Eye on Leadership: Compensation

Most senior management team members of large U.S. financial institutions have publically declined bonus compensation for 2008. We applaud this leadership. This action indicates to their employees that they are willing to share in the pain of both layoffs and lower compensation, but also indicates to their shareholders that they hold themselves accountable for the weak performance of their stock prices in 2008. Two notable CEOs that have yet to publically state that they will forgo bonuses this year are, Kenneth Lewis from Bank of America (BAC) and Vikram Pandit from Citigroup (C).

While U.S. Banker, an industry publication, recently noted in a headline that, “Lewis Emerges as Exemplar of Leadership in Time of Crisis”, the performance of his Company’s stock suggests otherwise. Over the last 52-weeks, BAC is down ~-67%. He may indeed be the best of an underperforming group of money center banking executives, but the reality of the poorly timed and overpaid acquisitions of Merrill Lynch and Country Wide Financial, has led to massive underperformance of BAC’s stock versus the broader market.

We have long been critical of Vikram "The Bandit" Pandit, the current CEO of Citigroup. In fact, we have been critical of almost all of Investment Banking, Inc.'s leadership. On the margin, though, we do find positive the fact that most of the CEOs and senior managers of the major Investment Banks are forgoing bonus compensation for 2008. Even John Thain, after likely pressure from his Board, has decided to forgo a bonus for 2008. As of now, the last major CEO of all the major investment banks to forgo his 2008 bonus compensation, at least publicly, is "The Pandit Bandit".

In June 2007, Citigroup acquired Old Lane, a hedge fund founded by Pandit, for reportedly more than $800MM. Pandit's take from the acquisition was more than $165MM. Less than a year later, Citigroup decided to shut down Old Lane due to "mediocre performance and the loss of top managers." Last Wednesday, Citigroup press released that the embarrassing story of Old Lane had finally ended as Citigroup press released that they will "severe ties with senior executives" of Old Lane Partners by December 31, 2008.

While Pandit cannot take back many of his questionable management decisions from 2008, we do think it is due time for him to forgo his bonus compensation for the year and return some of the $165MM that he paid less than a year and a half ago for a business, Old Lane Partners, that no longer exists. In Pandit's own words from August of 2008 as it relates to his changing the scheme of how Citi employees were paid, "people do what you pay them to do". Indeed.

Financials (XLF) continue to underperform the SP500 today.

Daryl G. Jones
Managing Director

Attention All Bubble Watchers

One of the more peculiar notions born out of the financial media’s perpetual patrol of all that is in the rear view mirror, is that bubbles, having already popped, can continue to “deflate.”

Have you ever tried to deflate a balloon that’s already popped? Try it, and let me know how that goes. That metaphor is more mathematically represented by the chart below that shows you what Commodities (measured by the CRB Commodities Index) have done, in the aggregate, since everything from fertilizer to grain elevators were given Park Avenue valuations.

The good news here is that, with the stimulus associated with a politicized US Federal Reserve creating FREE moneys from the heavens and countries from the USA to Eastern Europe devaluing their respective currencies, we have big thick patches being put on the former commodity hot air balloons that will allow for “re-flation.”

Gold trading up +4.1% week over week last week, and hitting a 2 month high again here today is the most obvious early signal of the commodity “re-flation” that is coming to a theatre near you in 2009. The revisionist CNBC bubble watchers saw this movie before, but right now they are still focused on how it ended versus how it begins.

Our “buy” zone for Commodities is shown below, from 209 to 219 in the CRB Commodities Index.


JC Penney is incentivizing management to drive short term earnings over long-term value. I don’t like it, even though Wall Street likely will. I can’t stop that freight train, but I can hop on board the Kohl’s express, which is a safer trip.

We’re all about Accountability and Transparency at Research Edge, and we think that one of the good guys in that regard is Michelle Leder and her team at Her catch on the JC Penney 8-K earlier this month is classic.

“… this 8K that has some of the most self-serving language we’ve come across recently. Penney’s board has decided to give Chairman and CEO Myron Ullman III a supplemental performance grant ‘to provide an incentive for performance during the current economic environment and to recognize Mr. Ullman’s willingness to continue his service to the Company.’ A quick skim of the agreement doesn’t seem all that offensive, though at $25 million, it’s quite an incentive to something that really should be considered doing your job.”

We couldn’t have said it better, Michelle.

From my perspective, JCP needs all the incentives it can get. Yes, I’m about to pepper you with another noisy SIGMA quadrant chart. But check out how JC Penney is performing versus arch-rival Kohl’s. Rather astounding, I think. JCP is on its 7th consecutive of inventory growth outpacing sales growth, and its 5th quarter of down margins. The margin trajectory is zig-zagging all over the place, as both SG&A and Gross Margins are managed reactively.

