Fructivore Investments

My loyal reader(s) who have been following this blog may recall that I called Coinstar a candidate for shorting . At the time it was at 25.91, and it is now at 36.15. So, that’s probably not my best work, although I maintain that the company’s return on its investments is too low to justify its prices. Anyone can spend 97 cents to earn a dollar; if they can do it with 87 cents I’m satisfied and if they can do it with 77 I’m intrigued.

Part of the runup was from the announcement that they reached an agreement to spend 80 million a year on Sony DVDs, and had a promising-looking earning announcement. A similar deal from Lions Gate films announced yesterday, though, failed to excite investors.

However, when Coinstar can’t reach an agreement they are perfectly willing to sue. They announced this morning that they were suing 20^th Century Fox for not allowing their distributors to sell new releases to them for 30 days after they come out. This suit parallels an existing one against Universal Studios that was filed five months ago. The grounds for the suit is violation of antitrust law, which, although a lawyer, I’m not an expert in. Much of the law about trusts and monopolistic behavior is fairly nebulous and open to clever argument, but at least in the intellectual property field there seems to be enough articulated law to guide the investor.

Antitrust laws in the US forbid generally any attempt to monopolize, and this includes attempting to maintain a monopoly by any means other than competition on the merits, including a refusal to deal with competitors.  Assuming that some clever economist expert witness can conclude that this denial will harm competition, 20^th Century Fox can still easily claim that they have the legitimate business reason of protecting the perceived value of their own products in the marketplace.  There is broad support for the view that antitrust law permits holders of intellectual property to unilaterally refuse to license it. After all, the Constitution provides for temporary monopolies for patents and copyrights, and although this does not provide a blanket immunity for antitrust actions (just ask Microsoft), most legal commentators allow them to retain that monopoly as long as they do not try to leverage it into a non-monopolistic area, although the 9^th Circuit has ruled that even this is permissible unless the owner is “not actually motivated by protecting its IP rights.” Since they have a legitimate business reason, which they seem to, they should be in a fine position for this suit. There is caselaw to suggest that there is a heightened standard for situations where a monopolist refuses to sell a product to one competitor that it makes available to others, or has done business with a competitor and then stops, but this seems to be more of an indicator of monopolistic action than anything imposing a higher legal standard, and a legitimate business reason will still defeat it. There is also case law to the effect that there is no difference between selectively granting a license and refusing to grant it all, so no worries to Fox and Universal on that front.

So, it would appear that Coinstar is facing an uphill battle in this area, and will probably have to deal with Universal and 20^th Century Fox on their terms. And, now that those companies and the rest of the market know that Coinstar will go whining to the courts whenever it doesn’t get its way, one can imagine those terms will end up more restrictive than bargaining from a clean slate.

My good friend Mike (here and here) recently left a comment about copper mines, which got me thinking about copper pennies. In 1982, the US Mint stopped making pennies out of 95% copper, and started making them out of copper-plated zinc. Even now that the price of copper dropped back down, copper pennies presently contain 1.8 cents worth of copper apiece. And some people are in fact sorting copper pennies out of the new zinc ones. Better than stealing copper from foreclosed homes, I suppose.

Copper penny enthusiasts pride themselves on what they see as high returns on investment. I suppose, at a .8 cent premium and perhaps 20% of 95% copper pennies left in the typical mix, they see themselves as making 16% on each lot of pennies they get—if they place absolutely no value on their time. And making 16% on a handful of pennies is not like making 16% off a wise stock purchase. Now that melting pennies is illegal, it is even less easy to turn a dollar’s worth of pennies into $1.80 cents in copper, not to mention the expense of the melting. If they cannot ultimately realize the value of the copper they have made -20% by taking perfectly good pennies and hiding them away somewhere.

