The World is Changing...Remember to Change Your Portfolio With It

If history tells us one thing, it tells us the world never stops changing. As the great French Philosopher/Scientist Blaise Pascal observed "all of human misfortune comes from one thing, which is not knowing how to sit quietly in a room".

Recently law makers and regulators have been getting their hands dirty. No where more so than in the USA. Laws to incentivise whistle blowing, laws to claw back management bonuses, laws on bank reform and health care. The list is a long, and their effects cannot be ignored. Lone investors cannot possibly follow them all and understand fully their consequences. However, one that has particularly caught by attention is the Dodd - Frank "Wall Street" reform.

This caught my attention as we were buyers of General Electric (GE) common stock in mid 2009 at prices around 13.0 - 13.5 USD per share. We hold only one other financial company in our investment portfolio as we remain deeply sceptical of highly leveraged businesses, be it banks or otherwise, and rarely invest in their securities unless we can buy the underlying net assets at very cheap prices (we don’t like paying for growth in leveraged companies).

Digging into this particular Act I realised a number of negative issues could arise for General Electric, as it has a very large finance company within the parent company – General Electric Capital Finance, which is involved in leasing, mortgages and all manner of financial activities. Furthermore, this business in 2008 consisted of 37% of total revenue and 36% of the profit – it is a major part of General Electric, and as a consequence, the company is not merely another industrial company.

Consider that towards the end of August 2010 General Electric was trading with a market cap close to 160 billion USD, whilst GECF had 345 billion financing receivables on its balance sheet. A 5% default rate on that portfolio would wipe out a third of the tangible common equity of the company from 2009 end of year financial statements. Not surprising to hear GE has one of the lowest reserves to loan ratios within the financial sector (comparing to banks) as well as provisions for non performing assets (NPA).

The more astute reader would ask why we are comparing GE to other banks? This is where the Dodd – Frank reform becomes important. GE Capital had been supervised under the Office of Thrift Supervision in the past. This will be merged into the Office of the Comptroller of the Currency. Under the latest reform, GE's financial entities will be expected to comply with more strict Fed requirements, commonly associated with bank holding companies (BHC). Section 113 of the Dodd-Frank bill gives the Fed the authority to regulate nonbank financial firms that "could pose a threat to the financial stability of the United States”. So while most banks and financial firms have been required to increase capital throughout the financial crisis, GE Capital has so far been able to avoid the Federal Deposit Insurance Corporation (FDIC) and its demands for more capital, and hence reducing leverage.

Furthermore, GE Capital itself engages in impermissible BHC activities. One example would be the equity investments made by GE Capital into commercial real estate deals. This is not permitted under Fed BHC rules. Will it be forced to sale? The possibilities of writedowns should this occur would be high. A large portion of their portfolio consists of real estate bought within 2006/07.

We also note that capital shifts between GE Capital and GE could be restricted under Section 23A of the Federal Reserve Act, which governs transaction with affiliates. Is GECC now sufficiently capitalised to cut this connection? If not, would the company would have to be spun off? GE has already stated it would make a 2011 capital contribution of $2 billion to the unit, in addition to the maintenance payments to GE Capital. GE Capital over the last two years has been well protected by the free cash flowing parent company. How would it do without it?

We didn’t stick around to find out. We sold all our positions at prices within 15.16 -15.20 USD per share. We feel there are a number of alternative positions in USD that offer a similar or higher dividend yield, growth potential and are significantly less leveraged and have less possibility of a permanent loss of equity due to regulatory and accounting changes.

Indeed, in the regulator front many changes are being made to help shareholders, be it greater transparency of information or trying to generate better feedback loops to stimulate productive management.

Indeed, economics is also making it better to be a shareholder. Being a resident of Southern Europe I am surrounded by double digit unemployment statistics. Though many highly qualified and bright individuals hope that they can receive a great job offer from a great company with a great wage at their home town, the probabilities are low. Should global growth pick up unemployment is so high that wage increases are unlikely. Should companies invest more to increase production it is more likely it will be done in Asian countries where costs are lower and growth is higher: hence job creation is not likely to be as strong locally. Hence, it is the large companies that would enjoy the fruits of growth, not local residents.

Local residents should consider becoming shareholders of such companies at interesting prices so they can enjoy their profits. It’s never been a better time to be a shareholder to balance your personal job security risk with the potential profits smart management, good products and an established infrastructure to do business can provide.

Full Steam Ahead...

Dear Readers,

Having lost my frame of reference over the last few weeks due to a wicked cocktail of agonising back pain and prescribed hard drugs, I awoke this morning not to the scream of a thousand different echos, but to a gentle melody that led me to a window with an interesting view....

What great and rapid changes are happening in the world today and how they are affecting the world we live in. The beauty of a free enterprise system is evolving in front of our eyes. We are living it. We are making it. But most importantly, we must appreciate and react to it if you wish to eat its fruits.

Only in the first few seconds of picking up a few newspapers and my head hurts from its pounding footsteps...

Dodd - Frank reform affecting the marked to market valuation of GE capital assets. This needs us to have a clear appreciation and an immediate re valuation of what we feel the company is worth and how the market may react to sudden write downs through its income statement. We were past buyers of this stock in mid 2009 and if the opportunity seems appropriate due to the markets reaction - we will buy more. We must be ready to react appropriately. If we feel the companies current value is fairly priced, we shall sale (the position is currently profitable).

Large Pharma investigation by the Department of Justice. Glaxo could be implicated as are Pfizer, Merck and a range of others. The grounds are based on bribery charges from selling value products to governments (i..e think of any state owned European health institution!). You can imagine the size of this lawsuit if that was true! In reality it is a little dirtier than that and probably will require us to limit the size of pharma exposure in our portfolios until we appreciate the true extent and agenda of this case. At this point in time we are happy with our portfolios approximate 15% exposure to healthcare. We remain intimate shareholders of Sanofi Aventis, Glaxosmithkline and Astellas Pharmaceuticals.


Yours sincerely,

Alessandro Sajwani