Hynes Capital

BP Settlement?

2010-06-15T10:38:00.000-06:00

Both British Petroleum and the Obama administration have a problem. They need to extricate themselves from the relationship they have been forced into due to the Gulf oil spill. And they need to do it quickly.

The issue is simple. The administration views the cleanup and payment of economic damages as instruments of social and political policy. BP approaches the process from a point of view of balancing legal, financial, and public perception aspects.

Obama needs a solution that will stop some of the bleeding before the mid-term elections. BP needs a solution that will restore confidence among lenders and business partners. Who wants to do business with a company facing an open-ended liability? Lenders will balk, and governments and other oil companies will be reticent to enter into long-term deals with a company facing such an uncertain future.

For its part, the Obama administration relies on the technique of ruling by fiat, taking money from hapless taxpayers (and Chinese bond buyers) to fund largess for which it takes credit. It seems to be taking the same tack with BP, continually making bolder demands.
While the claims settlement process is basically an insurance operation, however, the administration is unhappy with the speed and frugality of BP’s process. In addition, the administration is demanding an escrow fund administered by an “independent” panel. Would the government demand such a thing from an insurance company? The government has also put a moratorium on deep drilling in the Gulf, and wants BP to pay for the costs resulting from it. BP is balking. The Obama administration is already running into Margaret Thacher’s admonition that the problem with using other people’s money is that you soon run out of it.

The issue of the responsibility for the moratorium is a dangerous one for the administration. If regulations were adequate and BP made a mistake, there is no reason for a moratorium, and BP should not be liable for the costs of it. If the regulation was inadequate and BP followed the rules, there is an argument that the government bears not only the responsibility for the moratorium but also the cost of part of the cleanup or broader damages. Remember that offshore leasing is a $13 billion annual revenue source for the government. Given that revenue stream, it would make sense for the government to have disaster recovery procedures in place, including dispersant and boom inventories. It is more efficient for the government to do this than the individual drillers. If individual drillers provided this backup, the redundant costs would lower their bids and reduce government revenues to a greater degree. Similarly, bills in Congress calling for unlimited liability would have the effect of lowering revenues dramatically as fewer companies would bid smaller amounts for leases.

For the administration and BP, the current claims settlement system is a no-win situation. If BP pays a satisfied claimant, the government gets no credit. Unhappy claimants, most likely the vast majority, will wonder why the government isn’t “doing something.” And the more the government tries to expand the definition of relief, the more BP will pull back.

There may be international issues too. The British might not be happy to see the US legal system destroy an iconic British company that pays over 10% of the dividends of a major British stock index.

What’s the solution? Why not have BP pay the US government a large sum of money, say $30-50 billion, in exchange for the government taking on the cleanup liability? The administration can quickly claim a win before the elections. It can then set up a claims process and get credit for the largess that flows from it. It can freely use the military to assist in the cleanup. Over the years this process will take, the political process will allow the government to move expenses around so that it can be seen to have made a very shrewd deal, while once again using the hapless taxpayer’s money to pay for the broad social policy embedded in the settlement process.

If there is no settlement, there is a real chance that BP would be forced to file for bankruptcy, throwing sand into the gears and ensuring plenty of voter, as well as shareholder disenchantment. A settlement would also allow BP shareholders to survive with a reasonable valuation and dividend.

Both sides win—the right basis for any deal.

Obama in Copenhagen

2009-12-18T09:25:00.001-07:00

It will be interesting to see how Obama does in Copenhagen. A big part of his campaign was about regaining respect for America abroad. Internationally, he doesn't have official authority, nor any legislative majorities. He must operate on the strength of his ideas, and the concept of American leadership. He wants to succeed at Copenhagen. Secretary of State Clinton threatened that no deal meant no money. Americans should be concerned that Obama, hungry for a win, gives away the store.

The worrisome thing is that an agreement in Copenhagen may both spur further migration of industrial jobs from the US and Europe to the emerging markets, and that we will subsidize this process, and find no net greenhouse gas emission reduction.