But, where there’s a will there’s a way. There is a device called the Ryedale that can sort the two types of pennies out of each other, allowing people to get pennies in bulk from banks, run them through the machine, and fill their basements with copper coins at a vastly increased rate. It also puts banks to the trouble and expense of shipping a lot of very cheap coins around; after all, $100 in pennies weighs 64 pounds. Naturally, many of the penny people, unlike me, think a great deal about hyperinflation, but they almost seem to be looking forward to it. After all, in Zimbabwe during its hyperinflation they allowed old coins to trade at the new value when they revalued (i.e. chopped ten zeroes off of)  their currency, which was a nice bonus. And, well, without hyperinflation turning all your money into copper pennies would seem like kind of an odd thing to do.

Well, everyone needs a hobby, but there are easier ways to get something for nothing. Retail Ventures Inc. (RVI), market cap of $163 million, owns 62.9% by value (and 93.1% by vote) of DSW, market cap of $565 million, and this relationship has curiously persisted for some time. This implies that the remaining assets of RVI are worth negative 192 million dollars, which is not really possible. Instead of arbitraging pennies, we could arbitrage these two companies by buying RVI and shorting 59% as many shares of DSW (one of RVI’s 50 million shares is one 75 millionth of DSW, and 44 million shares of DSW divided by 75 million is .59). By virtue of their relationship, the two companies are unlikely to permanently shoot off in opposite directions, and so the fructivore who makes this trade should profit when this value discrepancy is resolved. There is, of course, a risk that a corporate relationship is severed before then (unlike merger arbitrage, here the risk comes from the restructuring happening instead of not happening). You may also find it difficult to borrow the shares; DSW has a 28% short interest and because a lot of them are doing this arbitrage, it would take dynamite to dislodge them.

So, for the diligent fructivore investor, there are easier ways to wealth than by one copper penny at a time. But in all fairness I must admit that I found two silver dimes in my change within the last year, and I still look. But I look harder for valuable opportunities in the securities market.

It now appears that the Department of Energy has agreed to defer a ruling on USEC’s loan guarantee application until “specific technological and financial goals have been met. The general consensus before the announcement of the pending denial a week ago was that the legislation for the loan guarantee program was tailor-made to allow USEC to pass it, and apart from the upstart French company Areva, no one else even bothered to apply. It seems very much as if the Department is waiting to make sure USEC qualifies for the guarantee before they rule on it, which is a good sign.

However, I am not sure what this implies for the timetable. During the initial denial, the Department had a schedule of 12-18 months before USEC could reapply (possibly also signaling that Areva is not going to get it, I hope). But it does save USEC the trouble of withdrawing its application, which allows the CEO, who publicly refused to pull it, to save himself some embarrassment.

The stock is up after hours, but I sold half of my position after the dead cat bounce over the last couple days. I’m a little better than even overall, which is surprising considering how dramatically the “story” of USEC changed last week. This either shows the wisdom of buying a stock for less than its working capital minus all its debts, or shows that I’m pretty lucky. However, value investors seem to get lucky often enough that something other than luck must be involved.

With $787 billion in stimulus, $700 billion in TARP money, deficits projected to hit $1.8 trillion, the Federal Reserve cutting rates to effectively nothing, and Neil Barofsky, the government’s inspector general of TARP estimating a $23.7 trillion total risk exposure to the financial crisis, it is only natural to worry about inflation. Of course, that $23.7 trillion figure would require absolutely everything going wrong, but recent events have surely convinced us that betting on the modal result and ignoring the other possible outcomes is reckless, a fact that seems destined to be rediscovered every few years.

Inflation, of course, is simply an increase in the money supply that outpaces an increase in the size of the economy (actually, that’s stagflation, but stagflation is really the pernicious aspect of inflation). The purpose of money is to facilitate transactions, and as the number of transactions increases the size of the money supply should increase accordingly. Now, of course, the economy has shrunk even as all this stimulus is being thrown at the market, and we are still worrying about deflation. This implies one of two things, either that inflation is going to come later, or that the inflation has been avoided.

I fall in the inflation avoidance camp. In a modern economy, credit serves almost as well as cash, and we are now witnessing a massive evaporation of credit. The appetite for securitization products that created a pool of liquidity that so many lenders were counting on turned out to be a mile wide and an inch deep. Now that every lender in the country is reining in its operations, and many people are unwilling to borrow or incapable of borrowing against their houses, trillions of dollars of credit that used to be bouncing around the financial system no longer are. Next to this unprecedented deleveraging of America, Congress has finally managed to make a couple trillion dollars look like a small number.

