W.I.L. Finance Digest :: May 2009, Part 4

FRIENDS OF THE MISUNDERSTOOD AND UNLOVED

What is wrong with being “just average?” Nothing, to these value investors.

Barron’s frequently features interviews with practitioners of the fundamental value style of investing, that is investors who buy stocks at a discount to their “true” value and hope to profit whent the discount narrows. We almost always find these interviews instructive and interesting – which is why they are featured so often on these pages.

Here is an interview with two value fund managers whose focus is on small- or mid-cap U.S. companies.

Vincent Sellecchia and J. Dennis Delafield are old-fashioned value investors, focusing on smaller companies where they think they can get a better edge compared with, say, IBM or Procter & Gamble. Poring over spreadsheets and company filings, they look for clues that a “change for the better is taking place that is not recognized in the market,” says Sellecchia, and they also spend considerable time talking to management teams. Delafield Asset Management, whose assets total about $800 million, includes the $480 million Delafield Fund [ticker: DEFIX], which Sellecchia, 57 years old, and Delafield, 73, have run since 1993. Although the fund was down 37.6% last year, narrowly trailing the broad market, its long-term record is solid. The fund’s 10-year annual return of 8.43% bests 90% of its peers in Morningstar’s mid-cap value category. Barron’s sat down for a chat with Sellecchia and Delafield last week.

Barron’s: What is your latest read on the stock market?

Sellecchia: The ability for companies to tap the credit markets is clearly helping equities. The equity markets have been remarkably resilient over the last month or so, but they were horrific in the fourth quarter. So in some respects the recent rebound has more to do with how miserable the markets were, along with the fact that the bond market has begun to improve.

Delafield: In retrospect, it has been clear that there was a massive inventory liquidation going on. So companies had to work through that. In some industries that will continue well into this quarter, but it is tapering off.

Has it been any easier to find attractive investments in this type of a market?

Sellecchia: Especially if you go back to the latter part of 2008, valuations simply fell off the cliff. Clearly, it was a period in which we did not know what was going on around us in the world and whether the credit markets were going to be there. In terms of their orders, companies are starting to stabilize on a sequential basis, though they are still down sharply year over year. But now you can begin to put some type of forecast together, coupled with cash flows, and take a look at what these companies will do over the next year or two.

Delafield: For the first time in probably a couple of generations, it has been more important to focus on covenants, bank lines and all of the credit sides of an industrial company, to say nothing of a financial company

Even if you are just looking at equities?

Delafield: That is right.

Sellecchia: Here is the debt-maturity schedule for one of the companies we are beginning to look at. Companies that 18 months ago would have been considered under-levered with a debt-to-capital ratio of, say, 30% to 40% last year became way over-levered and everybody began to question how they could access the credit markets. It was difficult just simply to roll over bank debt.

What did you learn from the recent market meltdown?

Delafield: That is an easy one. If we had realized the severity of the banks’ constriction of credit to companies in general, we could have saved ourselves enormous anguish.

“We had been worried for quite a while, we just were not worried enough.”

Sellecchia: We had been worried for quite a while, we just were not worried enough.

The fund’s cash position was about 13.5% at the end of March, and it is up a little since then. What is behind that?

Delafield: Our cash position reflects the investment ideas that we can find as well as our feel for how the economy is doing and for the valuations in the stock market. At the moment it remains relatively high, though it has been higher. But once the inventory liquidation is over and things have come back more to normal, then we will have to see if we get growth or whether we get stagnation for a while.

We will put people back to work in this country, and we will liquefy the banking system. But it will not happen over night.

Sellecchia: We have raised our cash position somewhat, given the sharp moves in quite a few of our holdings.

Are you concerned that this huge rally since early March might be a head fake?

Sellecchia: For sure. As Dennis pointed out, the question is, what does the economy look like once the inventory liquidation ends? It should naturally lift a bit. But what happens if the economy just plateaus?

How have you changed the portfolio?

Sellecchia: We have not changed our investing philosophy. We have always been very much focused on cash flow, and we are increasingly focused on free cash flow given this environment. We have sold down some holdings that have performed well for us because, as we discussed, it is not that we are worried or that we know that this rally is going to be a head fake – but it could be.

What keeps you up at night?

Sellecchia: The consumer. That is because the consumer has spent like a drunken sailor for years. Now they are doing the right thing and saving. How long does that last, and what is the impact on the economy? And what is the impact on the upturn?

What kind of companies do you look to invest in?

Sellecchia: We are looking for misunderstood companies where, in our view, we have identified a potential catalyst that has not been priced into the stock – and we think it can make the earnings power step up and make this a company that could be perceived in a better light. It does not have to be a very good company becoming a great company. Normally those are not the type of companies that we would have in the portfolio, because their multiples are too rich for us. Instead, we look for what could be an average company becoming better than average, and the market will reward you as if the same rate of change happened with a good company becoming a very good company.

Delafield: While we go across all spectrums and all sizes of companies, it is highly unlikely that Vince or I are going to discover a change taking place in Procter & Gamble that nobody else knows about it or in Texas Instruments before somebody else knows about it. But if you get down to a large middle-size company or a smaller company – and we spend a great deal of time with them – you have time to think about these companies, study them and consider everything, from the board of directors to the control of the company to the management. So there is a greater chance that we may perceive a change that is taking place for the better before the rest of the world perceives that.

Sellecchia: The other type of investment we make is companies that are simply depressed and inexpensively priced based on what we think the cash flows and earnings might be.

You have a small firm that relies on analysts who are generalists, not specialists. What are the pros and cons of that approach?

Sellecchia: It gives us a broader sense of the economy and we can compare different companies across different industries.

Delafield: But we are not so naïve that we think we know the industries the way a more specialized analyst might know an industry. But, fortunately, we can call on many of the industry experts. They provide that expertise to give you the background to go out and ask the questions.

Let’s talk about a few of your holdings.

Sellecchia: Albany International [ticker: AIN]. Its market cap is about $300 million, so it is on the smaller side of what we invest in. Its annual sales are about $1 billion. They are the worldwide leader in the manufacturing of paper-machine clothing. That includes fabrics and belts that are installed on paper machines and carries the initial wet pulp through each stage of production until it becomes paper. So every paper machine needs paper-machine clothing. They have about a 30% share of the worldwide market and they are clearly the dominant player by a factor of two.

The industry has been consolidating because its customers, the paper makers, have been consolidating, both for cyclical and secular reasons. So the International Papers of the world have cut back plants, and that has been accentuated by the cyclical slowdown in the business. So the earnings are down sharply and the stock has dropped from the mid-30s last summer to 10 and change last week, having bottomed at around 5.

What is to like about this company?

Sellecchia: Over the last three years or so, it has been shifting its production capacity. They have been closing capacity in the U.S. and in Europe, and they have been building up major capacity in Asia. That spending is just about to come to an end, and some of the capacity is coming on right now. So they are moving where the growing economies are. Another interesting thing about this company is that they have a small composites business, which is carbon-reinforced fiber that can be used for aerospace markets. Unfortunately, one of their important customers declared bankruptcy, hurting their near-term results, but they have been addressing that.

We like the stock’s yield, which is nearly 5%, and the company has earnings power north of $3 a share, compared with the consensus estimate for this year of 95 cents. It has sound management and the balance sheet looks reasonable, with a debt-to-capital ratio in the low-40% range.

Let’s move on to your next pick.

Delafield: Flextronics International [FLEX], which has a market cap of about $3 billion. It is an electronics-contract manufacturer with operations all over the world. We invested in it after they acquired Solectron, another contract manufacturer, in 2007. That deal got Flextronics into manufacturing more complicated assembly than they had been doing. We knew something about this, and we liked Flextronics’s chief executive and chief financial officer. The thesis behind the acquisition was that by putting these two companies together, they could consolidate the manufacturing facilities to the lowest-cost parts of the world.

But, of course, there was considerable money spent on the restructuring. Today they have about $1.8 billion in cash and $2.9 billion of debt. But people began to worry about the company’s financial flexibility, and the stock price fell sharply. They had to write off a good part of the goodwill because the share price fell below its book value. That triggered a covenant in one of the bank loans that said they could not buy back any of their own stock, and things spiraled downward from there.

What, then, do you like about this company?

Delafield: We continue to think it is a very well-managed company. Yes, revenues are going to be very much lower than anybody expected for the indeterminate future. But the company continues to generate free cash flow and pay off debt. As the economy recovers, they will be in a strong position to take on new business and to get more business from their best customers.

How about one more pick.

Sellecchia: Barnes Group [B] is a company we have known for about 20 years. Its market cap is about $750 million, and it has about $1.36 billion in annual sales from three businesses: aerospace components, industrial components and distribution. The aerospace business is a little bit smaller than the other two. What I like about this company is that if you went back to the second quarter of 2008, the aerospace business had 20%-plus operating margins, the industrial business was earning 15% operating margins, and then you had the distribution business, which was earning less than 5% operating margins. If you cut across that distribution business, the North America piece was earning 10%-plus operating margins, and the international piece was losing money. But it was clear they were going to do something with that business. And, sure enough, they restructured it, primarily in the U.K. They are now in a position that whenever that business does pick up, they should be able to show a nice improvement.

