Tag Archives: financial engineering

A frazzled Goldilocks?

Whatever measure you look at, equities in the US are overvalued, arguably in bubble territory. Investors poured record amounts into equity funds in recent weeks as the market melt-up takes hold. One of the intriguing features of the bull market over the past 18 months has been the extraordinary low volatility. Hamish Preston of S&P Dow Jones Indices estimated that the average observed 1-month volatility in the S&P 500 in 2017 is “lower than in any other year since 1970”. To illustrate the point, the graph below shows the monthly change in the S&P500 over recent years.

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The lack of any action below 0% since November 2016 and any pullback greater than 2% since January 2016 is striking. “Don’t confuse lack of volatility with stability, ever” is a quote from Nassim Nicolas Taleb that’s seems particularly apt today.

Andrew Lapthorne of SocGen highlighted that low risk markets tend to have a big knock on effect with a “positive feedback mechanism embedded in many risk models”. In other words, the less risk is observed in the market and used as the basis for model inputs, the more risk the quant models allow investors to take! [The impact of quant models and shadow risks from passive investing and machine learning are areas I hope to explore further in a future post.]

One risk that has the potential to spoil the party in 2018 is the planned phased normalisation of monetary policy around the world after the great experimentations of recent years. The market is currently assuming that Central Banks will guarantee that Goldilocks will remain unfrazzled as they deftly steer the ship back to normality. A global “Goldilocks put” if I could plagiarize “the Greenspan put”! Or a steady move away from the existing policy that no greater an economic brain than Donald Trump summarized as being: “they’re keeping the rates down so that everything else doesn’t go down”.

The problem for Central Banks is that if inflation stays muted in the short-term and monetary policy remains loose than the asset bubbles will reach unsustainable levels and require pricking. Or alternatively, any attempt at monetary policy normalization may dramatically show how Central Banks have become the primary providers of liquidity in capital markets and that even modest tightening could result in dangerously imbalances within the now structurally dependent system.

Many analysts (and the number is surprising large) have been warning for some time about the impact of QE flows tightening in 2018. These warnings have been totally ignored by the market, as the lack of volatility illustrates. For example, in June 2017, Citi’s Matt King projected future Central Bank liquidity flows and warned that a “significant unbalancing is coming“. In November 2017, Deutsche Bank’s Alan Ruskin commented that “2018 will see the world’s most important Central Bank balance sheets shift from a 12 month expansion of more than $2 trillion, to a broadly flat position by the end of 2018, assuming the Fed and ECB act according to expectations”. The projections Deutsche Bank produced are below.

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Andrew Norelli of JP Morgan Asset Management in a piece called “Stock, Flow or Impulse?” stated that “It’s still central bank balance sheets, and specifically the flow of global quantitative easing (QE) that is maintaining the buoyancy in financial asset prices”. JP Morgan’s projections of the top 4 developed countries are below.

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Lance Roberts of RealInvestmentAdvice.com produced an interesting graph specifically relating to the Fed’s balance sheet, as below. Caution should be taken with any upward trending metric when compared to the S&P500 in recent years!

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Of course, we have been at pre-taper junctions many times before and every previous jitter has been met with soothing words from Central Banks and more liquidity creation. This time though it feels different. It has to be different. Or Central Bankers risk been viewed as emperors without cloths.

The views of commentators differ widely on this topic. Most of the business media talking heads are wildly positive (as they always are) on the Goldilocks status quo. John Mauldin of MauldinEconomics.com believes the number one risk factor in the US is Fed overreach and too much tightening. Bank of America Merrill Lynch chief investment strategist Michael Hartnett, fears a 1987/1994/1998-style flash crash within the next three months caused by a withdrawal of central bank support as interest rates rise.

Christopher Cole of Artemis Capital Management, in a wonderful report called “Volatility and the Alchemy of Risk”, pulls no punches about the impact of global central banks having pumped $15 trillion in cheap money stimulus into capital markets since 2009. Cole comments that “amid this mania for investment, the stock market has begun self-cannibalizing” and draws upon the image of the ouroboros, an ancient Greek symbol of a snake eating its own tail. Cole estimates that 40% of EPS growth and 30% of US equity gains since 2009 have been as a direct result of the financial engineering use of stock buy backs. Higher interest rates, according to Cole, will be needed to combat the higher inflation that will result from this liquidity bonanza and will cut off the supply for the annual $800 billion of share buybacks. Cole also points to the impact on the high yield corporate debt market and the overall impact on corporate defaults.

Another interesting report, from a specific investment strategy perspective, is Fasanara Capital’s Francesco Filia and the cheerfully entitled “Fragile Markets On The Edge of Chaos”. As economies transition from peak QE to quantitative tightening, Filia “expect markets to face their first real crash test in 10 years” and that “only then will we know what is real and what is not in today’s markets, only then will we be able to assess how sustainable is the global synchronized GDP growth spurred by global synchronized monetary printing”. I like the graphic below from the report.

