Banking on waves

As predictably as the tides roll in and out, M&A bankers surf waves of acquisitions and divestitures – reaping fat fees along the way. Today’s announcement of Cendant’s split is just the latest example of the trend that has hit Viacom and others.

Bankers fuel CEO’s ambitions for increased wealth and press praise by talking up the virtues of one-stop shopping and synergies resulting from merger waves. When the CEOs bite, the bankers have companies set to be bought. This is how Cendant’s Henry Silverman got Century21, Avis, and Orbitz; Viacom ended up with CBS; Disney got ABC; and Citigroup got Salomon Brothers and Travelers. All these deals generated ample fees for the bankers and temporary praise in the media.

Unfortunately for the CEOs and shareholders, the missing piece in most of these ‘convergence plays’ was rising shareholder value. Viacom has lost 45% of its value, Disney has tumbled 38%, and Citigroup is off 18%. Surprisingly, Cendant has actually gained 70% in the last five years. But Cendant, whose shares have been stuck in the $20 to $25 a share range, is impatient.

Is its decision to split itself up into pieces a good answer to the challenge of increasing shareholder value? With Cendant stock down over 6% today, the answer in the short-term may be a resounding no.

My hunch is that nobody really knows the secret of how to increase a company’s shareholder value. But investment bankers are quite skilled at fanning this uncertainty to generate fee-generating transactions. By surfing the waves of convergence and focus, intermediaries profit while long-term investors suffer.

Second Anniversary of "Why the Secrecy About Financial Covenants?"

It's been two years since The New York Times published my idea about debt covenant compliance reporting (see below). But the proposal has been ignored -- harming equity investors in recently bankrupt companies like auto parts maker, Delphi.

Debt covenants are not some weird religious ritual -- they're contract terms between a lender and a borrower. When companies borrow money from banks, they negotiate many contract terms -- including the conditions under which the bank can demand immediate repayment of the loan.

Such convenants might include maintaining a specific debt/equity ratio, having ample cash flow to cover interest expense and other bank charges, filing financial statements on time, or getting an audit opinion that is free of suggestion that the company might not survive as a "going concern."

In 2001 many investors were surprised that debt-laden companies -- such as Williams Communications Group -- went bankrupt when they tripped a convenant. In this case, WCG got a "going concern" letter from its auditor. This violated a covenant that led WCG's nervous banks to demand immediate repayment of billions in loans -- and WCG filed for bankruptcy.

My basic idea was that companies should be required to warn investors if they are in danger of violating these bank covenants. I suggesed that publicly traded borrowers should be required to include in their quarterly reports the specifics of their covenants, their standing on each measure and the risks of noncompliance.

This proposal would have helped investors in Delphi, which filed for bankruptcy on October 8th. A review of its June 30, 2005 quarterly financial report -- the one preceeding its bankruptcy filing -- was pretty sanguine about Delphi's ability to stay compliant with its debt covenants. The quarterly statement presented Delphi's level of compliance with some of the covenants but failed to analyze the ones that it might be in most danger of violating. My reading was that Delphi was trying to avoid alarming investors by putting its situation in the best possible light.

But three months later, Delphi filed for bankruptcy and its stock plummeted from $5 in April 2005 when I raised the possibility of a bankruptcy to 33 cents today. We really don't know exactly why Delphi filed for bankruptcy -- an October 17th deadline loomed for a new, less borrower friendly bankruptcy law, Delphi was trying to get the unions to accept wage concessions, and its customer, GM, was not selling enough of its gas guzzling SUVs and trucks to keep Delphi's revenues from plummeting.

Debt covenant compliance may not have been on the radar of this bankruptcy. However, if my proposal had been implemented, I believe investors may have been in a better position to salvage their investment in Delphi stock before it was too late. If, for example, Delphi had been required to include an exhibit in its financial reports listing each covenant, its state of compliance, the chances of falling out of compliance, and the reasons for the estimate, then investors would have been in a far better position to conclude that it was time to sell.

Here's the original article.

Why the Secrecy About Financial Covenants?
By Gretchen Morgenson
12 October 2003
The New York Times

MANY companies have increased their financial disclosure recently, responding to shareholders' cries for greater details about their operations.

But most corporations still refuse to lay open a set of financial statistics that are central to their ability to survive. They're called financial covenants, or restrictions a company has set with lenders in exchange for loans.

Financial covenants vary, but they can involve a company agreeing to maintain its net worth at a certain level or keep its cash flow high enough compared with its interest payments. Covenants protect lenders by allowing them to call loans if a company fails to meet its requirements.