What kind of earnings power does this company have?

Sellecchia: It is north of $3 a share, versus this year’s consensus of around $1.19. If you look at a modest improvement in the earnings next year to, say, $1.25 a share, the stock is trading at roughly 6 times EBITDA [earnings before interest, taxes, depreciation and amortization]. This is one of the companies that was tarred because of the perception that it has too much debt. We added to our holdings, and now Barnes is in a position to begin to pay down that debt. If anything, their position will only widen versus the competition because they are financially strong, and they have top technology.

Delafield: I will answer your question in a slightly different way. If you try to make your investment at a level where you think there is little intrinsic and hopefully little market risk – and we certainly were wrong about that in the last year – you plant a lot of seeds in your garden. Then you can see which plant comes up first and how tall it grows and how strong it looks. And you do not have to have necessarily a goal for each one investment – i.e., that it is going to come up first. You do not know which one that will be. They tend to ripen one after another, and it is sometimes quite unpredictable.

Thanks, gentlemen.

HIGH-FREQUENCY TRADING STRATEGY YIELDS IMPRESSIVE RESULTS USING MODELS OF INVESTOR BEHAVIOR

Roy Niederhoffer’s trading strategy uses computerized models of how the human mind reacts under different market scenarios.

Every trader who relies on a technical system is trying to capitalize on certain regularities of investor behavior, whether the trader thinks in those explicit terms or not. Roy Niederhoffer thinks in those explicit terms. A rough ride in the 1990s while using a contrarian strategy convinced him to try something more sophisticated than just betting against the herd. The ride this decade has been considerably smoothery.

Niederhoffer explains that short-term investor behavior derives from several basic tendencies hard-wired into the human mind:

1. Investors overemphasize recent experience when making decisions;
2. people hate to lose more than they love to win;
3. investors become more predictable as markets become more volatile; and
4. when they are emotional, investors tend to be herd-like in behavior. That last tendency leads to selling when stocks are near a bottom, and buying when rallies are overextended.

Interesting stuff, and well worth thinking about more deeply with regard to one’s own investing behavior.

Few may see a connection between Wagner’s Ring cycle and investing, but to Roy Niederhoffer the parallel is clear.

In Richard Wagner’s epic of four operas, repeating themes foretell musical passages that follow, explains Niederhoffer, an accomplished classical musician and founder of R.G. Niederhoffer Capital Management, a New York-based commodity-trading advisor (CTA). Similarly, he says, changes in stock, currency and commodity prices often lead to predictable short-term investor responses.

Applying this thinking to a high-frequency trading strategy across 55 financial and commodity markets in developed economies has produced remarkable results. Niederhoffer’s Diversified Trading Program, which ranked 9th in Barron’s recent survey of the top 100 hedge funds (“Acing a Stress Test,” May 11), returned 34.6% in the year ended March, topping the BarclayHedge Fund Index by more than 52 percentage points, and the Standard & Poor’s 500 by more than 70 percentage points.

The program, with $480 million in assets as of April 30, also blew past most of the competition in the past five years, with annualized returns of 13.7%. That compares with an average gain of 2.51% for the hedge-fund industry, and an annualized decline of 4.76% in the S&P. Since inception in 1993, Niederhoffer’s strategy has realized annualized returns of nearly 12 percent, more than twice the market average. (BarclayHedge data does not go back that far.)

Niederhoffer, 43, built such a record by studying short-term trading patterns, tracking 10 to 1,000 trades every hour of the day. Indeed, 160 computer screens adorn his Midtown Manhattan command center, not including the Bloomberg over the men’s room urinal. Niederhoffer has sought to capitalize on the predictability of these responsive patterns his analysis uncovered by executing trading programs that target quick gains. His Diversified Program makes thousands of trades a year, ranging in duration from several hours to a week, and occasionally longer. Being right just a little more than half the time is all he needs to generate large profits, Niederhoffer says.

When stocks sold off after Lehman Brothers’ and American International Group’s collapse, for instance, Niederhoffer’s models strongly suggested a short-term market rebound was likely. In both cases, they were right.

Niederhoffer’s analysis ignores company fundamentals and macroeconomic trends.

Niederhoffer’s analysis ignores company fundamentals and macroeconomic trends, which should not surprise in view of his background. A Harvard graduate like his older brother Victor, a Wall Street legend who made and lost several fortunes, Roy Niederhoffer studied computational neuroscience, or how the brain processes information and makes decisions.

As he explains it, short-term investor behavior derives from several basic tendencies hard-wired into the human mind: Investors overemphasize recent experience when making decisions; people hate to lose more than they love to win; investors become more predictable as markets become more volatile; and when they are emotional, investors tend to be herd-like in behavior. That last tendency leads to selling when stocks are near a bottom, and buying when rallies are overextended.

Returns correlate negatively to market and hedge-fund industry benchmarks.

Not only has Niederhoffer produced consistently impressive returns, but he has done so in a way that is important to sophisticated investors: His returns correlate negatively to market and hedge-fund industry benchmarks. Last year, the Diversified Trading Program had a correlation of negative 0.68 to the S&P 500, and negative 0.74 to the Hedge Fund Research Global Hedge Fund Index.

Niederhoffer established his asset-management firm in 1993, investing in major financial and commodity markets based on a handful of contrarian trading rules, seeking to profit from overextended price moves.

After two years of poor performance – 1995 and 1999 – in which stocks soared but the Diversified Trading Program slumped – he realized he needed to broaden his then purely contrarian focus substantially. “Especially at the peak of the Internet-based bubble in 1999, when the market was up by a third and we were off by nearly 20%, we found all our hulls were breached,” he says. “To prevent sinking, we needed greater diversification.”

So Niederhoffer introduced a series of investment strategies – or families, as he calls them – that balance contrarian positions with momentum plays of various duration and conviction. He also added new trading rules, developing 60 in all, that undergird his strategies and relate to the predictive nature of recent market performance.

Unusual for a CTA, Niederhoffer likewise added individual stocks to the portfolio, choosing from a universe of the 800 most liquid stocks in the U.S. and Europe. “Each morning we apply a screen that identifies the stocks with the greatest recent liquidity, and those are the stocks we trade [for entry] that day,” he says, noting the firm will likely be adding Asian equities in the near future.

The new rules and new shares led to dramatic improvement in the Diversified Trading Program’s performance. From inception through 1999, annualized returns were basically flat. From 1999 through March 2009, however, the Program’s annualized gain exceeded 17% with less actual risk.

Niederhoffer wrote the original computer code to test and run his trading rules. He designed the Diversified Program to search for and trade on uncorrelated market positions, and to increase its emphasis on short-term momentum to counter positions that are losing money. (He declines to provide specific examples of how this works.)

The program is calibrated to reduce leverage and risk when value at risk – the amount the program could lose in any one period – exceeds certain thresholds. The firm’s risk-management committee can step in to reduce risk at anytime, sometimes through buying options to protect larger positions.

The program will apply additional defensive measures when a monthly drawdown, or decline from a peak, exceeds 8%. Collectively, such features help to limit average daily volatility to 1% and annual volatility to 16%.

In March, these measures limited the loss Niederhoffer incurred when he boosted his net long position on U.S. Treasuries to 30% from 5%, after the Federal Reserve announced it was purchasing Treasury bonds to pump capital into the economy.

The Fed’s apparent commitment to “quantitative easing” sent 10-year Treasury rates plummeting to 2.5% from 3.0% in a single session as prices rose sharply. But the rally did not hold, and rates rose back to 2.64% by the closing on Friday.

The firm’s model triggered a Sell, limiting the loss to 1%. It could have been worse: Treasuries subsequently slid by another 1.25 percentage points.

Most of the time, Niederhoffer’s bets are in the black. In just a few days last July, as commodity prices were in free fall, oil-futures prices collapsed to $136 a barrel from $145. At the time, the Diversified Trading Program was 15% net short oil and gas futures, which were moving in tandem. Niederhoffer’s screens signaled the selloff was excessive, and the program moved to 15% net long exposure. Within 48 hours, oil had rebounded to $140 a barrel, at which point the program moved to a Sell, netting it a 2% gain on the investment.

On September 18, the government announced a temporary ban on short selling of financial stocks. That sent the market up nearly 12%, as short sellers were forced to cover their positions. Soon after, however, Niederhoffer’s contrarian models flashed an indication that the market was extremely overbought, and set up a 60% net short play in S&P 500 futures. By September 22, stocks had sold off, and Niederhoffer exited his short position with a 4% gain.

The program also works with currencies. After falling against the dollar for most of January, the euro started to rally in the last week of the month, rising to $1.32 from $1.29. The firm’s screens said this was only a temporary reversal in the dollar’s rally, so the program went 25% net long the dollar. In two days, the euro had fallen back to $1.30 and the position was sold, netting Niederhoffer nearly 1%.

