Finance – Page 54

Bone-headed valuations marking the end of the cycle

The big headline is the deal Facebook made to acquire WhatsApp for an absurdly large piece of change – $4 billion cash and $12 billion in stock. There was also $3 billion in extra restricted stock that vests over four years, but really, $3 billion is a rounding error.

The owners of WhatsApp should be given a massively huge congratulations for extracting a huge pound of flesh and hopefully they will have the foresight to start hedging their stock so they’ll be able to live in luxury forever.

I highly suspect in five years or so that the guys at Snapchat and Instagram are going to be kicking themselves for not dumping their businesses at equally absurd valuations. They’ll probably end up being like Friendster when they are superseded by some other up-and-coming application service.

I am not a user of either technology, either Facebook or WhatsApp (or Snapchat and Instagram for that matter!). Today was the first time I ever heard of WhatsApp, and just looking at the Wikipedia summary, it looks like a well-used and functional version of BBM crossed with Skype.

This also explains why Blackberry is up today – if WhatsApp can fetch $16 billion, why can’t BBM?

Media is already panning the deal and I seriously have no idea whether this makes any sense for Facebook strategically – eventually they will want to fold the WhatsApp’s not insubstantial user base into Facebook in some seamless transition, but one can just ask Google how things went with Google+ and you’ll easily see it is a lot easier to do that on paper than it is in practice.

Financially, of course $16 billion is a huge price to pay. Even if you assume the stock component of the deal is worth zero, the $4 billion in cash is a huge investment. Putting that $16 billion in a 30-year treasury bond will reliably spin off $600 million a year in pre-tax income for 30 years and does anybody seriously think that WhatsApp will contribute that incremental income to Facebook’s bottom line?

This acquisition reminds me of what happened when Yahoo acquired Broadcast.com (from Mark Cuban), or the mergers that occurred in the optical networking space in the last couple years of the dot-com boom where you had massive equity-for-equity transactions (in particular, JDS, Uniphase, and SDLI come to mind).

Acquisitions like these highly suggest the 20-times-sales valuation hype is going to end sooner than later. I don’t know when, but I’m staying far, far away from this territory and letting the insiders and lucky day trader-types make their killing to the detriment of those that will be holding the bag when the party ends.

When interest rates rise

Constructively speaking, the federal reserve is engaging in raising interest rates, without actually raising the short term rate. The theory of what to invest in when rates rise is functionally the correct strategy here.

There is not a lot that is going to thrive except for US cash.

The federal reserve is likely to continue in the normalization direction for quite some time to come and as a result, volatility will be prevalent. Buying volatility is likely to be a winner.

Marginable vs. non-marginable equity

There is a lot of borrowed money out there. Even on the retail level, you can get Canadian currency for about 2.5% at Interactive Brokers, or if you’re going to borrow over a million dollars, you’re good at 1.5%. For US currency, it is currently 1.57% and 0.57%, respectively.

Borrowing money to invest makes you look like a genius when the markets are rising, but it adds a tremendous amount of pressure when things go south.

Interactive Brokers, in their most recent quarter, announced that year-to-year margin balances have increased 38%, while customer accounts grew 14%. This is not terribly dissimilar to the statistics reported by the NYSE – while they have yet to post December balances, looking at November-to-November they have a 29.6% increase in margin balances. It is significantly higher on a percentage basis if you net the margin debt with the credit balances available.

So let’s say you’ve borrowed to the hilt, and the markets experience a 4% decline and you start to feel uncomfortable about your 2:1 leveraged position. What do you trim first to avoid the dreaded margin call?

The answer is non-marginable equity. Each dollar you raise from a non-marginable stock contributes a full dollar that can go toward the minimum equity required to maintain the account. If you decided to dump one of those 30% margin stocks, you’d need to dump $3.33 of shares to get the equivalent of one dollar.

It is likely that there are a higher frequency of bargains in the non-marginable equity rather than the full margin equity (e.g. large-cap stocks) – forced liquidations have a tell-tale sign on charts which I am sure clever software programs are consistently looking for to ensure they extract the maximum amount of pain on those that are forced to sell.

Being human, however, restricts you to keeping a good quality watchlist, having done some fundamental analysis in advance to ensure you’re still not getting ripped off on valuation, and just paying attention.

Market is beginning to panic?

The S&P 500 is down two days in a row, significantly, and everybody is panicking.

Volatility is up from 12% to 16% and the whole world is about to collapse.

The fact that we are 3% from the all-time highs has nothing to do with this sentiment. Stock markets are supposed to go up forever, all in a straight line, right?

Less sarcastically, my general feeling out there is that almost anybody investing from about August 2011 has not felt the experience of real loss. As a result, I think the market sentiment is going to be quite skittish – people with gains will want to lock them in quicker than normal, especially now that the 2013 tax year is over. Just a guess.

I continue to have 1/3rd cash and am being patient.

When to give up investing in individual stocks and bonds

Michael James has a fairly good article on why he chose to stop investing in individual securities and instead just go with low-cost index funds (or ETFs).

Putting a long story short, he put in a lot of time into researching the stock market between 2000 and 2008 and failed to outperform his baseline index and then a couple years later made the decision to just give up and index.

Pretty smart, I would say.

When I look at my own performance where I have an 8-year baseline of data, 3 of those 8 years I have underperformed the major indicies. One of those years I definitely attributed to mental stupidity on my part and is a genuine outlier year of profound incompetence (2011). Overall, I am still performing about 12% over the S&P 500, but this could just entirely be luck. Very difficult to say as I do not believe 8 years is a sufficient baseline.

If I was performing at or close to the index average, I would easily say that giving up would be a good option.

The other component of individual equity and bond investing is that it requires a lot of time and mental concentration to be able to pluck value out of the marketplace (and more importantly, to know when to pluck it out!). An index investor just needs to decide what low-cost baskets to put his/her money into (e.g. an all-equity allocation would be 20% TSX, 20% S&P 500, 20% S&P 400, 20% S&P 600, 20% International) and just sit back. Of course, there is a science to this as well that requires a certain amount of research, but the idea is to just set the autopilot switch on and forget about it while focusing on other parts of life.