Trust Is Earned, Not Appointed

Don't tell people how to do things, tell them what to do and let them surprise you with their results.
~ George S. Patton

For you military history buffs, you’ll recall that Patton was plenty aggressive and controversial. His nickname was actually “Old Blood and Guts”. However, the man was a winner and didn’t have finger pointing in his arsenal of leadership weapons. Letting people be good is my interpretation of the quote above. That’s what winners do.

In order to let people be good, you have to trust them. As importantly, they need to trust you… so you better have an objective and flexible investment process that they can believe in. When trust is violated, teams, relationships, and systems start to break down. If there is one thing that I am seeing in the daily trading expressions of this market, it’s just that – the ultimate challenge to the trust that has been embedded into the American Financial system’s nucleus.

Yesterday’s US trading action was a crystal clear example of impaired trust. Paulson’s bailout plan was always earmarked for his banking buddies, and now the Street is having a hard time swallowing what the foxes will do now that they have the cash in the hen house. “Old Blood and Guts” would have blown up the hen houses, but these are much more politically polarizing times. Blowing things up isn’t cool. US market trading volume reflects that counterparties do not trust one another – it balloons on market down moves and dries up on the “bottom is in” CNBC sponsored rallies. Volatility, as measured by the VIX, remains in nosebleed territory at north of 55, and I think it could very well see 70 again before this war of attrition is all said and done.

The distrust in the American system is clearly not local. To borrow my favorite “Investment Banking Inc.” quote of October of last year, “it’s global this time”, indeed. Even after seeing the biggest cash injections in world history, LIBOR (the rate at which banks lend to one another) won’t budge. If it drops by 25 basis points, that might help the perpetually bullish narrative’s rhetoric, but it won’t do a darn thing for what matters out there on the battlefield – trust.

Tonight, we will watch the final US Presidential Debate. The “Question” on my mind is can the American people genuinely trust what I am now going to start calling “BAmerica”? If the answer to that question is yes, then we have a very positive macro catalyst on the calendar tee’d up for November. For some time now I have been saying that Obama is negative for the market’s immediate “Trade”, but the next macro call may very well lie in answering for duration as to whether or not his new administration could be positive for the intermediate “Trend.” There is no math in the driving factor in that model – just trust.

Do American investors trust Asian and European markets? That answer was yes – today, as regionalism and protectionism rears their ugly heads into the local economic dialogues, the answer is far less clear. In some cases it’s flat out scary. That’s why we shorted Austria’s (via the EWO) ETF yesterday (see note titled, “Eye on Regionalism: Austria's Spreading Xenophobia”, 10/14/08). We are going to be long countries looking to broaden their wings and incorporate free market trade and capitalism into their process. We trust those principles. We are going to be short close minded companies and countries who don’t get it.

The Chinese are starting to make moves towards capitalism. Are they in any way, shape, or form like Jack Welch’s definition? Of course not. But the point is that everything that matters in economic models happens on the margin. On the margin, they are more capitalistic than they have ever been. Unfortunately, I can’t say the same for the USA. Tonight, both Obama and McCain’s populist economic re-regulation rants will remind you of as much. Ronald Reagan these two politicians are not.

Of course, we are long China, and we will be getting longer via our ETF positions in the EWH and FXI this morning. We are short socialist Japan after re-shorting the EWJ yesterday, and we are also short the bureaucrats in India via the India Fund (IFN). India has a Presidential election that is coming up that will make the US populist calls to action look like Shrek. This is going to be the hard core socialist stuff that’s X-rated for we free market folks. India was the worst performing market in Asia overnight, closing down another -5.8%. We are looking at an immediate downside target on the BSE Sensex Index that is 11% lower. I do not trust asymmetric political tail risk.

Overall, I am a bit cheerier these days. Hopefully you are picking up on that in my notes. I definitely don’t want my son Jack to grow up in a neighborhood where his friend’s parents are calling us a family of “old blood and gut” bears. Both my team and yours should not trust an investment process that is perpetually negative. I would not have had a career in this business if I was never bullish. That said, I moved back to 80% cash and 20% stocks yesterday. For the immediate term “Trade”, I don’t trust that the current said leaders of this country get it. However, I am looking forward to November’s changes in the lineup.

Best of luck out there today,


“We will pass the Employee Free Choice Act. It’s not a matter of if, it’s a matter of when.” – Barack Obama

“Madam Speaker, I rise today in support of the Employee Free Choice Act, because the right to organize is essential to the path to prosperity for all Americans.” – Speaker of the House Nancy Pelosi

“Every single Senator ought to support this bill.” – Senate Majority Leader Harry Reid

These quotes should remove any doubt. If Obama is elected President, the Employee Free Choice Act will become law. Whether or not the removal of secret ballots in deciding union elections makes employees more free is not important. Since 1989, unions have contributed almost $500 million to political campaigns. Over 90% of that cash has gone to Democrats. The favor will be paid back by an Obama administration and a Democratic congress.