This year has been rougher for Niederhoffer. His program was down 1.9% through April – a fact that underscores the difference between Niederhoffer’s strategy and those of many other investors. With the stock market lifting off in March, an equity-trend follower could have ridden stocks higher. An ultra-high-frequency trading strategy typically profits, however, when price movements are constantly reversing course.

Having missed out on one of the great rallies – stocks have risen 30% from their March lows – does not concern Niederhoffer, however. To the contrary, he likens it to a 100-year flood. “You cannot design a program around this very rare event, and you certainly do not readjust your strategy to it,” he says.

Given the challenges still plaguing the global economy, he expects the current rally to run out of steam, and markets to turn more volatile. And that would be just fine for Roy Niederhoffer.

INFLATIONISM’S SEDUCTIVE BATTLE CRY

Incredibly, after so many failed attempts as using manipulated inflation levels as a policy-making tool, we still have some mainstream economists recommending a little more hair-of-the-dog inflation as a way to help reduce real consumer debts. The idea recalls a bumper sticker seen on Texas cars in the later 1980s: “Lord send me one more oil boom. I promise I won’t piss it away this time.” Just one more little bout of inflation, Lord, and I promise I will allow it to work its magic in reducing my real debt. No leveraged bets on inflation plays that spring to life when central banks inflate this time. Yeah, sure I believe you.

Doug Noland makes quick work of this utter nonsense. “The notion that there is a system price level easily manipulated by our monetary authorities to produce a desired response is an urban myth,” he says. I.e., implementing the idea is not even really an option at all. Second of all, the government creates inflation by creating more debt. Even if consumers go along with the gag and reduce their personal debt, they are still on the hook for all the created government debt. Exactly what has been accomplished? Thirdly, while the Fed could indeed create/inflate system liquidity, rather than the stimulus being directed to the intended particular liquidity-challenged sector it would instead flow instead to where liquidity was already prevalent. The effect would be like using grain alchohol to cure a vodka hangover. And finally, inflationists unerringly call for “whatever it takes” stimulus to counter the bursting of the bubble, ignoring that this activist policymaking was instrumental in extending and worsening a systemic credit bubble.

So the inflationists are uncredible wishful thinkers utterly lacking in rigor. They are decendents of alchemists, promising to turn crappy assets and ideas into economic vitality. If one appears at your front door, leave through the back and run as fast as your legs can carry you.

May 22 – Bloomberg (Dakin Campbell and Mark Crumpton): “Bill Gross, the co-chief investment officer of Pimco ... said the U.S. “eventually” will lose its AAA rating, but not any time soon. Both the U.K. and the U.S. have prospective deficits of 10% annually as far as the eye can see. ... At some point over the next several years’ the debt of each “may approach 100% of GDP, which is a level at which country downgrades tend to occur,” he said. ... Gross’s comments today come two months after he said the U.S. government will need to spend as much as $4 trillion in additional capital to cushion a slowing economy. The Federal Reserve said March 19 that it would purchase $1.8 trillion in Treasuries and housing-related debt to lower borrowing costs. “We need more than that,” Gross said at the time. The Fed’s balance sheet “will probably have to grow to about $5 trillion or $6 trillion,” he said.”

May 19 – Bloomberg (Rich Miller): “What the U.S. economy may need is a dose of good old-fashioned inflation. So say economists including Gregory Mankiw, former White House adviser, and Kenneth Rogoff, who was chief economist at the IMF. They argue that a looser rein on inflation would make it easier for debt-strapped consumers and governments to meet their obligations. It might also help the economy by encouraging Americans to spend now rather than later when prices go up. “I am advocating 6% inflation for at least a couple of years,” says Rogoff ... who is now a professor at Harvard. ... “It would ameliorate the debt bomb and help us work through the deleveraging process.” ... Given the Fed’s inability to cut rates further, Mankiw says the central bank should pledge to produce “significant” inflation. ... That would put the real, inflation-adjusted interest rate ... deep into negative territory, even though the nominal rate would still be zero. If Americans were convinced of the Fed’s commitment, they would buy and borrow more now, he says. ... In advocating that the Fed commit itself to generating some inflation, Mankiw ... likens such a step to the U.S. decision to abandon the gold standard in 1933, which freed policy makers to fight the Depression. ... Inflationary increases in wages – and the higher income taxes they generate – would make it easier to pay off debt at all levels. “There is trillions of dollars of debt, in mortgage debt, consumer debt, government debt,” says Rogoff. ... “It is a question of how do you achieve the deleveraging. Do you go through a long period of slow growth, high savings and many legal problems or do you accept higher inflation?”

A few more nails in the coffin of what is left of the credibility of conventional economics. Any idiot can see that the markets are not going to just sit still while the deleveraging planned by these world-improvers takes place. Theory and experience tell us the result will be contrary to intention, diamonds to dollars. We will not even mention the outright immorality of purposely stealing 6% of lender capital per year and giving it to debtors. Oops! We just did.

S&P’s move this week to lower the outlook for Britain’s credit rating brought the spotlight on the even more disastrous U.S. debt situation. And it does not help the situation that the dollar has found itself under renewed pressure of late, with even the British pound gaining about 5% this week against our currency. Rather ironically, two of our nation’s prominent economists called this week for the Federal Reserve to move even more aggressively to spur credit expansion and stoke inflation. It is difficult to comprehend how – with credit and inflation lessons that should have been learned by this stage in the cycle – inflationism remains so ingrained in economic orthodoxy. Yet the long and sordid history of inflation should have had us on guard. Inevitably, the typical policy response to the hardship wrought from an inflationary credit boom is the hope for some positive impact from one “final” bout of inflation.

I will commence this week’s discussion making the point that the issue is not whether the U.S. “inevitably” loses its AAA rating. Rather, the focal point of the current economic debate should be on whether our well-intended [ha!] policymakers (fiscal and monetary) have charted a course that risks bankrupting the entire economy. I will continue to argue that the paramount policy priority should be avoiding such an outcome. And I will add that there is ample confirmation these days of the inherent propensity for inflationary developments to proceed toward the worst-case scenario.

Dr. Rogoff, advocating 6% (consumer price) inflation, believes a rapidly rising price level would “ameliorate the debt bomb and help us work through the deleveraging process.” I disagree on both counts. Trillions of government debt issuance only worsen potential “debt bomb” consequences. There is a school of thought that holds that policymaking is today lessening the debt service burden. This may be somewhat true for the household and financial sectors. I would argue, however, that the benefits to American households are actually far outweighed by the systemic risks associated with the redistribution of multi-$trillions of debt and assorted risks to the Federal government (inclusive of the Federal Reserve). And this is an especially inopportune time to aggregate escalating systemic risk in Washington.

This aspect of the “debt bomb” – or, in my nomenclature, credit bubble dynamics – is not readily discernable today. While federal debt will likely expand an astounding 13% of GDP this year, the optimists take comfort that total federal debt as a ratio of GDP is not yet at a problematic level (and much less than Japan!). Yields are rising, but Washington has no problem selling its paper today. Nonetheless, a crisis of confidence in the Treasury market would be catastrophic. The consensus view believes that Fed-induced low mortgage rates (and resulting refinance boom!) are spurring system repair. I would argue that the associated massive redistribution of mortgage risk (credit, interest rate and liquidity), especially to the failed GSEs, is a real time bomb.

The “debt bomb” is not being diffused. Rather, the fuse is being somewhat lengthened as the bomb enlarges.

Dr. Rogoff and others believe policymakers are these days “ameliorating” the deleveraging process. My analytical framework takes a contrasting view. The critical “deleveraging” process at this point would amount to weaning the U.S. Bubble Economy off of its currently required $2.0 trillion or so of annual credit growth. The issue is at its heart embedded deep within the economic structure and will not be cured through additional credit inflation. Current policymaking is shifting the debt burden from the private sector to the federal government sector – and, in the process, increasing the total system (non-productive) debt burden by another $2.0 trillion or so annually. Moreover, I would argue that this momentous government (Fed and Treasury) intervention in the pricing of finance further corrodes our system’s process of allocating financial and real resources. The “debt bomb” is not being diffused. Rather, the fuse is being somewhat lengthened as the bomb enlarges.

Professor Mankiw believes that if U.S. consumers understood that prices were going to rise they would borrow more and accelerate purchases – and this would better our economic plight. But our economy does not produce enough of what they would likely want to buy, so our current account deficit would rapidly reflate. The dollar is already weakening, which means upward pricing pressure for imports (not to the benefit of the household sector or for system stability more generally). Besides, I would argue that rising inflation expectations lead quickly to purchases of foreign stocks, bonds, gold, energy, commodities and other “undollar” assets. As we have witnessed in the markets over the past few weeks, the latent (weak dollar-induced) inflationary bias in non-dollar asset-classes can emerge and quickly feed on itself.

At the end of the day, it is our maladjusted economic structure in concert with speculative market dynamics that will likely dictate future inflationary characteristics. The notion that there is a system price level easily manipulated by our monetary authorities to produce a desired response is an urban myth. During the 2000-04 reflation, I would often note that “liquidity loves inflation.” The salient point was that the Fed could indeed create/inflate system liquidity. It was, however, quite another story when it came to directing stimulus to a particular liquidity-challenged sector. Almost inherently it would flow instead to where liquidity – and resulting inflationary biases – were already prevalent.