Electronic Trading Debate

2009-09-14T22:32:00.000-06:00

The Wall Street Journal published our rebuttal to Senator Schumer's response to our editorial: http://online.wsj.com/article/SB10001424052970203440104574404581166261194.html

Investment management is a business that is easy to leverage, except in the area of trading, where size creates a disadvantage as lack of liquidity can penalize performance. For this reason, I believe managers and their clients all have an interest in defending innovation in trading markets. Innovation provides investors more opportunities to handle their orders according to their preferences, rather than in some monolithic, one-size-fits-all product that we wouldn't even accept for laundry soap. Customers, not Senators, should be the ones to choose which innovations to reward with market share.

WSJ Op-Ed

2009-08-27T08:09:00.003-06:00

This morning's Wall Street Journal carried an op-ed co authored by my former colleague Don Luskin and me. The subject is "Flash Trading" which is under regulatory attack in electronic markets, despite its existence in traditional markets for as long as I can remember. The op-ed can be found at:

http://online.wsj.com/article/SB10001424052970203706604574374431720968204.html#articleTabs%3Darticle

If you don't subscribe to the Journal, let me know and I'll email you a copy.

National Health Care

2009-08-26T04:16:00.002-06:00

We've got quite a dilemma as a country. We worry over the cost of universal health care, but it's probably something we should have as part of a process of rationalizing the system. Yet the addition of 40 million new customers will pur a big strain on primary care doctors. I reckon there are about 300,000 of those, and if each new client took 2 hours a year of their time, we'd need another 40,000 or so. Massachusetts has gone to universal health care and has this problem. If we pass universal care, this could create problems for baby boomers looking to retire and move to a new location--they might not be able to find a primary care provider--especially since the growing resorts are often heavily populated by uninsured workers and the undocumented. Ironically, it may be easier to get into the emergency room.

So rationing of some sort has to come, because the price of care will likely be too low for many new customers. Many people want ot cut down those expenses that occure in the last 6 months of life. Problem is, we don't always know when the last six months of life begins. Also, we don't want it to be our grandma, our ourselves!

And finally, there's a genuine concern about a "national option" run by the same people who run the post office, with potential for coercive legislation to ensure it's competitive position, bloat its cost, and further redistribute income.

I'm praying the Bue Dogs can resist their own party's attack dogs and move the plan in a semi-rational direction. Semi-rational--that's all I can expect from the goverment these days...

Decoupling: Has the Time Come?

2009-08-20T20:54:00.001-06:00

Decoupling may have finally arrived, a little too late for the believers of two years ago. The "this time its different" crowd argued that the emerging markets could stand alone without the US and Europe. It didn't work that way, and emerging market equities were hit even worse than those in the developed markets. Lately the Asian emerging markets have been moving up faster than the US market, but it also seem the economies are as well. And, funny thing, the Eurozone is growing faster than the US--at least for now. There should be concern for the Chinese market after the big rally--lots of IPOs, bank loans up at high rates, and maybe some of that money flooding into stocks. Global banks are considering listing in Shanghai and floating stock there. Of course, hot foreign markets are always the last place Wall Street goes to sell junk, when they've run out of locals who haven't heard the news. While playing the Chinese market in the short term given the current liquidity bubble is not for the faint of heart, especially with the government warning against speculation and bank loans finally slowing, continued economic decoupling may lead to returns exceeding those in the developed markets over a longer horizon.

20 Year Performance Results

2009-08-19T21:17:00.002-06:00

For the 20 years ended December 31st, 2008, Hynes Capital returned a compound annual rate of 11.7% per annum, versus 8.3% for the S&P 500, for an outperformance of 3.4% per annum. For the year 2008, Hynes Capital returned -37.4% versus 37% for the index. In the first half of 2009, Hynes Capital returned 13.6%% versus 3.2% for the index, for an outperformance of 7%. For 20 and one half year period ending June 30, 2009, Hynes Capital returned a compounded 12.1% per annum versus 8.3% for the index, an outperformance of 3.8% per year.

Two things are always said (by responsible people) about investment performance: first, it should be evaluated over a market cycle, and second, it may take the rest of your life to determine whether a manager adds any skill.

