Goldman Sachs upgraded the gaming technology sector (slots) this morning. While I don’t necessarily disagree with the pick that BYI is the most attractive in the sector, the overall call looks early and, quite frankly, wrong on many levels.

The following is a point-by-point retort:

• New states will expand gaming:

Yes, states are in a downturn and could be looking for new gaming sources. Ohio, New York, Kentucky, and Texas are cited as contenders. Even if any of these states pass gaming legislation next year (unlikely in our opinion), history shows us it will be another 2-3 years before a slot machine is sold.

• Slots are a high IRR purchase:

This is a static argument that sounds like it is coming from a slot salesperson. In a vacuum, a new slot does pay for itself in a couple of months. However, new slots just steal revenue from other slots in the casino. Casinos only buy them because they have to stay competitive with their neighbors. How do I know? Same store slot revenue hasn’t grown in a long time. Moreover, as we discussed in our post, “SLOTS LOSING OUT TO TABLES”, slot handle is on a 5 year decline relative to table drop.

• Tribal gaming, international, and Maryland will drive growth:

Tribal gamers won’t be buying slots any time soon (“TRIBAL GAMING IS SUFFERING TOO”, 11/28/08) and Maryland is probably 3 years away from buying slots. The international argument has been out there for awhile but Asians aren’t embracing slots “ASIAN SLOTS: SELLING HAGGIS TO VEGANS”. Where else is gaming expanding?

• Replacement sales should start to turn in 2010:

OK, I’ll give you this one, only because 2009 is going to be horrible. Estimates don’t seem to reflect this yet.

• Viewing slots as a derivative way to play an improving consumer without the balance sheet risk:

I don’t know what the macro guys are projecting at Goldman but we don’t see an improving consumer for quite some time. Gaming technology companies do have strong balance sheets.

• Low historic and relative valuation levels:

Mid-single digit free cash flow yields don’t make a value guy like me want to run out and buy the sector.

I will say that BYI and IGT do look cheap on P/E and EV/EBITDA metrics while WMS continues to look expensive. Consensus estimates need to come down for the whole space in my opinion. Maybe that will be the catalyst to look at the space for a 2010 turnaround.

Eye on Liquidity: Interbank Lending from Commercial Banks

The chart below dovetails with our view that credit markets are starting to loosen up, which on the margin is positive. On both on a week-over-week basis and year-over-year basis commercial banks are starting to lend to each other. In theory, commercial banks lending to one another should be the first step in credit trickling down to the broader economy and eventually to the consumer.

Interbank lending troughed at a decline of ~-30% y-o-y and in the most recent data lending is down ~-18% y-o-y. Yet on a week-over-week basis we are finally starting to see the first increase in lending between banks since the September time frame.

The caveat, of course, as the NY Times stated this weekend, is that “demand for interbank loans has been so low, the actual Fed rate has been close to zero for a month.” In essence, the Fed is inducing borrowing by lending money for close to nothing. Our view of inflation emerging in early 2009 is of course predicated on lending continuing to, as President Bush would say, become “unstuck”. We will have our “Eyes On” interbank lending as an important leading indicator of this non-trivial investment theme.

Daryl G. Jones
Managing Director

LIBOR and TED: You bet your Madoff credit is improving!

As we have been discussing our Morning Call (please call Jen White Kane or me at () if you have an interest in participating in the Morning Call), LIBOR doesn’t lie, people do.

We would have expected LIBOR to increase, particularly in light of the Madoff fraud ($50BN in assets gone!), but LIBOR continues to come in. As a measure of global counterparty risk, on balance, this is about as good as reference rates get (given Enron like fraud) and is a key unpinning of our bullish view on global equity markets in the immediate term.

In addition, the TED Spread continues to tighten as well and has narrowed to a level not seen since early September. This implies that the market is pricing in a much lower level of credit risk than in the past couple of months and that liquidity is improving sequentially.

Daryl G. Jones
Managing Director

Early Look

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Relied upon by big institutional and individual investors across the world, this granular morning newsletter distills the latest and most vital market developments and insures that you are always in the know.


The Depression came to be as a function of “the lack of honor of men in high places.”
-Franklin D. Roosevelt, at the DNC in 1932

In his famous Democratic National Convention speech that was ironically held in Chicago, Roosevelt also described these “men in high places” as “crooks”… and I guess that makes sense, because that’s what they were. I’d like to say that sometimes Wall Street’s narrative fallacy leads people to believe that everything that happens in this business is on the up and up… but, unfortunately, I have to say that most of the time it is not. It’s all about storytelling.