If the dollar bear has resumed, the global inflation/monetary disorder issue could quickly reemerge. Federal Reserve efforts to reliquefy our system would be expected to prove self-defeating in a backdrop of significant dollar and Treasury market weakness. Such a scenario would expose what I believe is a major flaw in the conventional economic view that there is a trade-off available between the difficulties inherent to a long economic workout and the acceptance of a higher level of inflation. I fear the current policy path ensures an especially arduous and protracted adjustment period – along with myriad problems associated with an unwieldy inflation backdrop.

I also want to take exception with Professor Mankiw’s likening of a Fed push toward higher inflation to the decision to abandon the Gold standard in 1933. This gets back to the disagreement I have had with the “inflationists” for years now: In the name of Keynesian economics, inflation proponents have repeatedly called for massive stimulus in response to the bursting of THE Bubble, while in reality this activist policymaking was instrumental in only extending and worsening a systemic credit bubble. This was especially the case after the bursting of the technology bubble and is again true today following the bursting of the Wall Street finance/mortgage finance bubble. Now, more than ever before, “Keynesian” inflationism is THE Bubble. When it eventually bursts Washington policymakers will have little left to offer.

THE HOUSING HURRICANE WILL HOWL AGAIN

We are out of the eye of the hurricane, but here comes the back half of the storm – says a real estate broker from Florida, who ought to know.

Mike Morgan owns Morgan Florida, which offers residential, commercial and investment real-estate services and research. His in-the-trenches perspective indicates we are nowhere near a housing bottom. Too much inventory, too many foreclosures, too much unemployment, etc. Perhaps most to the point is that asking prices for houses have not fallen down to the value supported by what one could rent the house for. Until that level is approached it does not make sense to buy unless you expect capital gains to make up the difference, and when prices are falling this assumption would be a heroic one.

A lot of people think that we have seen the worst of the housing crisis. They are talking about green shoots and glimmers of hope, when they should be back in the storm shelter, preparing for a flood of inventory that will overwhelm the markets and produce another round of falling prices.

For the past few months there has been a semi-moratorium on foreclosures. Most institutions with delinquent mortgages did not foreclose. The signs that blanket many neighborhoods have been posted by a fraction of the lenders. Now the rest of the banks are rushing to get their properties on the market.

As a Florida real-estate broker who works with bank asset managers to dispose of foreclosed properties, I get a good view of this market. From December 2008 through mid-March 2009, the number of asset managers calling to discuss REO (real estate owned) properties on their client bank–r books dropped by more than 80% from the level at which it previously had been running. In the past two months, however, asset managers have been busy, with most interested in how many properties we could handle at once.

Law firms for banks are once again lining up to file foreclosures and to process evictions. The asset managers we work with have warned us to expect a flood of properties, beginning in early June. This will hit as the number of potential buyers continues to dwindle. Builders, traditional sellers and investors who entered too early are already loaded with REO properties.

All of the Obama administration’s attempts to revive, resuscitate and shock the housing markets into recovery have failed. Potential buyers cannot purchase homes when they are losing their jobs, regardless of how attractive the credits and mortgages are. The price of homes will continue to fall until the properties are affordable for potential buyers.

Housing costs and rental values still way out of line in most critical markets.

If an investor could purchase a home and rent it out for close to breakeven, we might be getting close to a bottom. But we are nowhere close to that level in most critical markets. Until it is approached, prices will continue to fall. In fact, the negative cash flow now evident, along with the flood of properties coming into the inventory pool, warn of lower prices.

There is no light at the end of the tunnel yet. We are still supporting builders through misguided programs that are only adding to the inventory woes. California decided to offer a $10,000 credit to buyers of new homes, on top of the $8,000 federal credit. But California made the $10,000 available only for new homes purchased directly from builders. That shows the power of the builders’ lobby, but it only adds to California’s housing-industry problem. It encourages builders to construct dwellings we do not need, and it penalizes anyone else trying to sell a home.

Housing inventory soon will flood a market in which more than 500,000 homes are being built each year, even though the annual sales pace for new homes is closer to 300,000. We must also deal with a system clogged with impossible short sales, a surge of second and vacation homes being dumped, and third-wave flippers realizing that they entered the market too soon.

For the banks, the back half of the hurricane will destroy balance sheets, unless the Obama administration comes up with another plan to mythically mark these assets on the books. Or we might see some chimerical plan to write down mortgage payments, or move toxic mortgages into a dark pool, or create some new illusion that glosses over the problem.

Experience indicates banks selling real estate owned realize about 50%-75% of what they initially think they will get.

Our experience with banks’ selling REOs is they realize about 50%-75% of what they initially think they will get. Moreover, their expenses to bring these properties to market and manage them are growing. Court systems bogged down with foreclosures are raising fees so that they can hire additional staff. More and more homeowners being evicted are stripping homes to the bone, removing appliances, fixtures, carpet, cabinets, air handlers, motorized garage-door openers and anything else that they can carry off or sell.

Unemployment presents a two-pronged problem. If homeowners lose their jobs, they have difficulty meeting mortgage payments. And a high jobless rate forces more people to put their homes on the market.

During the housing bubble, many second homes were purchased with the mythical equity from primary residences. These second homes are coming onto the market at an alarming rate, as many middle- and upper-class sellers need to raise cash. In some very exclusive private communities in Florida, where home prices are in the seven figures, more than 50% of the homes are on the market. (For more on the vacation-home market, see Cover Story.)

Unfortunately, there are no signs of recovery, despite the hype and the twisting of numbers in many media reports. The end of the unofficial moratorium on foreclosures, combined with rising unemployment, signals that the back half of this housing hurricane is only just beginning.

TIME TO BUY AN IPO

Basic not surprising fact: Buying IPOs when the market for IPOs is “bad” – for sellers, that is – generates good returns on average for buyers. During times of IPO manias the concomitant expensive prices practically guarantees pain down the line for buyers.

This has been a very tough year for getting IPOs out the door. The conclusion is obvious.

The market for initial offerings has never looked so dry. Through April only four companies made stock debuts this year: Mead Johnson Nutrition, Changeyou, Bridgepoint Education and Rosetta Stone. Before the $828 million February offering for Mead, a baby food company carved out of Bristol-Myers Squibb, there was a 3-month drought. Grand Canyon, a for-profit university, offered shares in November.

The near evaporation of new-issue funding is tough on privately held companies in need of cash and private equity firms in need of an escape hatch. It is not necessarily bad for investors. Lean years often make for lush returns.

The reason is simple: supply and demand. When times are good and investors flush, investment bankers toss all manner of red meat into the initial public offering market. Remember tech-boom flops Webvan and Pets.com? In bear markets it is mostly companies with such allures as sound operating histories and consistent earnings results that make the cut.

Take the 3 years in the past 35 with the smallest crops of new issues: 1975, 1976 and 1977. If you had bought every one of the 59 offerings during those years, you would have averaged a 30% annual return in the three years following the offering dates. The S&P 500 averaged a mere 9% annual return during the same periods. Now consider the three busiest years for new issues: 1993, 1996 and 1999. Had you bought all 1,632 new stocks, your average annual gain with 3-year holding periods would have been 1%; the corresponding average for the market was 14%.

On the latest shoulda, woulda, coulda list: Mead Johnson, up 20% from its offering, and Grand Canyon, up 18%.

Exceptions abound. For all of 2008 a total of 25 companies went public; only 5 are trading above their offering prices. The average relative-to-market performance of the 25 (on a scale where tracking the S&P 500 is scored as 100) is 117.

Renaissance Capital’s IPO Index (at ipohome.com), which tracks returns on public offerings made during the previous two years, has climbed 18% so far this year, far ahead of the S&P 500’s 2.3% gain. The market-cap-weighted index’s outperformance is largely due to the nifty performances of giants Mead Johnson and Visa. Visa’s $19.6 billion March 2008 offering was the largest ever. These two companies are still buys, says Kathleen Smith, a principal at Renaissance, whose IPO Plus Fund owns shares of both firms.

Visa has proved to be an impressive cash machine. Unlike rival American Express, Visa does not have to write off balances of deadbeat consumers; that responsibility belongs to banks that issue its cards. Even as the economy tanked, consumers in Africa, Central Europe and the Middle East whipped out their plastic. For the March 31 quarter net income rose 70% to $536 million.

Smith also likes Mead Johnson’s size and profitability: $450 million in net income on $2.8 billion in sales. As with Visa, the majority of growth is expected abroad.

Rosetta Stone, which sells learn-a-language CDs, got a warm welcome on Wall Street. Its shares are up 23%. Bridgepoint Education, an online college, is off 1%.

In the pipeline: some solid outfits owned by private equity firms in need of cash. One such is Liquidnet Holdings, operator of a stock crossing service that caters to institutions looking to trade blocks of shares anonymously. It is owned by th Lee Putnam Ventures and Summit Partners. Benjamin Holmes, publisher of equity research Web site MorningNotes and manager of an affiliated fund, expects Liquidnet to benefit from continued stock market volatility and, if it continues to grow, a buyout by a bigger exchange.