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I found the reaction to the Trump’s administration misstep on dollar strength interesting this week. Aditya Bhave and Ethan Harris, economists at Bank of America, said of the episode that “the Fed will see the weak dollar as a sign of easy financial conditions and a green light to keep tightening monetary policy”. ECB President Mario Draghi was not happy about the weak dollar statement as that would complicate Europe’s quantitative tightening plans. It was also interesting to hear Benoit Coeure, a hawkish member ECB executive board, saying this week that “it’s happening at different paces across the region, but we are moving to the point where we see wages going up”.

I think many of the Central Banks in developed countries are running out of wriggle room and the markets have yet to fully digest that reality. I fear that Goldilocks is about to get frazzled.

Tails of VaR

In an opinion piece in the FT in 2008, Alan Greenspan stated that any risk model is “an abstraction from the full detail of the real world”. He talked about never being able to anticipate discontinuities in financial markets, unknown unknowns if you like. It is therefore depressing to see articles talk about the “VaR shock” that resulted in the Swissie from the decision of the Swiss National Bank (SNB) to lift the cap on its FX rate on the 15th of January (examples here from the Economist and here in the FTAlphaVille). If traders and banks are parameterising their models from periods of unrepresentative low volatility or from periods when artificial central bank caps are in place, then I worry that they are not even adequately considering known unknowns, let alone unknown unknowns. Have we learned nothing?

Of course, anybody with a brain knows (that excludes traders and bankers then!) of the weaknesses in the value-at-risk measure so beloved in modern risk management (see Nassim Taleb and Barry Schachter quotes from the mid 1990s on Quotes page). I tend to agree with David Einhorn when, in 2008, he compared the metric as being like “an airbag that works all the time, except when you have a car accident“.  A piece in the New York Times by Joe Nocera from 2009 is worth a read to remind oneself of the sad topic.

This brings me to the insurance sector. European insurance regulation is moving rapidly towards risk based capital with VaR and T-VaR at its heart. Solvency II calibrates capital at 99.5% VaR whilst the Swiss Solvency Test is at 99% T-VaR (which is approximately equal to 99.5%VaR). The specialty insurance and reinsurance sector is currently going through a frenzy of deals due to pricing and over-capitalisation pressures. The recently announced Partner/AXIS deal follows hot on the heels of XL/Catlin and RenRe/Platinum merger announcements. Indeed, it’s beginning to look like the closing hours of a swinger’s party with a grab for the bowl of keys! Despite the trend being unattractive to investors, it highlights the need to take out capacity and overhead expenses for the sector.

I have posted previously on the impact of reduced pricing on risk profiles, shifting and fattening distributions. The graphic below is the result of an exercise in trying to reflect where I think the market is going for some businesses in the market today. Taking previously published distributions (as per this post), I estimated a “base” profile (I prefer them with profits and losses left to right) of a phantom specialty re/insurer. To illustrate the impact of the current market conditions, I then fattened the tail to account for the dilution of terms and conditions (effectively reducing risk adjusted premia further without having a visible impact on profits in a low loss environment). I also added risks outside of the 99.5%VaR/99%T-VaR regulatory levels whilst increasing the profit profile to reflect an increase in risk appetite to reflect pressures to maintain target profits. This resulted in a decrease in expected profit of approx. 20% and an increase in the 99.5%VaR and 99.5%T-VaR of 45% and 50% respectively. The impact on ROEs (being expected profit divided by capital at 99.5%VaR or T-VaR) shows that a headline 15% can quickly deteriorate to a 7-8% due to loosening of T&Cs and the addition of some tail risk.

click to enlargeTails of VaR

For what it is worth, T-VaR (despite its shortfalls) is my preferred metric over VaR given its relative superior measurement of tail risk and the 99.5%T-VaR is where I would prefer to analyse firms to take account of accumulating downside risks.

The above exercise reflects where I suspect the market is headed through 2015 and into 2016 (more risky profiles, lower operating ROEs). As Solvency II will come in from 2016, introducing the deeply flawed VaR metric at this stage in the market may prove to be inappropriate timing, especially if too much reliance is placed upon VaR models by investors and regulators. The “full detail of the real world” today and in the future is where the focus of such stakeholders should be, with much less emphasis on what the models, calibrated on what came before, say.

A Changing Education

Anybody who has young kids at school knows the incredible impact that the internet is having upon modern education. My kids love Reading Eggs, a spelling game by a company called Edmentum. Others rave about Edmodo, a free online platform for teachers and students with over 17 million users worldwide.