Violating covenants can set in motion events that lead to bankruptcy. Enron's devastating spiral into Chapter 11, for example, was related to violations of financial covenants. Still, the details of most covenants are kept between a company and its bank.

''How many investors are out there who have no idea about these debt covenants and how important they are?'' asked Peter S. Cohan, a management consultant in Marlborough, Mass., and author of ''Value Leadership: The 7 Principles That Drive Corporate Value in Any Economy'' (Jossey-Bass, 2003). ''Anyone investing in a heavily indebted company is likely to be surprised by covenant violations because there is no systematic way of reporting them.''

Carol Levenson, director of research at Gimme Credit, an independent research firm, said, ''Many companies don't disclose these covenants or where they stand with regard to them, which can be tricky to calculate, until it's too late and they're in danger of violating them.''

One solution, Mr. Cohan said, would be requiring companies to include in their quarterly reports the specifics of their covenants, their standing on each measure and the risks of noncompliance. Filings could also be required if a material change took place in a company's operations that put it in violation of a covenant.

Ms. Levenson said she would like to see disclosure of any amendments to existing agreements or waivers that a company has requested from its bank. To be sure, many banks grant waivers to companies that are in violation of their covenants, so noncompliance does not always spell doom.

''It's very difficult to understand a company's liquidity position from reading the financial statements,'' said Pamela W. Stumpp, a managing director at Moody's Investors Service. ''Although steps have been made to make it more transparent, it doesn't go far enough.''

Some companies are already increasing disclosure. EDS, the computer-services company, described its covenants in its most recent quarterly statement, spelling out what its minimum net worth must be, how the figure is calculated and what would occur if the covenant were violated. Sean Healy, a spokesman, said the disclosure was a strategy of new management ''to give investors a better understanding of our business and to build confidence.''

Other companies should follow. Corporate defaults are down but remain high. Moody's said 66 companies defaulted on $30.3 billion in bonds in the first nine months of 2003 compared with 118 defaults totaling $135 billion during the same period last year. If a company does default, increased disclosure on covenants would keep investors from ugly surprises.

Wanted: A Better Ringmaster

In a three-ring circus, the indispensable man is the ringmaster, who directs the audience's attention to each act in turn. He makes sure that the lion tamer's act in ring one follows closely, but not too closely, behind the man shot from a cannon in ring three and the acrobats high above ring two. So it should be in the securities markets, which badly need an effective ringmaster to control the flow of information from those who create it to those who use it.

Today, the Securities and Exchange Commission manages Wall Street's three-ring circus with a whip and a gun. It cracks the whip to get traders to pay attention to its rules and, occasionally, it shoots a few right between the eyes. In April the SEC aimed such a shot at a gaggle of NYSE specialists who made almost $20 million by trading ahead of their clients. And two months ago, the agency struck again by indicting a day-trading executive and four former stockbrokers who took bribes to let the day traders eavesdrop on the brokers' squawk boxes.

According to the SEC, a rogue day-trading executive, John Amore, paid brokers at Merrill Lynch, Citigroup and Lehman Brothers to leave their phones off the hook right next to a squawk box that broadcast big trades to the brokers before the transactions were executed. Amore's firm, A.B. Watley, allegedly made $600,000 by taking positions in front of these trades and profiting after the trades moved the market. The Watley firm profited from the virtual certainty that a big trade would move the market in predictable ways.

It made $19,000 in a few minutes in one such trade: a Citigroup broker, Ralph Casbarro in Bayside, N.Y., left his phone off the hook for Watley. At 9:52 a.m. on July 24, 2002, Watley overheard a Citigroup trader announcing an order to sell Noble Corp. stock. Over the next three minutes, Watley day traders shorted 36,000 Noble shares -- selling borrowed shares with the almost certain promise of replacing them soon thereafter with less expensive ones and pocketing the difference -- at $28.63. In the next two minutes, Citigroup executed the sell order. As Noble shares dropped, Watley traders covered their shorts- buying 36,000 shares at $28.10-and pocketing a $19,000 profit.

In Wall Street, there are three rings of market information. The Inner Ring (for example, traders at major investment banks, hedge funds, and mutual fund complexes) is closest to trading decisions as they are made, and its members have the best information about the immediate future. The Middle Ring consists of intermediaries, such as analysts, brokers and the omnipresent NYSE specialists-15 of whom were charged in April with making $19 million by front-running. The Outer Ring is everybody else -- the ultimate buyers and sellers, for whom the market is a black box.