Renaissance Capital’s Smith thinks Emdeon (HLTH), which manages health care payments, should benefit from the Obama Administration’s ambition to streamline paperwork. Emdeon posted $98 million in operating income (EBITDA) on $830 million in sales last year.

Holmes has his eye on A123 Systems, a maker of rechargeable lithium-ion batteries for cars and buses that should benefit from stimulus handouts (see story, “Battery Scramble”). “The money fire hose will be pointed at batteries,” Holmes says. “Government may be dumb, but it’s rich.”

BUY JUNKY CURRENCIES

If you can stomach the occasional devaluation, it makes sense to own an assortment of trashy-looking foreign exchange contracts.

In a truly efficient market the high yields of “junky” currencies – we could be talking the U.S. dollar here, but that is another story – should be offset by their expected depreciation. In reality, a trio of academics say, you do just fine with junky currencies as long as you diversify. Perhaps the “strong” currencies are junkier than we think, although the academics are silent on this conjecture.

It is June 2006 and you are looking for a low-risk investment. The financial crisis is not even a rumble on the horizon yet, but you are wary of anything connected to the easy-money-fueled run-up in real estate and stocks. You decide to borrow Japanese yen, exchange them for dollars and stick the proceeds into one-year U.S. Treasurys.

The yen cost you less than 1% to borrow, while Treasurys are paying more than 5%. Since banks require you to put down only 20%, the four-percentage-point interest rate spread earns you a 20% annual profit. Bear markets, bankruptcies and changes in governments do not bother you. The only thing that can go wrong is if your dollars fall in value against the yen that you must repay.

This, essentially, is the currency arbitrage strategy known as the carry trade. Why should a small investor care? Because the carry trade is an attractive way to earn a buck or pound or euro – as long as you are patient and avoid excessive leverage. In fact it offers respectable risk-adjusted returns that are conveniently uncorrelated with those of stocks.

That is according to “Carry Trades and Currency Crashes,” a 2008 paper published by three professors, Stefan Nagel of Stanford, Markus Brunnermeier of Princeton and Lasse Pedersen of New York University.

The crux of their argument is that the higher money market yields on weak currencies more than make up for their weakness (risk of devaluation, that is). Buy a basket of money-market instruments denominated in shaky, high-yielding currencies like the Australian and New Zealand dollars and you will, over the long term, do better than you would owning paper in strong, low-yielding currencies like the Japanese yen or Swiss franc. You could capture this excess return simply by switching your money market investing to weak spots. Or you could make an equivalent bet by using the futures market to take long positions in weak currencies.

How did that Treasury/yen arbitrage work out? It worked – for a while. While you were earning the four-percentage-point spread between the 1% cost of yen and 5% return on one-year Treasurys, the dollar also appreciated 7% to 123 yen in June 2007.

Economic theory posits a world in which easy profits like that are precisely offset by disasters in which the currency being bought falls in value relative to the currency being borrowed. Sure enough, in last fall’s financial crisis the dollar plunged against the yen, ruining that carry trade.

Theory says that there is no easy money to be made. History says the opposite: Long positions in high-yielding currencies come out ahead.

The theory says, in other words, that there is no easy money to be made. And yet history says the opposite: Long positions in high-yielding currencies come out ahead. This is, in the economists’ word, a “puzzle.”

Before we get into the economics of the puzzle, let us look at the arithmetic of currency futures. If the one-year Libor (bank lending rate) is 2% for U.S. dollar borrowings but 3% for the Danish krone, there is going to be a built-in deterioration in the value of kroner in the futures market. Say that the spot value of a krone is 18 cents. Then the futures value one year out should be 17.82 cents, or 1% less. Why? If the June 2010 krone future were any higher than 17.82 cents, banks could lock in profits by borrowing dollars at 2% and lending kroner at 3%, while erasing their currency exposure by selling kroner futures.

The professors did not find any surprises in such arbitrage arithmetic. After all, if prices got out of line traders would pounce on the discrepancies. Rather, the paper looked at people who take long positions in weak currencies and short strong ones. They buy krone (and peso and baht) futures and sit on them. These investors have nothing locked up; they are speculating.

Now if the krone winds up worth more than 17.82 cents in June 2010, the futures buyers make a profit. Going long a weak currency (especially one with really high interest rates, like Brazil’s real) is risky, since every now and then it gets whacked with a devaluation. The surprise: Long positions in weak currencies wind up, over time, in the plus column.

How risky is it to own shaky currencies? Not horribly if you buy a lot of them. The professors’ research indicates that by buying high-yielding currencies and hanging on investors get returns similar to historical averages for the S&P 500 but with 43% less volatility.

The downside: black swan events of the sort described by finance professor Nassim Taleb. These are rare but inevitable financial cataclysms of the sort the world is now suffering. When Lehman Brothers collapsed, panicked lenders called in their loans. Hedge funds and other carry trade investors saw the value of the high-yielding currency they were holding, like the Australian dollar, collapse. With so many yen loans needing to be repaid, the currency also advanced 20% against the dollar last year. All told, years of yen-dollar carry trade profits vanished.

That was mild compared with Iceland’s experience. Its banks were playing the carry trade by gathering low-cost deposits in Europe (in euros and pounds) and lending them out at home at 14%. The financial crisis wiped out 2/3 of the value of Iceland’s krona versus other currencies’. Its leveraged banks and citizens could not repay the foreign currency they had borrowed. Street protests swept Reykjavik. The banks were nationalized. In January the government collapsed.

The lessons: (1) Diversify. (2) Go easy on the leverage. For every $100,000 you have to play with, your long currency positions should total only $200,000.

HOW TO MESS UP A SUCCESSFUL COMPANY BY “UNLOCKING” ITS REAL ESTATE VALUES

Target’s stellar reputation should keep activist shareholder at bay.

Hedge fund operator Bill Ackman’s fund holders took a bath on his investment in Target call options. He is trying to recoup some of the loss by forcing Target to spin off its real estate into an REIT, thereby allegedly realizing some heretofore unloved and unappreciated real estate values. Critics say Ackman is off-target.

Among the criticisms is that the idea that the two parts would be valued at greater than the current whole is “financial alchemy.” We can readily see that point. Target’s real estate’s value depends on Target’s performance as a retailer like a silk glove depends on a hand to give it structure. There is no diversifiable risk to be separated out here. There may be some value to be realized due to the tax breaks available to an REIT, but we are talking small change here.

Another criticism is that Target is essentially the only general retailer who has prospered going head to head with Wal-Mart. The last thing it needs is to have its financial flexibility constrained by taking on more leverage.

The legitimate points made by Ackman is that Target should have unloaded its credit card receivables portfolio when the getting was good, and low equity ownership by the board – who Ackman is trying to replace.

Do the points in Ackman’s favor outweight those against. Ackman airs out his his point of view below – which, one will see, is quite different than the one presented by the article writer or the Target board of directors.

Target, one of the nation’s most successful retailers, is under attack by an activist investor who has lost his shirt, and his clients’, in a hedge fund that bet the wrong way on the direction of the company’s shares. Bill Ackman, head of Pershing Square Capital Management, launched the unusual single-stock fund, Pershing Square IV, in 2007, investing $2 billion only in Target call options and other derivatives. The fund lost 90% of that money as Target’s shares plummeted 50%, to 31 earlier this year. The fund has recovered somewhat since then, as the shares have rebounded to 41, but it remains down about 80% since inception.

Another hedge-fund hotshot gone cold might concede defeat in such circumstances. But Ackman, who manages $4.5 billion, and whose other, diversified funds have produced impressive annualized returns of more than 20% in the past 5 1/2 years, is ramping up the pressure on Minneapolis-based Target (ticker: TGT) – as if a brutal economy has not exerted enough. Pershing Square, which owns 24.8 million Target shares, as well as options on 20 million shares, has mounted a proxy fight to get any of Ackman’s five candidates – himself included – onto the Target board, replacing incumbents favored by management. Results of the shareholder vote should be released around the time of Target’s annual meeting on [May 28].

The battle between Ackman and Target boils down to whether a sizable but not dominant institutional share-holder – he owns about 3% of the stock – is entitled to board representation, and whether a well-managed company ought to be free from the input and potential interference of such a shareholder in the boardroom.

Many on Wall Street think Ackman should leave Target alone and let management run the business without undue meddling. The betting is that Target will fend him off because of the company’s strong standing in the investor community, not to mention Ackman’s limited stake.

“Institutional investors are loath to support a dissident in the absence of a strong showing of malfeasance on the part of the directors,” says Greg Taxin, a principal at Spotlight Capital Management in New York. “There is very little to complain about at Target.”

Target is taking the Ackman challenge seriously; management has met with top holders and fired off a series of letters to shareholders. Chief Executive Gregg Steinhafel began the company’s earnings conference call [May 20] with a 10-minute address about the proxy fight that included a defense of Target&Rlsquo;s slate, including Wells Fargo Chairman Richard Kovacevich. Steinhafel blasted the Pershing Square plan to separate Target’s real-estate holdings as “risky” and “speculative.”

