Value Investing

Blowing Bubbles – Marathon Asset Management (2006)

Blowing Bubbles by Marathon Asset Management, dated May 2006. This is discussed in their new book Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 we think – anyway read it below.

Blowing Bubbles

Several indicators of speculative activity suggest a market peak has been reached

“I’m forever blowing bubbles, pretty bubbles in the air,
They fly so high, nearly reach the sky,
Then like my dreams they fade and die,
Fortune’s always hiding, I’ve looked everywhere,
I’m forever blowing bubbles, pretty bubbles in the air.”

— Chant of West Ham football supporters

The recent crack in the markets had to some extent been foreshadowed in recent months by signs of excessively confident behaviour from market participants. Given the capital cycle focus of our firm, we have always had a strong interest in identifying bubbles. Recent speculative activity in commodities, emerging markets, hedge funds, IPOs and, of course, private equity all suggest a market peak has been reached. Current evidence of market froth can be found in:

1. Commodity Bubbles

The gold price has recently touched a 25-year high, whilst the prices of copper, zinc and other base metals have all risen vertically for several months. Most recently however commodity prices seem to have gone into overdrive as natural strong user demand (mostly from China) has been exacerbated by speculative demand from financial market participants. Copper is trading at a premium to the face value of the coinage. It now pays to melt down pre-1992 British pennies, as well as US cents and nickels. The steep rises in commodity prices in recent weeks remind us of the intraday spikes in Internet stocks in the last few weeks of the 2000 tech bubble. It is rather ominous that the pink paper launched a new supplement, entitled “FT Copper,” on May 10, two days before copper touched an all-time high only to plummet subsequently by 14 per cent.

2. Private Equity Mania (I)

In the last few months some large and well established private equity groups – namely KKR and Apollo – have taken advantage of abundant market liquidity, and the allure of their own historical track records, to list funds that invest in their own funds. Needless to say these funds charge management fees on top of the fees already charged by the underlying funds. KKR initially aimed to raise $1.5bn, but interest was so strong they increased the amount to $5bn. After Citigroup and other bankers took $270m (5.5 per cent of net asset value) for placing fees, KKR’s fund is now trading at a discount to the issue price. Nice money if you can get it! Incidentally the Apollo fund is set to pay away 6 per cent in fees to Goldman Sachs and friends.

3. Private Equity Mania (II)

A few weeks ago Blackstone, one of the world’s largest private equity groups, invested €2.7bn for a 4.5 per cent stake in Deutsche Telekom, the German telephone operator. Deutsche Telekom is a publicly traded company that index funds (no fee) and many long-only (low fee) managers are free to invest in. Yet Blackstone paid a 2.6 per cent premium for its stake and has agreed to be locked up for two years. Its consolation prize being the possibility of getting a board seat on a 20-person German board. The shares are trading 11 per cent below Blackstone’s purchase price. This is by far the largest investment made by a private equity outfit in a listed equity. Why their private equity clients should pay exorbitant fees for this kind of investment is difficult to comprehend. To us, the DT deal suggests that buyout groups now have more money than ideas.

4. IPO Frenzy

The IPO calendar has suddenly exploded. Marathon’s proprietary IPO indicator – namely the size of the pile of issue prospectuses by our desks – which worked so well in the TMT bubble, is flashing a strong warning sign. Interestingly the industry composition of the IPOs has shifted markedly from the last bubble and now the main areas of capital raising include the energy, commodity, utility and specialist financials industries.

In the case of the latter, specialist fund management groups and fund of fund managers are opportunistically raising money or selling out. One listing last March that caught our interest was that of a Swiss based entity, called Partners Group, which manages funds of funds in private equity and hedge funds. At the year end, Partners had assets under management (AUM) of SFr 11bn and 2005 revenues of SFr 125m. After the first day’s trading, in which the shares popped 25 per cent, Partners was valued at SFr 2.1bn, a staggering 19 per cent of AUM and nearly 17 times revenue.