The digitalization of education content and the multitude of new online learning platforms are resulting in a substantive change in the education of our kids. A recent study of online learning found that, on average, students performed better than those receiving face-to-face instruction. Technology also offers an array of tools for teachers to monitor student’s learning and to highlight specific issues with students. John Fallon, the CEO of Pearson Plc, believes online learning is a “once-in-a-generation opportunity” and could be “one of the great growth industries of the future”.

Coupled with my kids’ interest in the latest learning game (when they are not playing Minecraft!), the re-emergence of a company called Houghton Mifflin Harcourt (HMHC) from bankruptcy in 2012 and its return onto the stock market in November 2013 has caught my attention. The rise and fall of HMHC over the past decade, a leading provider to the kindergarten through twelfth grade (called the K-12 market) educational sector in the US, is a fascinating case study on the effect of the financial crisis coupled with the disintermediating impact of technology.

Before looking through HMHC’s past the exhibit below outlines the market leaders in the education sector according to a presentation from Pearson Plc.

click to enlargeEducation Market

The firms above are from a cross section of the industry, some focus on adult education, others on universities, whilst others on the K-12 market. The main firms in the K-12 sector are Pearson Education, McGraw Hill Education, HMHC, Cengage Learning, Scholastic Corporation and K12 Inc.

The educational textbook market has been struggling with declining sales. Cengage Learning filed for Chapter 11 bankruptcy last year and the private equity firm Apollo are known to be looking for an exit from its purchase of McGraw-Hill Education in 2012. The graphic below shows the share history of a number of the firms (from 2008 for many and from 2011 for a larger sample).

click to enlargeEducation Stocks

As can be seen, the experience has been decidedly mixed with only Pearson achieving an acceptable long term performance (although it was hit recently by a profits warning in January due to poor US sales, particularly in the career college sector).

Houghton Mifflin has a long history in publishing going back to the 19th century.  A public company since 1967, Houghton Mifflin was bought by Vivendi in 2001 for $2.2 billion and, following financial issues in Vivendi, resold in 2002 for $1.7 billion to a number of private equity firms. By 2005, Houghton Mifflin had revenues of $1.3 billion with an EBITDA margin of 23%.

Riverdeep was an Irish educational technology firm taken public in 2000 at the height of the internet boom by its then 30 year old CEO Barry O’Callaghan. O’Callaghan had a background in investment banking firms such as Credit Suisse where he had developed his deal-making and financial engineering skills. He took Riverdeep private after the internet crash and by 2005 Riverdeep had revenues of $140 million and an EBITDA margin around 50%.

In 2006, O’Callaghan orchestrated an audacious merger of Houghton Mifflin and Riverdeep, an old and a new firm in educational content. The deal involved $600 million of new equity with the merged entity leveraged with $3.5 billion of debt. In the deal, Houghton Mifflin was valued at 10 times 2006 forecasted EBITDA whilst Riverdeep got a 13 times multiple.  The investment case for the deal was to use Riverdeep’s technological experience to drive new revenue opportunities for Houghton Mifflin’s content whilst cutting costs through supply chain optimization and outsourcing. Barely within a year of the deal, the merged Houghton Mifflin Riverdeep again went on the M&A trail. This time it purchased Harcourt Education, another significant player in the K-12 market, for $4 billion. The idea was to resell on a number of non-core units of the combined entity  such as the College division (sold to Cengage Learning for $750 million) and Harcourt Religion Publishing to focus on the K-12 market.

The new company, which operated under the name Houghton Mifflin Harcourt, looked at quickly taking out the targeted $250 million of annual costs froml the combined entities (for example, printing was outsourced) and focusing on leveraging existing content in an online learning environment. Houghton Mifflin Harcourt increased market share and performed well in the first half of 2008 before the financial crisis started to take hold. For the full 2008 year, revenue was $2 billion down approx 5% from the 2007 proforma figures but, due to the impact of cost savings, EBITDA grew substantially to over $700 million and an impressive EBITDA margin of over 35%. The firm remained highly leveraged with debt of over $6.25 billion or over 8 times as at the end of 2008. The new Houghton Mifflin Harcourt was heading into a storm, the like of which had never been seen before in the sector.

The impact of the financial crisis wreaked havoc on the firm’s business as local State finances resulted in a sharp rise in postponed and deferred sales. Education textbook and material purchases are seasonal with particular liquidity strains on the business in Q1 and Q4. By mid-2009, the company announced a debt restructuring to reduce debt by over $1 billion. However, trading conditions continued to deteriorate in H2 2009 and the full year recorded a 25% reduction of revenue and a reduction in EBITDA of over 30%. Houghton Mifflin Harcourt ended 2009 with an estimated debt to EBITDA ratio of over 13 which was clearly unsustainable. A question mark loomed over it’s future.