Our head of compliance, Moshe Silver, who joined Research Edge LLC after working with me at Carlyle’s hedge fund submitted the following observation: “We recognize that market manipulation is not an exact science. That being said, there are people out there who are recognized pros, and it would have made more sense to bring them in – the same line of reasoning that led FDR to appoint Joseph Kennedy to head the newly-created SEC.  We’d have been much more comfortable with Ace Greenberg or Jimmy Caine. Or, for that matter, Mike Milken or John Guttfreund, on the premise of Been There, Stole That…”

Moshe was expanding upon my ‘Weekend Edge’ “Quote of the Week” that ‘You Tubed’, Paulson’s “yes man”, Neel Kashkari, for saying “we’re not day traders, and we’re not looking for a return tomorrow.” Poor Paulson and his junior banker from Goldman (Kashkari) have t-minus a few weeks left until we get them off of team USA and back into the unemployment line where they belong. They’ve already lost almost $9B, or one-third of the value, of the “preferred investments” they’ve made in their favorite cronies banking schemes. Clearly, they weren’t proactively managing risk or “looking for a return” – we could have paid for this ridiculous big auto bailout with their trading losses.

These aren’t the only sell side bankers who have a hard time making money on the downside of the cycle. This week, we’ll have both Goldman Sachs and Morgan Stanley report their version of the numbers. “Ex” everything, be certain that there will be some serious storytelling on these conference calls. After putting an “outperform” on it somewhere close to $175/share in July, Goldman’s depleting research department is downgrading Apple this morning at $98/share. They apparently did some “channel checking” and set the table for their public parent’s finger pointing session on Tuesday – I’ll bet you a “Made-Off” buck that GS gets on that call and blames “the slowdown in the economy”… what’s a made up bet on a made up story with a made up buck anyway? Let’s roll the bones and lever up some bets!

Anyone can sit down in their year-end review and make things up. That’s what Wall Street does. Not all bankers are in on it – but Bruce Wasserstein knows a thing or two about banking, and he said that “accounting has now become an exercise in creative fiction… saying assets are worth a lot doesn’t make them worth a lot.” I think he was alluding to Steve Schwarzman’s argument for “marked to model” pricing of private equity investments, but heh, who’s keeping track of this stuff.

It wasn’t hard to keep track of how many shoes that Iraqi reporter gunned at ole Bushy’s head this weekend – both! If this wasn’t a metaphor for the bottom of the barrel of ‘You Tubing’ global confidence in the departing leadership of America, I don’t know what is. Between “Made-Off”, Bush, and Kashkari, I don’t think confidence in the American financial system can get worse. This is a very good thing.

Good thing? Yessir – very good. Stock market confidence isn’t built on nominal expectations – it’s built on what happens on the margin, relative to those expectations. Friday’s 500 basis point intraday rally from the thralls of the “made-up” Madoff lows was a significant one on this score. The ingenious bears who are figuring out things in the global economy are bad can choose to ignore it at their own risk. China just printed their slowest monthly Industrial Production growth number in a decade, and the Chinese stock market closed UP on the day. Markets don’t trade on yesterday’s news – they are leading indicators for tomorrow, and they don’t make stuff up!

In the USA, Friday’s University of Michigan consumer confidence report had me put up a note on the portal titled “Has American Confidence Bottomed” (see, under the North America tab). This report rhymed with the American confidence poll for the President elect moving to greater than 70%. You can call Obama “too young”, but he’s at least a good decade older than who Paulson, in his poor judgment, appointed to head up America’s “Financial Stability” program. Since Wall Street loves to compare performance on a relative basis, Obama and his team of Volcker and Summers are grey beards!

I am not into grey. I am more of a black and white guy, and as sure as I ran that NFL Sunday ball up the middle with our newly initiated long USA stock positioning on Friday morning is right back to where I am sitting here for you today.

I am here to stand on our investment process and be held accountable. There are many men and women “of honor” looking to lead in The New Reality, so let’s get the storytellers out the door and get on with it. I have an immediate term upside target for the SP500 of 916. And no, that number wasn’t just “Made-Up.”

Best of luck out there today,

Long ETFs

SPY-S&P 500 Depository Receipts – CME front month contracts traded as low as 876.4 this morning before 7AM.