Ackman’s initiative could be one of the worst-conceived efforts in recent years by an activist investor, considering the dubious benefits his proposed strategy might produce. Target is the only major retailer that has thrived while going head to head with one of the world’s most formidable companies: Wal-Mart Stores (WMT).

“Ten years ago there was a host of regional discounters, and Target was the one that emerged successfully with much more limited resources than Wal-Mart. It is a remarkable achievement,” says Michael Exstein, a retailing analyst at Credit Suisse. “Not all of America wants to shop at Wal-Mart, and Target is the best alternative out there.” Among retailers, Target has the third-largest market value – $31 billion – behind Home Depot (HD) and Wal-Mart.

Target stock has bested its retailing peers and the Standard & Poor’s 500 index in the past decade, and the company’s earnings have nearly doubled in the past five years. Its fiscal first-quarter profit of 69 cents a share, reported last week, topped expectations and was down a modest 7% from year-earlier levels. Revenue was up slightly to $14.4 billion, making it one of a handful of retail giants to post sales gains. Bulls like Exstein say the stock can hit $50 in the next year. Target now trades for about 14 times projected 2009 profits of nearly $3 a share.

Target has succeeded with a mix of staples and style that has attracted a more affluent customer base than Wal-Mart, particularly young women who come to the stores for low-margin toothpaste and diapers, as well as higher-margin clothing and housewares. Female shoppers account for an estimated 75% of Target customers.

Target is following a financial program that worked well for Wal-Mart in 2008, when the Bentonville, Arkansas, behemoth was one of only two stocks in the Dow Jones Industrial Average that registered a positive return (the other was McDonald’s ). Target has scaled back new-store openings and capital expenditures, which could produce more than $2.5 billion of free cash flow this year, and even more in 2010, compared with negative free cash of about $800 million in 2008. The added funds could allow the company to cut debt, resume its share-repurchase program or increase its dividend, which yields a modest 1.5%.

The Ackman initiative is tamer than most activist campaigns that flag underperforming companies and urge significant corporate actions, such as major divestitures or outright sales of the company. Activist investor Carl Icahn generally has sought major changes when he has tangled with companies such as Motorola, Time Warner and Yahoo!.

Ackman has no beef with Target management. “What we have here is not a management problem, but a board problem,” he said ... His view is that the Target board is too “cozy” and “insular” and lacks members with requisite retailing, credit-card and real-estate backgrounds.

In a letter to shareholders, Ackman said the company “has substantially underperformed its potential” due in part to the board’s failure to sell Target’s credit-card operations, and that it should consider moves to “unlock real-estate” value. He has said Target’s real-estate portfolio, mostly land and stores, could be valued at $40 billion, or nearly as much as the company’s enterprise value (equity-market value plus net debt). Target has about $12 billion of debt outside its credit-card operations.

Two real-estate analysts contacted by Barron’s question how much value could be created via an Ackman real-estate proposal made last year that involves placing the land under Target’s stores into a real-estate investment trust and leasing back the land from the REIT. This would cost the company about $1.4 billion in annual rent. Ackman’s premise is that the lease payments, roughly 20% to 25% of Target’s annual cash flow, would garner a higher valuation inside a REIT structure, and that the Target REIT and new Target without real estate would be worth more than the current Target.

Ackman plan relies on “financial alchemy.”

Mike Kirby, head of research at Green Street Advisors, a California real-estate specialist, says “there is a bit of financial alchemy attached” to the plan. “Ackman may have a point, but usually these proposals have a ‘too good to be true’ element.”

Kirby says, “For a REIT to get a high valuation, it needs to have a secure cash-flow stream, and for Target, excluding its real estate, to have a high valuation, investors have to feel secure about its creditworthiness.”

Kirby says single-tenant REITs like the one envisioned by Ackman are not too popular with investors, who like a diversified tenant base. “It definitely is not something that people get excited about,” he says.

“Transferring all of this real estate would constrain Target’s flexibility to make renovations, expansions and enhancements that are part of the ongoing evolution of any retailer,” wrote Richard Sokolov, president of Simon Property Group, the biggest U.S. mall operator, in a recent letter supporting Target. “Most of the retailers we deal with would be very pleased to own all of their real estate and have the financial strength and flexibility that Target has today.” It is tough enough competing with Wal-Mart with a great balance sheet, let alone with a weakened one.

Besides, valuations in the REIT sector are depressed. Target trades for about eight times projected 2009 pretax cash flow, while a Target REIT might not command much more than 10 times cash flow.

Ackman also criticized Target for not selling its credit-card operations, which have about $8 billion in receivables. Most major retailers have gotten out of the card business. Target sold a 47% stake to JPMorgan Chase in 2008, but retained significant credit risk from the portfolio. The company took a sizable charge in the fourth quarter to build reserves, and its losses on the portfolio hit 16% in April, although it is still profitable.


Ackman has some legitimate beefs with Target, including low equity ownership by the board. Two board members own no stock beside stock option and equity grants. Target’s sales performance has trailed that of Wal-Mart in the past year, although that has come after several years when Target bested its larger rival.

While there may be merit in some of Ackman’s arguments, Target remains one of the best-run retailers in the country. His proxy fight seems to have a lot to do with ego and has been a major distraction for management at an otherwise challenging time. Indeed, it seems time to buy Target shares, not Ackman’s campaign.

The Would-Be Unlocker Responds

Hedge fund operator Bill Ackman responds to the above piece, and reveals why in a trial both sides are allowed to testify. His major points: (1) The overriding issue is the insularity and resistance to outside ideas of Target’s management and board; (2) his REIT spinoff proposal actually makes sense, because it is just the land underneath the stores he wants to separate out, as opposed to the whole land/stores shooting match.

The actual REIT proposal by Ackman does make more sense on the face of the it. The more interesting angle is the 1980s-style complacent and entrenched management vs. upstart, value-enhancing, gunslinging outsider. Michael Milken gained his maximum notoriety by junk-bond financing such outsiders. One of the early bubbles well before the final bubble saw junk bonds used to finance takeovers that had no margin for error, or that never should have been made in the first place ... ever. But initially they were used to finance entrepeneurs to buy companies whose public value was depressed by incompetent management. With the takeover and capable management installed, the leveraged financing worked out OK for everyone. Ackman is far lower key and more modest in his stated aspirations, but the context has the aforesaid flavor.

So what is the difference in this case? It is not clear that Target is selling at that depressed a price. The notional arbitrage between the hypothetical sum of the parts’ values and the current stock price may be positive, but it is not huge. So, Ackman may be correct in principle on his major points. The issue is whether fixing them would make any practical difference. Ackman’s assertion is it would, but conservative money managers may view this as betting on the come.

To the Editor:

As a long-time Barron’s reader, I was disappointed to read Andrew Bary’s recent article, “Ackman’s Target Campaign is Off-Target,” [see above] which does your readers a disservice for it fails to accurately characterize what our proxy contest at Target is about, and is riddled with numerous materially false and misleading statements.

Pershing Square has been one of Target’s largest shareholders for more than two years. Over the last two years, we have had a constructive and cordial dialogue with Target management about various strategic initiatives which we believe could create significant long-term shareholder value while reducing the company’s credit risk, increasing its access to capital, and potentially improving the company’s already strong credit ratings.

After two years of working with the company from outside the boardroom, we felt that we could better assist the company in creating more value if one representative from Pershing Square joined the board and one mutually acceptable additional director with relevant expertise were also added to the board. Unfortunately, the nominating committee rejected me and every other nominee we proposed for the board giving us no choice but to seek shareholder support for adding new independent directors to the board. The nominating committee to this day has refused to explain the basis for rejecting me and the other independent directors we proposed.

While we think highly of Target management, Target’s board has become insular and unwilling to consider directors outside of their intimate circle. According to Target’s proxy materials, the nominating committee did not even meet once in 2008, but still collected their annual fees for committee membership. The nominating committee would also not meet or interview the independent director candidates we proposed. Insularity and not-invented-here thinking have caused the demise of many of our country’s one-time greatest retailers; Sears and Kmart, being but two of many such examples. We are working hard to make sure this does not happen at Target.

Target’s board has consistently taken steps to protect their incumbency that we believe are not in the best interest of shareholders. Target’s board has extended the 12-year term limits that were put in place by the company’s founding family (originally designed to ensure “fresh blood and new perspectives”) to 15 years and most recently 20 years. The most recent term limit extension was done to accommodate Solomon Trujillo, the recently deposed head of Telstra, an Australian telecommunication company. We don’t understand why the board believes an additional three-year term for Mr. Trujillo on top of the 15 years he has already served would add value to Target’s board compared to the numerous other board candidates with more relevant experience and better and more relevant operating track records than Mr. Trujillo.