In early 2010, a recapitalization involving a debt for equity swap and new investment of $650 million was agreed which reduced the firm’s debt load to below $3 billion and wiped out the existing equity holders. Paulson & Co and Guggenheim Partners were amongst the new owners. Astonishingly, Barry O’Callaghan kept his job as CEO after the recapitalization.

In the US, educational products are split into 2 categories – basal and supplemental. Basal materials are complete materials for students and teachers covering comprehensive courses. Supplemental materials speak for themselves. Approximately half of the States in the US follow a State wide adoption of basal materials by subject, usually ever 3 to 5 years (and are called “Adoption States”). The others allow districts to select their own course materials and are called “Open States”. Important adoption States in the K-12 market include the largest – Florida, Texas and California.

Unfortunately for Houghton Mifflin Harcourt, the impact of the financial crisis on education budgets was not yet over, as an exhibit below on State finances from a presentation by the Partheneon Group compared to basal and supplemental sales illustrates.

click to enlargeUS K-12 Basal & Supplemental Market

Houghton Mifflin Harcourt classifies their education products are follows:

  • Comprehensive Curriculum which are materials for a complete study course, either at single of multi grade level and include subjects like reading, literature/language arts, mathematics, science, world languages and social studies.
  • Supplemental Products which are materials to assist learning through incremental instruction.
  • Heinemann produces professional books and developmental resources aimed at empowering pre-K-12 teachers whilst also providing benchmarking assessment tools.
  • Professional Services provide consulting services to assist school districts in increasing accountability & training services.
  • Riverside Assessment products provide district and state level solutions including psychological and special needs testing to assess intellectual, cognitive and behavioral development.
  • International products are educational solutions in high growth territories primarily in Asia, the Pacific, the Middle East, Latin America, the Caribbean and Africa.

HMHC’s other business is the traditional trade publishing business with recent titles such as The Hobbit and Life of Pi.

In 2011, Houghton Mifflin Harcourt was particularly impacted by a reduction in spending by Texas, one of the largest spending States, with revenues from Texas down from $190 million in 2010 to $70 million in 2011. The graphic below shows the business split by the above product classification for 2010 to 2012. The EBITDA margin is also shown (interestingly its averaging in the mid twenties at a level very similar to that achieved by the stand alone Houghton Mifflin in 2005!).

click to enlargeHoughton Mifflin Harcourt 2010 to 2012 Results

In September 2011, Linda Zecher took over as CEO from O’Callaghan who left the business. Zecher previously held leadership roles at Microsoft, Texas Instruments, and Peoplesoft. She has reorganised the executive suite, bringing in new expertise, many from Microsoft or with extensive technology backgrounds. In June 2012, Houghton Mifflin Harcourt emerged from voluntary bankruptcy under Chapter 11 with a cleaned up balance sheet with debt as at YE 2012 of less than $250 million and cash of over $450 million (cash balance is down to $230 million as at Q3 2012 with debt at the same level). Over the recent past, the business has been relatively steady if nothing spectacular.  For FY2013, the business is likely to run at an operating breakeven, cashflow positive, with a EBITDA margin in the mid-20s. HMHC currently trades at an EV/EBITDA multiple of 7.5 which seems reasonable. They report their FY results in early March. The graphic below shows quarterly revenues since 2011.

click to enlargeHoughton Mifflin Harcourt Quarterly Revenue

The company went public again in November 2013 under the ticker HMHC and points to its new found financial strength, its experience in digitalising its products, favourable demographics and the need for key States to adopt new programmes as catalysts. Florida, California and Texas are all scheduled to adopt educational materials for certain subjects between 2013 and 2016.

One important development that will determine the future success of firms such as HMHC is the newly developed Common Core State Standards agreed by State governors with implementation scheduled to begin in the 2014-2015 school year. Some, such as HMHC, argue that the long established firms with proven content and relationships will benefit the most from such standardisation. Others see these new standards as offering newer firms the opportunity to compete and innovate. The Partheneon Group, in the presentation referenced above, contend that digital disintermediation offers multiple content providers the opportunity to see their products if a common framework can be established, as the graphic below shows. Firms like Apple and Google are active in the education sector and would love to position themselves as such a platform.

click to enlargeDigital Disintermediation

The future of companies such as HMHC may be uncertain but it will be interesting to observe how it plays out for them. Given HMHC’s recent experiences, I wish them well. Battle hardened now; they look in better shape than some of their old school competitors.

In some ways, you have to admire the vision of people like O’Callaghan for trying to pre-empt the future back in 2007. It is debatable whether the company would have survived with such an inflexible debt load in such a fast moving environment even without the financial crisis. To add the pressure of excessive leverage makes the task look foolhardy in retrospect.