Of course, it never hurts to have a backup plan in the form of inflation-protected investments. Our choices include gold, TIPS, and land. For our fructivorous purposes, however, we want an investment that produces a decent return with or without inflation. Gold or other precious metals has no baseline return, or even a negative one when counting storage, insurance, etc. TIPS pay a low rate but increase their principal value alongside inflation, which is better than gold, but I still think there are more potential opportunities in the land category.

In terms of land, obviously single family homes are far too speculative as events have indicated. In fact, using Seth Klarman’s definition that a speculation, as opposed to an investment, produces no current or potential cash flow to its owner, single family homes are not an investment at all. Rental properties are closer, but I think the ideal land for an inflation hedge is land that produces something: farmland, mines, oil fields, or timber. Any of these has advantages and disadvantages, but I’m going with timber, and with Rayonier in particular.

Rayonier owns 2.6 million acres of timberland, and also produces lumber and wood products, and wood fibers for hygiene products and also specialty fibers for industrial use running the gamut from packaging to LCD displays. Naturally the decline in demand for construction materials has hurt them, but even at this low ebb of their business, they have managed to squeeze out at least $25 million in earnings per quarter lately. Their free cash flows are approximately equal to their dividends, currently yielding 5%. This puts them at risk of a dividend cut, but for inflation hedging purposes this is not really relevant, as it is better to keep the money in the firm to buy more timberland with in that event.

The advantage of timberland is that when, as now, demand is down, producers can simply decline to harvest. Unlike farmland, and especially mines and oilfields, not harvesting for a time allows the product of the land, trees in this case, to grow and produce a greater yield when conditions return to normalcy. And given their vertically integrated fiber business, they are not wholly dependent on the construction market.

Rayonier also is getting a nice little bonus from the tax system this year from black liquor, a byproduct of the fiber refining process that contains the nonfibrous parts of the wood and the leftover chemicals used in the process. The refining of wood into wood pulp for their fiber business produces some nice long usable fibers, and a great deal of black slime. A highly toxic black slime. When dried, a highly flammable black slime. When dried and mixed with a bit of diesel fuel, a highly lucrative black slime, since the government pays a subsidy of 50 cents a gallon for its use under an alternative energy program. The program expires at the end of this year, and there is a movement in Congress to cut off the eligibility of pulp mills immediately, on the grounds that black liquor is not really an alternative fuel. (It has been used since the 30s and nearly every pulp mill uses it, meaning that it is not an “alternative” to anything.) To date this year, Rayonier has benefited $86 million from this subsidy, and there are two more quarters. Since the program will expire if not extended (which extension is not outside the realm of possibility), we cannot count on this $43 million a quarter as part of the firm’s operating income, but it is a nice little enhancement that will cushion the blow of the business slowdown for the moment.

However, without counting the black liquor subsidy Rayonier’s PE ratio is hovering around 20, which is generally too high to qualify as a low-hanging fruit considering the lack of growth (not that a fructivore lays too much emphasis in growth anyway given the difficulty of predicting the future). But as an inflation hedge, timber companies like Rayonier are definitely good places to look into.

Remember what I said about the dangers of event-driven trading? USEC has been denied the loan guarantee for their centrifuge enrichment plant construction, for reasons of concerns about commercial viability (which is unusual because the technology is already in use  by other uranium enrichers) . As a result, the company seems to be making good on its vow to cancel the project, although they claim they are now investigating strategic partners or buyers. The Department of Energy has taken the unusual step of asking USEC to withdraw and resubmit the application in 12-18 months, although I’m not sure to what end.

Naturally, the stock has fallen by about a third as of this writing. I’m as surprised as anyone, but as I’ve stated, this rush for the exits is a common enough reaction to an event coming out the wrong way. I should also point out by way of shameless bragging that, since I purchased it at a low price when it was still a net-net situation, I’m actually about even on this one.