DIA –DIAMONDS Trust Series –CBOT front month contract traded as high as 8,756 early this morning before pulling back.

XLV Health Care Select Sector SPDR – Bristol-Myers Squibb (XLV: 4.07%) and Sanofi- Aventis won an appeals court ruling vs. Apotex  to block generic competition to the blood-thinner Plavix in the U.S. until 2011.

OIL iPath ETN Crude Oil –Front month NYMEX light sweet contracts traded as high as 49 before 7AM this morning as the market reacted to comments regarding production cuts from OPEC Secretary-General El-Badri  before the meeting scheduled in Oran this Wednesday.

EWG – iShares Germany – The DAX is trading up this morning 1.72% to 4743.42, a gained for the first time in three days as European Union regulators approved the country’s revised bank-rescue plan and on expectations for a swift US bailout for carmakers. Arcandor AG, the German retailer that controls tour operator Thomas Cook Group Plc, posted an annual net loss of €745.7 million ($1 billion), or €3.35 a share, in the year through September.

EWH –iShares Hong Kong –The Hang Seng closed up 288.56, or 1.96%, to 15046.95.

 FXI –iShares China – China’s industrial production grew at the weakest pace in almost a decade as export growth totaled 5.4% in November Y/Y as compared to 8.2% in October. CSI300 closed this morning up just slightly to 1975.03, or 0.75%.

Short ETFs

FXY – CurrencyShares Japanese Yen Trust –The Yen fell slightly to 90.9230 against the USD.

IFN The India Fund—India’s rupee rebounded more than 5% from a record low touched on Dec. 2 on speculation the US will bail out its automakers. India’s 10-year bonds rose for a sixth day, pushing yields to the lowest level since September 2004, on speculation the central bank will cut borrowing costs as economic growth and inflation slow.


When it comes to inventories heading into holiday during a recession, less is definitely more. Here are the names with the biggest and least margin risk.

Yeah, business stinks – we all know that. But it’s times like these that separate the winners from the losers. Let’s take a quick look at the standouts over the past quarter in managing inventories relative to sales. You don’t need to be a retail genius to know that a lean sales/inventory spread (sales growth > inventory growth) sets up for a positive gross margin event in 4Q – well needed in this climate. Lululemon, UnderArmour, Liz Claiborne, Timberland and Ralph Lauren are my favorites in that context. On the flip side, watch out for expectations to be in synch for names like Abercrombie, Volcom, Skechers, J Crew, DSW and Brown Shoe.

Eye On Leadership: Jack Bogle

“The motivations of those who seek the rewards earned by engaging in commerce and finance struck the imagination of no less a man than Adam Smith as something grand and beautiful and noble, well worth the toil and anxiety."
- Jack Bogle, Founder of Vanguard Group

“Good people do not need laws to tell them to act responsibly, while bad people will find a way around the laws.”

Since we are located on the fringe of Yale’s campus in New Haven, CT, the Yale Daily News (“YDN”) tends to be one of the many daily newspapers our research team reads every week. It is the United States’ oldest college daily newspaper (although the Harvard Crimson disputes that claim) and has been the starting place for many successful journalistic careers, including Henry Luce, William F. Buckley, John Hersey, Pete Axthelm, and Dana Millbank, to name a few. From our perspective, it is worth reading because it offers a view into the current mindset of college students.

On December 4th, 2008, we picked up a copy of the YDN and a headline on the front page article read, “A Job on Wall Street: Are you Crazy?” The insinuation being that not only were jobs tougher to come by on Wall Street, but, and not surprisingly, the allure of such jobs had faded meaningfully. This was reinforced by a recent talk Keith gave to a group of students who were emphatic in their disdain for finance and the said “leaders” that run these major financial and investment banking firms. Smart, motivated graduating seniors want to be proud of their emerging careers and that pride begins with picking an industry that has integrity and respect.

The events last week relating to the fraud of Bernie Madoff’s hedge funds obviously even further tarnish the financial industry. We discussed Madoff this week on our portal, so won’t rehash the facts again, but the extent of the fraud is breathtaking and is estimated, in some reports, at over $50 billion. Ironically, while Madoff was not a household name, both he and his firm were considered long time leaders in the financial industry.