I'm still wondering whether the last 20 years has comprised a market cycle yet? A few years ago, I would have said I'd seen a few in this period, which shows you how much I know. While I was chagrined to lose a lot of money in 2008, I noticed many of my value investing heros suffered even worse losses. Legg Mason Value Trust, run by Bill Miller, who beat the market for 15 years in a row, was down 55.1% (although he made almost 50% in the first half of this year--which still leaves him down substantially). Bill Nygren at Oakmark Select I was down 36.2% in 2008, but that followed a horrible -14.0% return in 2007. David Dreman's DWS Dreman High Return Equity was down 45.5% for the year. He's no longer running the fund. 2008 was a year in which, if you kept doing what you'd been doing the past 20 years, you were simply crushed. We had been buying good financial services businesses with good branding/franchises on weakness for years. We were complacent on balance sheet risks. Even though we owned, at times, some of the most famous financial flameouts, some small voice in our ear kept us from averaging down and down and down. It was clear that the balance sheets were getting worse and worse, and we didn't seem to be getting the truth from managements. Our emphasis had always been in financial services, where we had the point of view that increasing productivity would lift living standards beyond the need for physical goods and create plenty of capital for financial companies to get a piece of. So we're glad to have averted absolute disaster last year, and very happy to be making a reasonable recovery so far this year.

Over the years I've tended to have what I call "inside" volatility. I was up less than the market in good years, and protected capital in the declines. While I averted disaster, I really didn't get the mortgage meltdown until it was too late.

I have always focused on relative, not absolute performance. Philosophically, being in the absolute performance business requires a pure arbitrage approach to markets. My concern with this approach is that it removes the benefits of actually owning a share of the production of real goods and services. Performance depends upon the skill of the manager, and not the skills underlying the investments. Given the issue of how long it might take to know whether your manager has any talent, you can see why I would eschew this approach. Rest assured this does not mean I like losing money in any period.

Earnings have outpaced estimates recently, but revenues have often been weak. Doesn't that mean companies have been very aggressive with cost controls and layoffs? Maybe employment won't be as bad as expected going forward. Better than expected employment numbers would really be a plus for consumer lenders such as credit card companies and regional banks. Also, corporate profits tend to get invested rather than spent, so having money in corporate coffers rather than in consumer piggy banks may be a positive for economic expansion.

I'm trying to identify companies with emerging business models that are more efficient than the models they replace. Recessionary times mark an inflection point for these kinds of companies. Older managers at potential customer businesses get laid off, making way for younger folks who appreciate the new, usually higher-technology models. And the new people need to cut costs. Consumers as well are more likely to accept new models. My outperformance this year is partly a result of sticking with some of last year's losers and finding some of these game-changers. I've also been able to make asset class decisions on China and real estate, which seemed to trade at absurdly low values earlier in the year. After being defensive through January and February, almost everything seemed undervalued by the beginning of March. I bought aggressively, and there were stunning returns to be had in some relatively conservative situations, although I suppose that no one believed that taking any risk was conservative.

At this point, my posture is defensive, but I'm worried that just about everyone is bearish. It's a crowded trade, and money seems to pour into the market every afternoon. What's worse, the bear story is fairly obvious. What's not obvious is that the people who seem most anti-wealth, the Congress, is running for re-election next year, and beginning to think about the impact of deficits and tax threats on their chances. The first two months of the year, I believe, were less a result of the economy than a fear of the government's influence on the business climate. While equity valuations seem high relative to historic norms, they seem more reasonable when compared to fixed income.

I think the key to America's future is increasing innovation at the expense of legacy manufacturing. The recession has done us a favor by getting rid of a lot of legacy employment. Because I believe big companies have cut overly deeply into workforces, I believe there will be rehiring. I believe the mature companies, however, will tend to do that hiring in emerging markets, leaving a large potential labor force for the innovators to harness into a more productive manufacturing center. Simply put, we need to make the stuff the offshore folks aren't ready to do yet, not try to compete with them for the business they are good at. Right now we tend to look at the Chinese as a threat. I think China has about 250 million excess farm workers who will roll into the industrial economy over the next 10-20 years. You can guess where a lot of those jobs will come from. We can grow if innovation creates better jobs here. Economics is pretty simple--growth in labor force times growth in productivity equals growth in GDP/GNP.