At around the same date, Charlemagne Capital went public on the London Stock Exchange. This fund management business was founded by some of those who had been behind the Regent Pacific group and the now defunct Regent Eastern European leveraged debt fund. Charlemagne specializes in investing in the hot Eastern European emerging markets. Its AUM has grown from $250m in 2000 to $5bn today. The current share prices values the fund manager at some 10 per cent of AUM. Two-thirds of last year’s profits came from performance fees. The IPO provided the opportunity for insiders and directors to sell between 25 per cent and 33 per cent of their holdings in the company. Following the emerging market turbulence of the last few days, Charlemagne’s stock is down 32 per cent in the seven weeks since listing.

5. M&A Mania (I)

Another indication of market froth is the return of animal spirits in the mergers and acquisition world, where activity has moved back up to levels last experienced in the 1999-2000 technology bubble. According to Thomson Financial, announced M&A volumes in Europe in Q1 2006 amounted to some $437bn, which is 240 per cent above the same period last year. It is conventional wisdom that M&A destroys value over the long-term, which is why the share price of an acquiring company normally falls when a deal is announced. Yet we’ve recently observed several cases when the acquirer’s stock has climbed on the announcement of a bid, even it is paying a large premium for the target company. For instance, when Ferrovial, a Spanish infrastructure group, announced it was buying the somewhat larger British airports group, BAA, at a 28 per cent premium to the undisturbed share price, Ferrovial’s own share price climbed by nearly 6 per cent. Likewise when Mittal Steel announced a bid for rival steel maker Arcelor, its shares rose by 14 per cent over a 48-hour period.

6. M&A Mania (II)

M&A deals devoid of strategic logic or potential cost-savings is a strongly developing theme. We have recently witnessed an Australian infrastructure fund buying a national telecom operator in Ireland and a similar Singapore entity buying a UK ports operator in combination with the private equity arm of an investment bank. In both cases, large acquisition premiums were paid, despite the absence of synergies. The tax savings from leveraging these companies after they’ve been taken private can hardly justify these hefty takeover premiums.

7. Retail Exuberance

No discussion of stock market excess would be complete without reference to the antics of the retail investor. After the debacle of their day trading experiences at the turn of the century, retail investors have finally recovered their appetite for equities; their spirits lifted by US house prices at record levels and an equity market that has been rising steadily for over 18 months. In the US, Charles Schwab recorded triple the commission income in February versus three years ago. The retail crowd is currently behind some 60 per cent of option trades on the NYSE where turnover has been rocketing. It comes as no surprise that emerging markets have caught the eye of Main Street given emerging’s strength over the last few years (from its low in 2003 to the recent peak, the MSCI Emerging Index rose by 240 per cent, while S&P 500 is up only 63 per cent from its 2003 trough.) In the first ten weeks of this year, emerging market funds attracted more inflows from US investors than for the whole of 2005, which itself was a record year.

8. Insiders Out

Directors’ dealings have also been sending some strong signals of late. The level of insider selling has risen steadily over the last several months. The most recent monthly statistics for the UK show that directors sold 16 times as many shares as they bought in April. This compares with a ratio of lower than four times a year ago. Although the ratio of insiders’ purchases to sales is almost always skewed towards selling, as directors tend to accumulate free or cheap shares from options and incentive plans over the years, the current level of insiders exiting is pronounced.

All of the above, combined with the usual anecdotal signals transmitted in meetings with companies and sell side practitioners, suggests that May 2006 has represented something of a market peak.1 It is always difficult to predict market turns but the signs of excessive and hubristic behaviour should serve as a warning. The period of easy money which has fuelled much of this speculative activity may be coming to an end, and if easy money continues it will probably be for bad reasons.

  1. Calling stock market peaks is a perilous activity. As it turned out, the S&P 500 continued to climb until October 2007, at which point the S&P 500 was some 22 per cent higher than its level at the time of writing.

Digital Moats Piketty Blowing Bubbles

Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 1st ed. 2015 Edition by Edward Chancellor