Market regulation tries to enforce fairness by keeping walls between the members of the three rings and the information possessed in the inner and middle rings. Watley profited illegally by tunneling through one of these walls. Casbarro and his peers gave privileged access to the information in the middle ring. Through his illegal payments, Amore pretended to be in the outer ring while gaining access to the middle one.

Regardless of whether Amore's scam is isolated or more widespread, it raises a broader question of fairness. Who should know what, and when? The real profit action is in the interaction between the inner ring, where decisions to buy or sell big blocks of stock are made, and the middle ring where they are executed.

Why were the inner-ring sellers of Noble Corp. who placed their big order with Citigroup on July 24, 2002, so eager to dump their shares? Is it fair to those in the outer ring not to know the answer?

What the SEC needs is a ringmaster to impose order on the market from the moment its participants create material information. Its Regulation Fair Disclosure (FD) requires the managers of public companies to disclose market-moving information simultaneously to all investors. As the Watley case demonstrates, big trades move markets, so why are those in the inner ring afforded a special privilege of not disclosing their trading intentions?

Some shrug: Trading is a rough business; let the buyer beware. They would suggest that there is no reason that willing buyers or sellers should be protected from their ignorance of an upcoming trade. But there are already many protections for investors, ranging from the insider-trading laws to financial reporting requirements, which were put in place in the wake of abuses which cost investors money. The resulting loss of confidence diminished market liquidity and threatened the long-term survival of the markets.

Reg FD came about in 2000, after the SEC received 6,000 comment letters from individual investors who felt that securities analysts attending posh outings sponsored by management received market-moving information before they did. The SEC decided that Reg FD's cost to companies was far lower than the benefits of market liquidity that would result from plugging a leak in the dam holding in investor confidence.

Regulators must address practical questions if they are to head off further investor-confidence-shaking incidents like the Squawk Box probe and the NYSE specialist front-running indictments. Among them: How big should a trade be before disclosure is required? How soon before execution should such a transaction be disclosed?

An answer to the first question is to apply the materiality standard used for Reg FD. If the trade is considered potentially large enough to move the price more than, say, 1.5%, it should be disclosed. Regulators could set materiality thresholds by analyzing stock-price movements resulting from trades, based on the transaction's size as a percent of average daily trading volume. As for the timing of disclosure, it would be best to apply the Reg FD standard prohibiting selective disclosure by broadcasting the squawk box to all investors at the same time, not just the brokers in the trading room.

Those in the inner ring would no doubt resist the added transaction costs they would incur. However, over the longer term, stock prices would adjust to the idea that big investors will no longer be able to earn that little bit extra, due simply to the market-moving power of their fat wallets. Investors with the power to move markets owe a duty to smaller investors-and themselves -- to keep a level playing field.

If this helps preserve small investors' confidence in the market, the large ones ultimately will benefit from the added market liquidity. And until their information advantages evaporate, the stock market will remain a weighing machine whose scales slope steeply toward those privileged members of the inner ring.

Published in the October 10, 2005 Barron's

First, do no harm

Through September, stocks mentioned in The Cohan Letter have gone up an average of 20.6% compared to a 1.4% rise in the S&P 500. Part of this gain is due to The Cohan Letter's 2% stop loss rule – which says that an investor should sell a stock that declines 2% from its purchase price. Several stocks mentioned there have been “dropped” due to this rule.

A stop loss is analogous to part of the Hippocratic Oath “first do no harm.” A stop-loss is similar to the Oath in concept because it is based on the idea that investing money depends critically on removing emotion from decision making. If the best that can be done is to stop the bleeding, then that is what should be done – and as quickly as possible.

Many people invest their emotions in a stock along with their money. That is, when they decide to buy a stock, it might be because an acquaintance they respect has recommended the stock. If the stock goes down, they feel it could strain the relationship with the acquaintance and lower their self-respect if they take a loss in the stock.

Conversely, if the stock rises after the tip, the investor will enjoy with the acquaintance who mentioned the stock their shared gain in net worth. Such social reinforcement can be had through many forums – a country club, an investment club, a day trading office, or stock message boards. Some derive emotional rewards from sharing the ups and downs of owning a particular stock. And when they sell the stock, they are afraid of losing that connection.

About 15 years ago I made this mistake – buying shares in a Mexican waste management company at the urging of a professor who I thought was a market guru. I neglected to read the company’s financial report until after I had invested. After I read the report, I kept trying to reconcile this professor’s recommendation with the phenomenally lousy financial performance of the company. This stock lost most of its value as did my respect for this professor’s investment acumen.

I think of the lost money as a tuition payment for a valuable lesson: check your emotions at the door before you invest.