So what does this mean? The elimination of secret ballots will make it much easier to unionize. Secret ballots are the cornerstone of any modern democracy for a reason. People can vote without the pressure that an open petition would apply. More unions = higher wages and benefits for hotel, casino, and leisure companies to name just a few.

Margins are going down over the next few years and not just because the top line is under pressure. Sorry to pick on Starwood but the hotel industry is pretty easy to analyze in this regard. The consensus EBITDA margin estimate for HOT declines only 80 basis points in 2009. With likely RevPAR declines of at least low to mid single digits, this projection is laughable. A note to analysts: labor costs are going up not down.

DPZ – Cash is King

I wrote a post about DPZ titled “Follow the Cash” back in July and despite the company’s disappointing 3Q results reported today (particularly from a top-line perspective), DPZ’s business continues to yield ample free cash flow. Year-to-date, DPZ has generated $25.8 million in free cash flow, and that number would be closer to $44 million, excluding two non-recurring expenses.

Although the company’s balance sheet is significantly leveraged (debt/LTM EBITDA over 7x), DPZ’s business model will allow it to meet its interest payments and/or pay down debt over time. I am even more confident in DPZ’s ability to pay down debt following management’s comments today on its earnings call about its plans to build cash reserves. “We are going to pile up more cash than we would think about piling up until the situation sorts itself out and once we know where the credit markets are, where our revolver is as we see more trends develop in terms of what's happening with the health and vitality of our franchise system, we would make a better decision as it relates to stock repurchase at some point in the future. So right now we are going to carry a larger cash balance and see how this all sorts out.”

In argued back in July that DPZ should not buy back stock, so needled to say I would agree with management that buying back stock might not be the most prudent use of cash right now.
  • Management voiced a lot of concern about the credit markets and the impact tightened credit markets are having on its franchisees, particularly as franchisees experience lower EBITDA margins (management expects 2008 franchisee EBITDA margins to be worse than the already low margins in 2007). The current credit conditions are making it increasingly more difficult for financially stable franchisees to acquire underperforming stores or for underperforming stores to get the short-term financial support they need to turn around their businesses.

  • DPZ currently working with banks and other lending institutions to get deals done, but they went on to say they will provide financial support if need be. “It will never be my preference to provide financing to our franchisees. We would rather keep our relationship with them being the franchisor rather than their bank. However we are weighing through unchartered waters and we are not going to let our A and B franchises fail if there are ways we can be helpful with some short term financial support and solution.”
  • The company said that one way it could offer financial support is by providing some deferral of costs and/or royalty payments. One primary benefit of the franchisor/franchisee business model is that it allows a franchisor to grow without bearing as much financial risk. By providing short-term financing to its franchisees, DPZ will be increasing its financial risk and heading down a potentially slippery slope.

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From The "Bond Guy"...

Our chief correspondent in bond land continues to provide us proactive insights when it matters most... Here's what he had to say today:

"mortgages are now wider than they were pre-GSE taking over by governement...
remember they wanted to make mortgages "affordable and available" to home owners? 6.55 30yr mortgage rate right now. And that's for <80 ltv, >720 fico guys, full doc."

Access to capital continues to tighten, as cost of capital continues to rise, globally.


We shorted EWU this morning

Today’s CPI number for the UK came in at an unexpected increase of 5.25% over the same month last year –a decade high. Despite the commodity sell off British consumers are still feeling the pain of the Pound’s decline in their wallets.

This increase in CPI has left the Bank of England caught in a in a tug of war between near term inflationary concerns and the capital markets liquidity draught. Last week’s 50 basis point rate cut has not yet created the desired market stability; meanwhile the UK public pension system is pegged to the inflation index, meaning that the government faces billions in additional state payments if inflation rises. In theory the potential exists for a vicious cycle -rising inflation levels contribute to increasing public liabilities, potentially further weakening the Pound against the Euro, Dollar and Yen and contributing to more inflation. This worst case scenario seems unlikely. In fact, most economists are counting on decreasing food and fuel costs to get inflation levels back below the government’s target rate of 2% rapidly, but the prospect of any further weakness for the Pound is still sobering.

Even if inflation does recede quickly, national debt is still on the rise. The first bank bailout linked bond issuance, 30 Billion Gilts and 7 Billion in Treasury bills, has been announced with an additional 70 billion+ expected to come to market over the next several quarters.

We sold EWU into this morning’s knee jerk rally in response the US bank bailout announcements. This is a significantly damaged economy that will take time and pain to right itself, making the decision to sell into near-term wishful thinking a lot easier.

Andrew Barber

What Would We Do Without Charlie?

From our friends at Street Account late in the day here: "Goldman Sachs and Morgan Stanley "drawing up plans" to buy banks; notes CNBC's Gasparino"...

This reporting of what doesn't look to be public information is all just part of what was a mania. It's sad.