As a slight digression, not everyone bought into Madoff’s returns. We reread a May 2001 article from Mar/Hedge this weekend , which was entitled, “Madoff tops charts; skeptics ask how”. This is a major publication in the hedge fund industry and a must read for anyone allocating capital to hedge funds. According to the article, from June 1989 to February 2001 “it (Madoff’s fund) would rank as the best performing fund for the period on a risk adjusted basis, with a Sharpe ratio of 3.4 and a standard deviation of 3.0%.” The returns appeared to be too good to be true, and were.

As I reflected on Madoff this weekend (admittedly, many of the details are yet to come), I found it incredibly difficult to understand how a man could live his entire life under such a fraudulent scheme. Not only did he cheat his friends, close associates, but, ultimately, his own sons turned him in. In my mind, it would be better to be destitute and unknown than to live an entire life based on a lie, but, of course, Madoff thought otherwise.

The unfortunate implications of the Madoff fraud are that confidence in the “old boy” financial services industry will deteriorate further. While mistrust in the leadership of the industry is certainly well founded, I do think it is important for us to value the Madoff situation appropriately as his actions appear be an outlier, even for a terribly conflicted and compromised industry. While reading this morning, I a read article online by psychologist Juliann Mitchell about sociopaths and she wrote:

“It is typical for sociopaths to engage in illegal or deceitful behaviors. Compulsive lying is the norm. Guilt and remorse are not in their vocabulary. All sociopaths are incapable of feeling sorrow or sadness for their wrongdoings and destructive behaviors. Any tears you might see are for themselves. “I am crying because I got caught, not because I am sorry for anything I have said or done.”

Madoff was clearly a sociopath and, therefore, in a league of his own.

As the Madoff scandal and the failed leadership of Investment Banking Inc. are leading to a crisis of confidence in the financial industry and creating real doubts by our leaders of tomorrow, it becomes even more important to highlight that there are many great leaders in finance. These are people that have built long and successful careers on the pillars of integrity, transparency, and trust. One such person is Jack Bogle, the founder of the Vanguard Group.

John Clifton “Jack” Bogle was born on May 8, 1929 in Verona, New Jersey. Bogle went to Princeton University and while at Princeton happened upon an article in Fortune about the emerging mutual fund industry. Eager to write a thesis about a topic that had not been widely studied, Bogle wrote a successful thesis about the industry and was awarded with a job at Wellington Management, where he worked for the next 23 years and ultimately became CEO. Bogle left Wellington in 1973 and founded Vanguard in 1974.

The rest, as they say, is history. Vanguard today manages over $1.3 trillion and is the largest pure no-load mutual fund company in the world.

In a 2003 speech at the Harvard Club of Boston, Bogle said:
“The extensive study of the industry (in his 1951 senior thesis at Princeton) that followed led me to four conclusions: One, that mutual funds should be managed in the most “efficient, honest, and economical way possible: and that fund sales charges and management should be reduced. Two, mutual funds should not lead the public to the “expectation of miracles from management,” since funds could “make no claim to superiority over the (unmanaged) market averages.” Three, that the “principal function (of funds) is the management of their investment portfolios” – the trusteeship of investor assets-focusing on the performance of the corporation . . . (not on) the short-term public appraisal of the value of the share (of stock).” And four, that “the prime responsibility” of funds “must be to their shareholders”, to serve the individual investor and the institutional investor alike.”

These are fairly basic principles that embody transparency, accountability, and putting the client first. Bogle developed these principles as a senior at Princeton over 50 years ago and has managed his businesses based on them ever since.

The quotes from Plato and Bogle at the start are meant to emphasize two points. First, capitalism and the pursuit of profits can very much be a noble endeavor. Secondly, bad people exist and they will find ways around our laws. Careers like Bogle’s tell me one thing, incredible profits and success can be found within the framework ethical conduct and, in fact, and a long term legacy is almost impossible without that ethical foundation. We need to encourage our leaders of tomorrow to study the careers of people like Bogle, so they will realize that there is much to be proud of in the investment management industry.
Biographer Richard Slater described Bogle’s life as “evolutionary, iconoclastic and uncompromisingly committed to the founding principles of putting the interests of the investor first . . .” There is clearly a vacuum of leadership in the financial and money management industry at the moment. While the lack of credible role models justifiably concerns the leaders of tomorrow, this leadership vacuum will also create opportunities for people to lead themselves, to define “The New Reality”, and to aspire to become the next generation’s Jack Bogles.

Daryl G. Jones
Managing Director
111 Whitney Avenue
New Haven, CT 06

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