebooks. The 60 year chart of long term US Treasury Yields.

An important factor in our "New Reality" investment outlook for 2009 is the thesis that the Queen Mary (see chart) is set up to turn up into the right. Long term US interest rates are unsustainably low, and preventing real US savings in this country to find a bottom. Give liquid investors the ability to earn a real return on their capital, and they will start lending it again - liquidity will follow.

Being prepared for an environment where access to capital continues to be tight as long term cost of capital begins to heighten is critical. The free money days of slapping leverage onto levered long bets are ending, abruptly.

US Market Performance: Week Ended 11/21/08...

Index Performance:
Week Ended 11/21/08:
DJ (5.3%), SP500 (8.4%), Nasdaq (8.7%), Russell2000 (11.0%)

November 2008 To Date:
DJ (13.7%), SP500 (17.4%), Nasdaq (19.6%), Russell2000 (24.4%)

Q408 To Date:
DJ (25.8%), SP500 (31.4%), Nasdaq (33.8%), Russell2000 (40.2%)

2008 Year To Date:
DJ (39.3%), SP500 (45.5%), Nasdaq (47.8%), Russell2000 (46.9%)

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