If we neglect the new construction project entirely, we are left with the existing plant, which will probably not be competitive in the marketplace once the Urenco’s centrifuge enrichment plant is finished in a projected 2013, or perhaps Areva’s Eagle Rock facility, which will be fully constructed in 2018 or 2022 but like the Urenco plant, can operate without being fully operational (one of the awesome things about centrifugal enrichment is that it’s modular), or any of the other centrifuge plants around the world. Of course, since centrifuge technology is already being used at some overseas enrichment plants, the demise of USEC’s competitiveness has already started. It is still operating at a profit, but as centrifuge technology becomes more and more common their operations will most likely be squeezed out. USEC also takes weapons-grade uranium from Russia and dilutes it to fuel grade, but that program also comes with an expiration date.

However, as I stated, without R & D on the plant, which the company may have to follow through on their promise and put on standby, the company has average earnings of $180 million a year. After this price collapse, their PE ratio is down to 3, so it might still be a hold. But I was definitely more optimistic yesterday.

How many times have we heard the above advice? Usually, it gets people to burn through their savings by starting ill-fated businesses, but that is not the only thing to love. We Fructivores love buying and selling at the right price. The right price is when a security is fairly valued, since at that point there is no longer any advantage to holding it. When a security is fairly valued, sell it off and find one that is unfairly valued. We also are familiar with stocks that went up before we had the funds to buy them, or worse, we bought them, gave up, and then they went higher.

Writing options allows us to squeeze a little extra money out of both these situations. Specifically, writing covered calls and naked puts. I know, most people would advise small investors not to write naked options, or they’ll never become large investors, but there are ways. Larry McMillan, in Options as a Strategic Investment, talks about the difference between having essentially a stock strategy and using options to augment it, and having an option-based strategy. He advises the second one, but this strategy sticks with the first.

With our value investing approach, we know what our exit target is because we had to value our holdings in order to be sure that we got a discount from that price. So, if we know when we are going to sell it, we can write a covered call at that price. If the stock exceeds that price at expiration, the stock will be called away from us and we will have made the money we were going to make anyway, and also collected option premiums while we waited. A related, but riskier proposition, is writing a naked put on a stock we like but that is at too high a price. If the stock declines below the price of the put, we are forced to buy it (make sure you have ample margin), but we would have bought it anyway at that price. It is riskier because if the company deteriorates during the life of the option, the price that we thought was low enough to make it a bargain could now be hugely overpriced. However, for a company with stable operations, like Windstream, or better still, a company like CMO that can never be worth less than the government-guaranteed securities it owns, this strategy is safe and reasonable.

For example, suppose that I think Capital One is worth at least $30 a share based on my sense of its minimal earning power after the economy and the markets get sorted out. The January 2010 $30 calls are at $3.40 now, so by writing them I take in $340 less commissions per hundred shares, and expose myself to no risk other than selling when I would have sold anyway. It also removes from me the agonizing over whether I should take my profits now or hoping it will go up (If it does go up it will do so for reasons unrelated to its bargain status and therefore this is an unfruitful waiting game). If, however I did not own Capital One but wanted to, I would consider writing puts, perhaps the January 2010 $20 puts at $1.75. This takes in $175 less commissions per hundred shares, and if the stock drops below $20 I will be forced to buy a stock I would have bought anyway at a discount I chose in advance. Of course, the choice of the January options was arbitrary; my focus is on valuation, not option pricing theory, so picking the date of the options is less important to me than the strike price.

So, this fundamentals-based option strategy is a way to make other market participants pay you to take the actions you would have taken anyway, thus bringing in extra money and it also has the advantage of making decisions in advance, thus freeing up your limited investing analysis time to focus on the really important matters like valuation.

Event driven trading is never as simple as people think. The concept is simple enough: identify an event that is likely to change the price of a stock, determine the price of a stock after the event does or does not occur, determine the probability of the event occurring, and take a position accordingly. Of course, the ending price and the odds are difficult to predict, but the real problem with event driven trading is that if the event fails to occur the price of the stock will typically drop precipitously, since everyone else is watching for the same event. The typical event is a merger, but a spinoff, divestiture, or even a bankruptcy filing can create an event.