The board has also gone so far as to ask shareholders in this election to limit the number of directors to 12 to reduce the potential for even one of our proposed nominees to join the board. The company has also adopted a staggered board and merged the Chairman and CEO roles including chairmanship of the executive committee, governance approaches that Ken Dayton, one of the founding family members opposed in his public pronouncements about corporate governance more than 25 years ago. The board has refused to allow shareholders to vote on a universal proxy card in this election which would allow shareholders to choose which nominees it wants on the board without being forced to attend the shareholder meeting, which the company has located at a construction site for a new store in Wisconsin, a location not designed to be convenient to the vast majority of Target’s owners. As an alternative to a universal proxy card, we have offered to add the incumbent directors to our proxy card to make choice easier for shareholders. The company has yet to respond to our offer to do so.

In light of the nominating committee’s rejection of all of our proposed nominees, we had no choice but to run a proxy contest to seek shareholder approval for new independent directors. Despite the implications of Mr. Bary’s article, this proxy contest is not a platform for a change in strategy at Target. Rather, we have identified five new independent directors, four of the five with no affiliation with Pershing Square, so that shareholders have the opportunity to choose among the nominees we have proposed and the incumbents to determine who would best represent shareholder interests on the board going forward. We have no coordinated plan with these directors despite Mr. Bary’s implication to the contrary. Rather, we believe adding new independent directors with CEO-level food retail, credit card, and real estate experience to the board in addition to a top corporate governance expert and major shareholder would materially improve the background, experience and shareholder alignment of the board of directors and their long-term oversight of the company and its management.

The current board has also failed to create a culture of stock ownership at Target. Senior management had not purchased one share of Target stock in the last five years until one day after we launched this proxy contest. Rather than purchase stock in the company, the board and management have sold more than $400 million of stock in the last five years. The board owns less than 0.27% of the company’s stock and options despite their extended tenure on the board and the annual restricted stock and option grants they have received over the years.

While Mr. Bary’s article implies that our candidates are somehow my cronies, I am the only Pershing Square affiliate on our proposed slate. The other proposed nominees have no affiliation with Pershing Square. Neither I nor Pershing Square has any commitments, agreements, or understandings with any of these proposed directors other than they have agreed to serve if elected to the board, and we have agreed to indemnify them from any costs they incur as a result of the proxy contest.

The Nominees for Shareholder Choice, as this slate is identified, include Jim Donald, one the country’s top grocery store executives who helped Wal-Mart develop and grow their now-dominant superstore strategy; Richard Vague, the co-founder of First USA and Juniper Financial, one of the most successful credit card executives in the country; Michael Ashner, a major owner/operator of real estate; and Ron Gilson, one of the country’s most important experts on corporate governance with a joint appointment at Columbia and Stanford's law and business schools.

We believe that Mr. Bary’s confusion about what we are trying to achieve at this election has to do with the fact that it is extremely rare for shareholders to have a choice of more than one nominee for each board seat. In the most democratic country in the world, so-called corporate “elections” for which Target’s is but one example, have become a farce. How can it even be called an election if there is no alternative choice for each seat on a board? In its previous uncontested elections, Target’s director nominees have been elected by a plurality which means that directors who receive as little as one vote can be reelected year after year. This is particularly absurd in light of the fact that brokers are allowed to vote a shareholder’s stock in favor of incumbent directors without their clients’ consent.

It is easy to understand why so many of our major financial institutions have failed because of inadequate board oversight when one considers that effectively none of these directors had to compete to earn the right to represent shareholders on these boards. What would our country be like if voters had no alternative but to vote for only one presidential candidate every four years, the mailman could vote for the incumbent without your consent, the incumbent could spend your money to advertise his campaign, and there were no term limits?

The Securities and Exchange Commission clearly also views the current approach to corporate elections as problematic in light of the SEC’s recent proposal, announced last week for public comment, to give major shareholders an opportunity to propose alternative directors on a company's own proxy card if they hold 1% of a company for a year or more. Unfortunately, this rule was not yet in effect when we launched our own contest at Target, so we have had to spend $10 million or more of our own money to give shareholders a choice at this shareholder meeting. Next year, if the SEC's proposed rule is in effect, you are likely to see alternative independent directors proposed by shareholders at hundreds of companies. This will cause boards to take nominating new qualified directors seriously, and I guarantee you the quality and independence of directors will rise. I also suspect that Target’s nominating committee will now begin to take its job seriously and will likely meet more than the zero times it met in 2008. Don’t be surprised to see Target’s board and the rest of the corporate lobby fight the SEC’s proposal aggressively because it threatens incumbency and their overly cozy and insular boards.

Now I will address some of Mr. Bary’s specific assertions about the two areas of strategic opportunity at Target about which we initially met privately with management over the last two years. Our first initiative was an attempt to convince the company to form a partnership with a major financial institution and transfer the credit and funding risk of its credit card receivables in exchange for an ongoing earnings stream to compensate Target for acquiring customers, assisting the bank partner in growing receivables, marketing the program, running the call center and other elements of the business where Target, as opposed to the partner bank, has a competitive advantage. For years, Target’s shareholders had pushed the company to follow the lead of its principal competitors who have all chosen a credit card partnership approach to their credit card businesses. By September 2007, we were successful in finally causing Target to take a look at alternatives for its credit card operation.

In May of 2008, the company took a partial step with its credit card program in a transaction with J.P. Morgan which in economic substance amounts to a non-recourse financing of 47% of the company’s receivables. Unfortunately, this transaction left Target in a first-loss position with respect to effectively all of its receivables and requires the company to continue to fund its remaining receivables, an expensive, risky, and capital-consuming proposition. We believe that Target’s failure to implement a true credit-risk-transfer partnership has cost the company hundreds of millions of dollars in losses and billions of dollars in the company’s stock’s resulting price decline. While we were disappointed with the form of the J.P. Morgan transaction, we viewed it as a step in the right direction that we hoped would ultimately lead to a future, true partnership transaction which will reduce more risk and free up more capital, contributing to an increase in shareholder value.

Our next initiative with Target was to encourage the company to look at potential alternative ownership structures for its real estate. Target owns a greater percentage of its real estate than any other major retailer. In the article, Mr. Bary characterizes our transaction as, “placing Target stores into a real estate investment trust and leasing them back from the REIT.” He then goes on to quote Richard Sokolov, President of Simon Property Group, “Transferring all of this real estate will constrain Target’s flexibility to make renovations, expansions and enhancements that are part of the ongoing evolution of any retailer.”

In fact, we never proposed that Target consider transferring its stores to a REIT. Rather, we proposed that Target would continue to own its stores while contributing the land under its stores to a REIT. This is an extremely important and material difference. The benefits of our proposed structure is that there would be no restrictions whatsoever on Target making “renovations, expansions and enhancements that are part of the ongoing evolutions of any retailer.” In fact, there would be no covenants at all other than the requirement that Target make semi-annual rent payments. Target already leases the land for 10% of its stores. Our proposed transaction would simply expand this percentage to nearly all of Target’s stores.

Because a ground lessor, in this case the REIT, would have the security of Target’s guarantee on the lease plus approximately $20 billion of additional security from the buildings on the land (which would be transferred to the REIT in the event of a default), the REIT would have an extremely secure income stream. As Mr. Sokolov as well as other sophisticated real estate investors should know, ground leases trade at extremely low cap rates because of the security and the inflation-protected nature of ground lease rental streams. Big box retail ground leases even for inferior credits to Target trade at 6.5% and lower cap rates. We believe a 1,400 property cross-collateralized pool of 75-year ground leases guaranteed by Target would likely be valued at an even lower cap rate or higher multiple of cash flow than a one-off ground lease transaction to an inferior tenant.

We also designed our proposed REIT transaction so that it would be ratings neutral or potentially even enhance Target’s already strong credit ratings. In our revised transaction which we made public in November of last year, Target would sell a 19.9% interest in the REIT and pay down debt with the approximate $5 billion of IPO proceeds. Next, the company would complete a credit card partnership transaction and take the $8 billion or so from the sale of its receivables and pay down debt. Target would continue to own 80% of the REIT until such time as the company’s free cash flow reduced debt to $5 billion, less than one turn (one times EBITDA) in leverage. Only at this time would the company spin off the remaining interest in the land REIT to shareholders.

In our proposed transaction, Target’s ongoing dividends would now be paid by the REIT, at an approximate 3-fold higher level than the current dividend rate. Target’s ground rent expense would be tax deductible and future land acquisitions would be funded by the REIT. The company would retain its stores which it could continue to depreciate for tax purposes. As a result of these features, Target’s after-tax, after-cap ex, and after-dividend free cash flow would be materially higher than it is presently and its outstanding debt would decline by approximately $13 billion. With only $5 billion of debt (which could be repaid in approximately two years) and a 75-year ground lease with no covenants, Target in our view would be in a materially superior financial position than it is today. This would not only benefit Target but also the REIT because the stronger Target’s credit quality, the more valuable the REIT would be.