On the other side we have Kohl’s. Its SIGMA trajectory (the yellow line that goes from 1Q07-3Q08) is a smooth arc that shows how management proactively clears its balance sheet in an effective manner while inventories build. Yes, margins are down today, but so are inventories relative to top line trends.
I would not bet against JCP at sub 3x EBITDA – even though I could argue that margins should take a 200bp hit from here (ie, nearly cut in half – again). The reality is that management is being incentivized to make the near-term call and pull levers that shouldn’t be pulled. That probably makes Wall Street happy – except for those who pushed short interest to all-time highs (10%).

Even at a 2x EBITDA point premium and less bullish short interest ratio (5% of float, down from 8.5%), I’ll take KSS any day over JCP as an investment. The fact that SG&A and capex compares get very easy 1 quarter out offers a nice cushion as well.

Keith and I will be revisiting these two more frequently as it relates to meshing my fundamental analysis with his ‘Trend vs Trade’ models.
The first chart (JCP) is just plain ‘ol ugly. It tells a story of a very defensive management team. In this environment, reactionary is evil. KSS is polar opposite. Quality matters…
Short interest definitely looking more bullish for JCP.

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Ireland Going Dry?

It seems that the Irish government may need further liquidity to maintain banks that have recently received government capital.

Since the guarantee of all deposits in Irish banks at the end of September, The ISEQ index has plunged more than 70%. Immediately following the government action, we made our skepticism clear in our “DUBLIN DOWN” post of 10/1/08. A deeper property market problem, and the degree to which large banking institutions are levered to the property market, was not likely to be meaningfully improved by the government’s gesture, however momentous.

It will be interesting to observe how the ISEQ fairs in light of the government’s latest action. In the last few days it was proposed that €5.5 billion be pumped into three major banks: Allied Irish Bank, Anglo Irish Bank, and Bank of Ireland. According to some reports, each of these institutions has lending exposure to the commercial property sector of 22%, 71%, and 18% respectively. The commercial property market is suffering heavily at the moment due to a lack of funding from banks, according to the last bi-monthly update for 2008 by property consultants CB Richard Ellis. The situation (banks and property) is somewhat self-perpetuating.

The downward spiral of the Irish economy has been in step with that of the US economy. As corruption has been exposed in the United States financial services sector, it has been exposed in the Irish finance world. Seàn Fitzpatrick, former Chairman of Anglo Irish Bank, has stepped down following the revelation that he had “borrowed” over €87 million in clandestine director’s loans. Now the Irish government, following an injection of €1.5 billion, has taken a controlling stake in that bank.

Morgan Kelly, professor of economics at University College Dublin, labeled the €1.5 billion as being motivated by purely political motives and devoid of any other logic. Anglo Irish Bank funds developers, and, Kelly states in his Irish Times article entitled “Better to Incinerate €1.5 billion Than Squander it on Anglo Irish Bank”, developers fund the main party of the ruling coalition. The losses of Anglo Irish Bank, in the face of the housing slump, could total (based on conservative estimates, according to the article) €15 billion. This, Kelly states, means that the €1.5 billion from the government will “vaporize” in little time in the face of Anglo’s mounting liabilities.

By having considerable shareholder power in major financial institutions, the Irish government may be able to encourage a freeing up of credit markets. However, if the simple arithmetic outlined by Professor Kelly is to be believed, and if the property market doesn’t turn sooner than expected, the government may have to commit more and more capital to keep institutions like Anglo Irish Bank afloat.

Rory Green
Research Edge LLC

Flattening The Curve...

For those investors looking to borrow short and lend long, this is one of the most negative 3 week charts that has developed in American Capitalism.

This morning’s narrowing between 10s and 2s has resulted in a +126 basis point spread. This is well off the higher levels that we saw in both late October and early November when I started to get more constructive on US Equities (see chart). In “The New Reality” of American Capitalism, we need to be able to see an expedited wealth transfer from the levered long to the liquid long investor. Steepening the curve is the best way to ensure that process takes hold. It’s the only way to incentivize those with real savings to lend.

It’s not only 2 month Treasury yields that increased on a week over week basis last week (from 0.74% to 0.88%), short rates like 3 month Treasuries went from 0.00 (ZERO) to +0.06%. I have long maintained the most basic of arithmetic thesis’ that once you cut to zero, the only way to move next is UP. Now, albeit slowly, that’s starting to happen… and this development should be monitored very closely on a day to day basis. This is why the XLF (Financials) continue to underperform.