USEC Inc. has an interesting one; a loan guarantee from the Department of Energy that they applied for in order to construct a new facility. USEC is currently the only uranium refinery operating in the United States. It turns mined uranium into low enriched uranium for use in nuclear power plants, and presently employs archaic and inefficient gaseous diffusion technology. Ironically, one of the biggest inputs to producing fuel for electric plants is electricity; 65% of USU’s operating costs come from electricity, and centrifuge technology requires an impossible-seeming 95% less power. For this reason, most nuclear fuel enrichers have switched over to centrifuge technology, and USU wants to open a new plant in order to join them.

To that end, they applied for a $2 billion loan guarantee from the government, and since then they have been looking forward to it like Australia has been looking forward to rain. They have recently announced that they expect the announcement from the Department of Energy in early August, and that they may consider mothballing the entire project if they do not get their guarantee. Since there are two other centrifuge plants proposed to be built in the United States in the near future, and both of them foreign owned, their strategy is probably to embarrass the government into approving their request. Still, calling the government’s bluff like that is a dangerous strategy.

I have to admit that when I discovered USEC, it was because it was a net-net situation, not an event driven trade. At the time, they had enough cash on hand, and uranium inventory, to redeem all of their debts, repurchase all of their stock, and still have money left over. (Such a situation is the holy grail of value investing since Ben Graham started hunting them up)  Now, a couple years later, this is no longer the case because they have sunk $1.4 billion into the centrifuge project already–which, if the project is shelved, will have been wasted. In the last couple of years, the stock has produced on average $70 million in earnings ($110 million more than that if the R & D spent on the centrifuge project is capitalized). It now trades at a PE ratio of 10 without capitalizing the R & D and 4 with it capitalized and amortization of the R & D is deferred until the plant is operational. However, those figures are largely meaningless because the existing plant is going to be shut down. If they keep the same volume of business, their operating earnings (not counting R & D) goes from $180 million to $850 million, but the existing $200 million in plant is thrown away, and the $28 million they now have in depreciation and amortization is going to expand to, say, $300 million, plus the interest on the loan of $160 million at 8%, plus taxes, produces a bottom line of about $270 million, which stacks up favorably to the $70 million they reported making now, after the construction and transition periods.

So, it is easy to see the optimistic case that comes from getting the loan guarantee. (Assuming the company can keep the same margins and laser uranium enrichment, the “new” new technology, is not significantly more efficient). It is equally easy to see that cancelling the project would leave USU stuck with outdated technology against two centrifuge-using competitors in this country. So, there is the case for USU, and the basic problem that comes from trying to predict the future better than everyone else in the market. I should point out that USU is up nearly 20% since they announced that they demanded a decision by August (I hope for their sake they have a contact in the Department of Energy that gave them the date), but still has a PE ratio of about 2.6 for the company once the project is completed. So, if you like the odds, go for it.

Every financial panic needs a good person to blame. This one can be blamed on securitizers and financial derivatives engineers; the one before on deluded dot-com investors, the one before (the junk bond collapse) on frenzied, ill-advised mergers, and the one before that (the Latin American debt crisis) on the oil crisis. I’ve skipped the savings and loan crisis since at least part of it was just bad timing. However, three of these four panics can be explained by the tendency towards yield hoggery.

A yield hog is, simply enough, an investor who is dazzled by high yield investments. A big fat coupon impresses investors and also serves to erase a few embarrassing mistakes. In fact, an investment that produces a large cash flow that is reasonably safe is the kind of low-hanging fruit that the investor should be seeking out. The emphasis, though, is on “reasonably safe,” whereas a yield hog sees “large cash flow” and stops reading. They are willing to reach for yield, and either get it by ignoring established standards of investing safety, or worse, they make up new standards that show that what they’re doing is now safe.