In his article, Mr. Bary makes the unsupported statement that our proposed REIT would trade at approximately 10 times cash flow. While the REIT universe has been under pressure over the last year because of declining occupancy, declining rents, tenant bankruptcy risk, large capital expenditure requirements requiring funding, and most REITs’ inability to refinance debts as they come due, Simon Property Group continues to trade at approximately a 7.5% cap rate, or approximately 15 times cash flow. Our proposed Target REIT would have no debt, a strong investment grade tenant, little if any maintenance capital expenditures (land leased to Target does not need to be maintained), and no occupancy risk, elements which we believe would cause this REIT to trade at a material higher valuation than the 15 times multiple awarded to Simon Property Group.

That said, our issue with Target’s board was not that they rejected our REIT proposal, but rather that they would not authorize the company’s advisors to work to develop a superior alternative to what we proposed. By limiting Goldman Sachs to a narrow review of our proposed transactions, Target and its shareholders were deprived of the opportunity to consider other potentially superior alternatives.

For years, despite consistent advice from shareholders to complete a credit card partnership, Target’s board refused to consider these alternatives. The company is now saying it completed an inferior credit card transaction only because the market deteriorated by the time company executed its transaction. We hope Target does not make a similar error with respect to other potential strategic opportunities because of their unwillingness to even consider alternatives.

Please publish appropriate corrections to Mr. Bary’s article.

Thank you.

SHORT TAKES

Cocoa Prices Go Cold

Maybe chocolate is not a recession refuge after all.

Cocoa prices rallied earlier this year on supply deficits and thoughts that even an economic slowdown would not persuade anyone to deny his sweet tooth. But there are signs that even this most comforting food is subject to the pocketbook.

In mid-May, the International Cocoa Organization said it expects worldwide cocoa demand to see its largest yearly decline in 50 years because of the gloomy global economy, and the group narrowed the size of the expected production deficit. Furthermore, the Commerce Department also said this month that U.S. cocoa imports were down 30.6% in March and 36.5% below their levels a year ago. This news chipped away at prices, and the bulls’ bellyache might not be over.

The mid-crop cocoa harvest is beginning in the world’s top grower, the Ivory Coast, so supply is flooding the market as prices melt.

Technical price charts also favor the bears as seasonally, cocoa prices start to set their annual low in early June, says John Person, president, NationalFutures.com and contributing editor of the Commodity Trader’s Almanac. “If cocoa falls to $2,000 to $1,800 [a metric ton], I would absolutely be a buyer,” Person says.

Even if they are right, the bears will have to be patient. [May 22], ICE Futures’ U.S. July contract cocoa settled at $2,420, up 4.04% on the week, as the dollar weakened.

Shawn Hackett, president of advisory firm Hackett Financial Advisors and publisher of the Hackett Money Flow Report, says that $1,900 to $2,000 July cocoa would be fairly priced for now. He believes cocoa demand will contract further this year and into 2010, tempering prices, provided there are no problems with supply.

So far, demand for chocolate on the low end of the spectrum is holding up. This was most visible in Hershey’s quarterly earnings, which were better than expected, boosted by consumers trading down to more moderately priced treats. But even the chocolate giant is worried volumes will fall later this year.

All things being equal, both Person and Hackett said candy companies such as Hershey and Néstlé look fairly valued. Lower cocoa prices could spell good news for chocolate producers, of course. “Hershey has been known to come in and lock in prices in the market,” Person says. Yet he notes: “While cocoa prices might be down, others are rising, like sugar and like wheat.”

Hackett says that candy companies in the U.S. – the biggest consumer – face more than just a slumping economy. The biggest sweet-consuming demographic is the 5-to-20-year-old age group, but that is shrinking. That is one reason the companies were targeting adults with more premium-type offerings – the kind now dwindling. “This is a longer-term headwind for them,” he says.

Person is less pessimistic. “Cocoa is a product that does not get knocked off the shelf in bad times. People are doing their part to be fashionable and do their part to trim excess ... but we are not going to see a huge dip in demand.”

Western Money Is Flowing Back to Asia Again

Recent Asian fund-flow data offer some solid reasons for the region’s 37% rebound in stock prices since the March lows. Research firm EPFR Global recently revealed that $1.62 billion of new money flowed into Asia ex-Japan equity funds in the first week of May alone. Of that, more than 2/3 went to Greater China plays.

Oliver Lemaigre, senior portfolio manager at Esemplia, an emerging-market equity-asset manager, says there has been a marked increase in “investor flows and an increase in allocations” by institutional investors toward Asia since March.

Much of this money has come from the U.S., where institutions are looking to move a portion of their portfolios out of defensive plays and into high-growth markets. Many of the investors polled said they are reallocating portions of their cash and U.S. Treasury positions. Since March, more than $14 billion of new money has flowed into these funds, replenishing some of the $45 billion that was pulled out of them in 2008.

Further evidence of investor flows into Asia come from the Emerging Markets Private Equity Association (EMPEA), which released the results of its annual survey of where investors in private-equity funds are looking to park their money. The No. 1 pick? China, retaining its top position from 2008.

With U.S. institutions regaining their appetite for growth, Chinese economic numbers provide the tastiest morsels. They suggest that Chinese growth is finally coming from its consumers and not just from exporting cheap goods to busted consumers in the west. According to Chinese government figures, fixed-asset investment in China’s urban areas grew 30.5% in the first four months of the year, more than offsetting a 22.6% fall in its exports.

If this trend continues, it is a major turning point, and one investors would welcome. “It is the beginning of the shift,” says Esemplia’s Lemaigre. There are concerns that much of the uptick in consumer spending is the result of government infusions of cash into the economy. With savings rates still some of the highest in the world, it will take time to get the Chinese to open their wallets as freely as their counterparts in the West.

Even so, tapping into these Chinese domestic trends will be important for U.S. investors. Stocks such as Chinese food company China Mengniu Dairy (ticker: 2319.HongKong) represent a targeted play on this theme with little or no exposure to exports. In early April, the firm released its 2008 numbers, showing revenue had increased by nearly 12% over 2007, despite the milk-tampering scandal that roiled the country in September.

Another way to play this trend is through providers of raw materials, such as oil and foodstuffs, which tend to come from other emerging markets, notably Brazil. Stocks such as steel company Vale do Rio Doce (VALE) or food company Perdigao (PDA) are both big exporters of products for the domestic Chinese market. One fund that includes both China consumer stocks and those of providers of raw materials into the country is Legg Mason Partners Emerging Market Fund (SMKAX).

ETFs are a boon to buy-and-hold investors. Just don’t get suckered into one of the flaky ones.

The exchange-traded fund is maybe the fastest hit in the history of financial products. In the decade and a half since its inception the category has attracted $450 billion in assets. The ETF is a cross between a closed-end and an open-end fund. It offers diversification, low cost, high tax efficiency and the convenience of trading on a stock exchange throughout the day.

What is not to like? Plenty. Many of the 850 ETFs now vying for your attention suffer from one or more of the same cardinal sins seen in other Wall Street products: an excessively narrow focus, high leverage, misleading packaging and tax inefficiency. First Trust Global Wind Energy, for example, sells itself as a clean-energy ETF. But the pool of wind-energy producers is so shallow that it owns significant stakes in carbon polluters BP and Royal Dutch Shell just to maintain liquidity.

U.S. Oil Fund purports to track the price of West Texas Intermediate Crude Oil. The futures market in which it trades is so thin, however, that pros can front-run it each month, knowing that the ETF will have to roll over its positions. Two highly leveraged funds, Ultra Oil & Gas ProShares and UltraShort Oil & Gas ProShares, are supposed to move in opposite directions; they lost 74% and 30%, respectively, last year.

“If you are hell-bent on using leverage for longer than a day, use a margin account,” suggests Paul Justice, a Morningstar analyst.

What about tax efficiency? Most ETFs entirely escape the obligation to pay out capital gains because they do not buy and sell shares of stock; rather, brokerage firms respond to the demand for the ETF by assembling baskets of component stocks and swapping them for newly minted ETF shares. Redemptions work in reverse fashion. But many commodity ETFs are structured as grantor trusts. Own one that holds physical metals, like SPDR Gold Shares or iShares Silver Trust, and you will be taxed on the sale at ordinary income levels.

A better idea: Stick to plain-vanilla ETFs. Most of the time that means deciding on a broad index to own and then buying the ETF that does so for the lowest cost. The best ETFs are cheaper even than the lowest-cost mutual funds. Vanguard and iShares, for example, each offer an S&P 500 ETF that charges 0.09% a year to own. That is little more than half what you would pay in fees for Vanguard’s signature S&P 500 fund, which requires a $3,000 minimum investment. ...

About the only time it makes sense to go further afield and buy a sector ETF: When you have funny money you are willing to lose, and to save on taxes. In the latter case, it can make sense for long-term investors with substantial portfolios to buy several sector ETFs in areas like consumer staples, health care and energy. Then sell your losers along the way to lock in losses. Capital losses can be used to offset any amount of gains plus up to $3,000 a year in ordinary income, like wages and interest. Unused losses can be carried forward indefinitely.

No, you probably will not get rich quickly following such a strategy. But chase after some of the wacky ETFs now on the market, and it is a virtual certainty that the only ones who will profit are your broker and Uncle Sam.

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