Re-Flate! - asset allocation122908

"To be wronged is nothing unless you continue to remember it."

For many, it has been a long hard year. Being a record setting 0-16 Detroit Lions, or being down as much as the SP500 year to date (-41%) is actually nothing now, "unless you continue to remember it." In t-minus 3 trading days, both levered long Portfolio Managers and NFL coaches missing the post season get to move out of the way. For many of their investors and fans, it can only get better from here. Don't forget, everything that matters in markets happens on the margin!

Rather than pointing fingers and getting bogged down by the rear view mirror, this is a great moment in American history to look forward. This is quickly developing into one of the greatest opportunities that American Capitalists who proactively prepared will ever see. US Equities are on track to lock in their best sale prices since 1931, oil prices have dropped -76% in the last 6 months, and interest rates around the world are going to zero. Can you imagine what the "it's global this time" bulls would have done with a fact-based economic narrative like that? Actually, we don't want to go there... we might find a whole band of Bernie's.

Fortunately for him, Bernie didn't quite find his way to Russian or Asian coffers. Rather than bouncing reporters on Park Avenue, he would have had himself quite the situation to deal with. The best news about the moral-less Madoff story is that it too will find its way out of the mass media in the New Year. That, on the margin, is also a bullish catalyst for markets.

Israel raining down on a region where there are 1.5 million Palestinian civilians has not been able to shake the boots of The New Reality investor. Neither has Pakistan deploying tens of thousands of troops to the Indian border. Weekend at Bernie's New York apartment looks tame compared these geopolitical risk sirens, but markets find a way of discounting news before it happens. You don't need an SEC that actually looks for insider trading anymore - if you watch markets and stocks closely enough, you'll see plenty of it revealed before the mass media rehashes it.

Thankfully, we bought oil into its vortex of year-end dismantling. This isn't about "year-end selling" - that's over with. This is about dismantling... and now, as a result, you can find plenty a "prop energy trading desk" being sold on EBay. Like the Lions NFL season, thank God it's over. Having to deal with the "he said, she said" nonsense of some of these vaunted institutional jungle gyms was making me nauseous. Now, volatility is coming down as fast as employment in this segment of the financial services sector. The VIX was down another -3.4% last week, taking its cumulative cliff diving score to -46% from its manic peak.

My asset allocation model went to 14% in Commodities last week. I was thankful for the blessings of family at Christmas, and many of the tidings that came alongside Wall Street's cycle crashing. Buying oil under $40/barrel was something that doesn't make sense until it does. This morning, like many other mornings on the interconnected planet called Earth, those who sell oil low are reminded that the price of oil has a geopolitical risk premium. Some mornings it is more obvious than others - but wherever you wake up in this world, there it is.

I have dropped my asset allocation to Cash down to 44%, and that's very close to its lowest level of 2008. With only three trading days left, I had to splurge on some of these holiday deals. The "shop till you drop" mantra of many moons past is really quite cool, particularly when there are no lines. The US Dollar continues to get hammered, because ... well, the US Government has decided to devalue it. This decision by our politicized Federal Reserve is not unlike the one that Nationalist hero Vlady Putin has made. When in doubt, devalue - and "Re-flate."

With the US Dollar index trading down another -1.5% this morning to 79.53, our decision to short it on Friday is making our clients smile. This exercise isn't that complicated. "Re-flation" is what you get after everything has deflated!  With all of the bubble watchers on CNBC reminding you that things can pop, you have to be a little confused now that all of the bull market parties balloons are dead flat laying all over the floor.

We remain long Gold via the GLD etf, and that asset class had another fantastic week, closing up another +4.1% at $871/oz, outperforming the SP500 by almost 600 basis points. With the Russian Ruble hitting all time lows against the Euro this morning, the Chinese Yuan hitting its lowest price since December 10th, and the greenback feeling the ills of a nasty Hank "the Market Tank" 2008 hangover, gold continues to "re-flate."

Whether you are an exec at Rohm & Haas this morning who is seeing his/her stock price deflate due to the Kuwaitis not having the cash to supply Dow Chemical for the acquisition, or your one of them poor fire engine chasing "activist" people who chased Bill Ackman all the way to "Tar-g-eh"... it's all one and the same. 2008 was a year that everything from the madness of petrodollars to those "Made-up" Madoffs has all deflated. The only thing that gets air back in the tires of global finance is to "re-flate" them. Don't worry about the long term implications - this country hasn't worried about them for decades now. "To be wronged is nothing, unless you continue to remember it."

Best of luck this week.

Re-Flate! - etfs122908

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