The central concept in yield hoggery is that risk can be made up for with a higher interest rate. I discussed that in the Capital One context, and in theory, it works as long as the risk premium does adequately capture the default risk and pays a premium to the holder on top of that. In other words, it works until it stops working. But worse for the sleepy investor, a risk that fails to materialize seems to fall out of the view of the typical market participant, and the risk premium narrows even as the risk becomes more and more likely. If, say, a certain class of bonds has a 4% annual default rate, this does not mean that 4% of them will default every year like clockwork; it means that they will see 1% default rates for years at a time and then suddenly get hit with a 20% default rate all at once. However, the investor that invested in those bonds will, until that happens, make more money than the more conservative investor who avoids them, and will also steal all of the latter’s clients. After all, clients pride themselves on not being cowardly and very risk averse–until the risk actually happens.

This was the view held during the Latin American debt crisis, wherein according to Nassim Nicholas Taleb, American banks lost, in nominal terms, all the money they had made in the history of American banking (which makes it kind of amazing they scraped together more money to lose so quickly in the subprime crisis). Latin America was growing at a fast pace and investors were naturally attracted to the higher yields available. After all, surely a government is safer than a corporation they could be lending to, and really, what are the odds that many countries would default at the same time? I mean, it’s not like defaults are likely to be correlated or anything.

However, at the very least they were following established financial standards rather than writing new ones, which is what they did during the junk bond explosion. The priests of the junk bond religion argued that since debt financing was generally cheaper than the cost of equity, it was entirely feasible to do leveraged buyouts, saddling companies with irresponsible levels of debt.The traditional corporate financier looked at the money a corporation could spare for debt service in terms of earnings, or at least EBIT, but the new method was to expand it to EBITDA, on the theory that capital expenditures could be delayed and so depreciation and amortization were basically “free money.” Of course capital expenditures can be delayed for a time, but not indefinitely and almost certainly not for the entire term of a junk bond. The switch to EBITDA provided a justification (i.e. excuse) for all manner of crazy, ill-advised mergers, and formerly solid companies were even pushed into borrowing large sums of money and distributing it to shareholders to hold off the acquirers.

Subprime securitizers had their own version of changing standards; the CMO structure allows investors in the lower credit tranches to absorb credit losses so that the higher tranches are not likely to be invaded by losses (again, what are the odds that many borrowers would default at the same time?). Their safety also depended on the availability of refinancing and and the ability of the housing markets to continue producing the ridiculously high returns they had been, and, although it went unmentioned, they also depended on the health of the foreclosure market. At least the Latin American debt investors were honest about the risks they had taken; junk bond and subprime investors just reached for yield and rewrote the rules in order to get it. The yield hog was absent during the triple-digit-PE craze of the dot com era, since with that kind of PE it is more profitable to reinvest any earnings into the company. (Is there such a thing as an appreciation hog? I think so.).

Since I seem to be in the habit of raising problems and not solving them, I suppose I should mention a holding that a yield hog can get behind. Windstream (WIN) is a rural telecom company that as of this writing sells for a little over $8 and pays $1 per share annually in dividends, which is dramatically impressive in a time of low interest rates. Their earnings have been stable over time, true, but have been stable at just a hair under a dollar. Using the trick we learnt from Qwest (see below), we find that their depreciation exceeds their capital expenditures, which gives them some extra free cash flow. As a result, their dividend is covered by distributable earnings, but just barely. On the plus side, they have recently announced an acquisition that in the opinion of management (ha ha) will begin to enhance their bottom line by the end of the year, which will enhance the safety of their dividend. They also have a debt maturity coming up in 2011, and hopefully the financial markets will have recovered by then enough to make rolling their debt over reasonably cost effective. Obviously, the company is unlike to appreciate significantly since they are paying out every penny they earn in dividends, but given their stability in earnings it is not too likely to drop either. Of course, in the unlikely but not impossible event of a dividend cut, the company would probably would drop in price, but they would still be earning somewhere in the area of $1 a share, and that money is still the shareholders’ whether or not they have it in their hands.

So, good luck and remember that even hogs can be eating low hanging fruit if they’re careful about it.

The deeper I get into investing, the more I find my interests are aligned with those of our corporate overlords. Thus, even though a piece of legislation is objectively progressive and fair, I also have to view it in terms of how it tilts the power away from the fat cats. Such is the case with the recent credit card legislation. Among other things, it bans universal default clauses, prohibits credit card companies from raising rates on existing balances, and requires charges and late penalties to be reasonably related to what they cost the company.

Capital One stated that, unlike mortgage lenders, credit card companies have the ability to build expected default rates into the interest they charge their customers. The ability to raise rates on existing balances may be viewed by them as an attempt by them to fine-tune this ability. In fact, universal default, a policy by which credit card companies impose large rate hikes if their customers default on other debt payments or even utilities, is an attempt to fine tune this process, since when it comes to defaults it’s hard to stop with just one. Even the legal test for insolvency is that the borrower is not paying bills as they come due. As the credit card companies probably pointed out in their meeting with President Obama before the bill passed, the alternative is serving less customers and pushing some of them into the less-regulated, less-convenient, more loan-sharky market. More likely, however, they told him it would mean higher rates for everyone, a principle that companies have certainly demonstrated by slipping in an across-the-board rate hike before the new law comes into effect. Under the new law, they can only raise rates on existing accounts after there have been two missed payments, which is probably inadequate for the companies to protect themselves, since after missing two payments it reasonably becomes more and more likely that they will miss the next four and be written off.

Even with the new legislation in place, and credit card default rates hovering around 10%, credit card companies and pretty much all corporations have short memories. Any credit manager under pressure to produce bigger numbers will eventually roll the dice on relaxing the lending standards just a little, in exchange for a higher initial rate, even if it can’t be adjusted so easily. So, with or without this legislation, when the shock of this recession is over it should be back to business as usual, apart from greater volatility in chargeoff rates. . Oh and the bit about fees and penalties being reasonably related to the actual cost to the credit card company? Who, exactly, is going to be telling the regulators what their costs are?

So, this legislation is probably not a good thing for credit card companies, but I don’t think it will be too bad of a thing either. Long live the corporate overlords.

Benjamin Graham wrote in Security Analysis that  there are few tests of management competence and none of them scientific. This was in the 1951 edition of his book, and in almost 60 years there have been few improvements.

One reasonable test, however, is management’s opportunism and understanding of the broad economic climate. Although “proactive” is viewed as a desirable quality to the point of being cliche, being reactive is also a good quality. Although there is a risk of confirmation bias (remembering what management did but forgetting what management didn’t do), developing a history of management actions is about the only way to assess their competence.

At this point it may seem unusual for me to hold up Capital One, a credit card company that is writing off its accounts at an annualized 10% rate, as an example of management competence. Well, first of all, I didn’t say they had to be a positive example, but my focus is more on the financial than the operations aspect. Yes, they overexposed themselves to a risky credit market, but short of liquidating themselves it’s not immediately clear what they could have done to avoid it (not that they deserve a free pass for it). Given that their chargeoff situation is going to dominate their earnings at least until the recession ends, I cannot say they are an unqualified buy.

In terms of their financial maneuvering, however, Capital One has not done too badly. Like all credit card companies, they rely on securitization of their credit card holdings as a source of funding, In order to diversify their funding sources, in 2006 Capital One acquired North Fork bank. In 2007 they divested the bank’s subprime mortgage origination unit, when the housing situation was still a slowdown instead of a meltdown. Their reason for doing so was that, on top of the housing situation, credit cards are capable of pricing the default rate into the interest charged to people, rather than relying on a potentially nonfunctional foreclosure market. Earlier this year they acquired Chevy Chase bank, for the same reason. Also, during the brief euphoria that accompanied the initial passing of the TARP, when their stock jumped from 30 to nearly 60, they made a secondary offering of stock at 48, which, given the current share price of $20 and change, also shows some fairly prescient timing.

As I mentioned before, the credit card situation allows the issuer to price the default risk into the interest charged. As I shall explain in my next post, this assumption may be called into question by the upcoming legislation.