Goldman Sachs

If any event could illustrate the fragility of the BRICS conceit, it is the recent blackout in India, which left as many as 600 million people without power for up to two days. More than anything else, it reveals the sorry state of India’s governance. Yes, there are some extenuating circumstances: an unusually hot and dry monsoon season, which has reduced the available flow in hydroelectric plants while also causing the wealthy to use more power to run their air conditioners, while at the same time farmers are using more power to run pumps bringing up irrigation water from deep wells.

But the real story is under-investment in power generation, in coal production, and in transmission and distribution infrastructure, which in turn are attributable to monopoly pricing, hugely inefficient subsidies, endemic corruption, and political stagnation. The power outage was unique only in its extent and duration. Businesses, households, and public institutions all rely on diesel generators, which to a large extent have gone from a backup to the primary source of electricity, as “load shedding” – the system of rolling blackouts that utilities impose to reduce the strain on an overtaxed network, which often deprive whole areas of a city of power for as much as 14 hours a day. The event, and the global publicity it has attracted, has put a dent in India’s self-image as a nascent superpower. India has nuclear weapons and a space program – it launched a lunar probe in 2008 and has announced plans to send an orbiter to Mars next year – but it can’t keep the lights on. [click to continue…]

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Less than a week after a federal court in Manhattan sentenced hedge fund boss Raj Rajaratnam to a record 11 years in prison for insider trading, and ordered him to pay forfeiture and fines of more than $60 million, comes the news that Citigroup has agreed to pay $285 million to settle a to settle a civil complaint by the Securities and Exchange Commission that it had defrauded investors. According to last Thursday’s New York Times,  “the transaction involved a $1 billion portfolio of mortgage-related investments, many of which were handpicked for the portfolio by Citigroup without telling investors of its role or that it had made bets that the investments would fall in value.” This is the third such complaint brought by the SEC. In July 2010 Goldman Sachs paid $550 million to make the SEC’s charges go away, and this past July JP Morgan Chase settled its case with a payment of $154 million. None of the three firms has admitted any wrongdoing, and neither the firms nor any of their employees have been charged with any crime. [click to continue…]

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Let me admit my bias right here: I don’t “get” Twitter. This isn’t just because I’m too old. My teenage daughter, Isabel, tells me she thinks it’s pointless and that none of her friends use it. I also don’t see how Twitter will ever make money, though it’s certain that some of the best minds in Silicon Valley are already working on that problem. But this article isn’t about any of that.

Echoing Goldman Sachs’s investment in Facebook in January, which gave that company a notional value of $50 billion (which has subsequently risen to $70 billion in the secondary market), it was announced today that J.P. Morgan’s Digital Growth Fund is in negotiations to buy a 10% stake in Twitter for $450 million. The J.P. Morgan fund, which has raised $1.22 billion of a planned $1.3 billion, also has its eyes on potential investments in Skype, the telephony provider, and in Zygna, a games maker. Any or all of these investments could lead a few years hence either to outsize profits or to people scratching their heads and muttering, “What were they thinking?”

None of this should normally be of any concern to anyone but the shareholders and investors in the target companies and in the banks and funds buying the shares, but there is something not quite normal going on here. In both the Goldman/Facebook and the anticipated J.P. Morgan/Twitter transactions, the purchased shares will be made available only to a tiny handful of very wealthy investors. The J.P. Morgan fund, for example, will have a maximum of 480 investors, which works out to an average investment of $2.7 million each. Although an initial public offering (IPO) for both companies is planned, with Goldman Sachs and J.P. Morgan having the inside track to manage the IPOs and reap the enormous advisory fees and commissions, there is no certainty as to what percentage of these companies will actually be floated, and what proportion will remain in the hands of the banks and their wealthy fund investors. It is possible – even probable –  that a majority of the ownership of these companies will remain vested with a very small group of people. Though a secondary market will certainly develop to allow these initial investors to dispose of their shares, it is also likely that activity in this market will consist primarily of private sales to other wealthy insiders.

Let’s not be naïve; wealthy and well-connected investors have always had access to investment opportunities the rest of us don’t even know about, and nothing will change that. But if Twitter- and Facebook-style investment arrangements become more widespread, it could undermine American capitalism, which for  the past hundred years has been based on the modern public corporation in which no individual or institution owns more than a few percent of the whole.  It’s common nowadays for institutional investors to own well over 50% of big U.S. corporations, but even among these investors ownership is highly diversified. In very few Fortune 500 companies does a single institution or family group own more than five per cent of the outstanding shares or exercise control via a special class of shares (Ford Motor Company, in which the Ford family owns just 6% of the company but controls 40% of the voting shares is one of a very few exceptions). Even Bill Gates owns only seven percent of Microsoft. This model is now under threat.

As regular readers of this blog know, I am a capitalist. Capitalism, especially when it is based on widespread ownership and freely traded shares and debt instruments of large public companies, is the best way mankind has yet found to allocate capital to its most productive use. Anyone who doubts this can look at the legion of countries in which some form of central planning – Marxist, fascist, Peronist, or just plain old dictators and their cronies – has prevailed.

Stock markets – though we now recognize that markets are not perfectly efficient – have been a vital way for companies to raise capital. The link between the stock market and the real economy, in which companies and people produce and sell goods and services, has traditionally been strong. This is vital, since financial markets rest on an uneasy compromise: corporations and their financial advisors can make as much money as they want as long as everyone else has the opportunity to share in that wealth. The public shares in the wealth in a variety of ways, the most important of which is employment income and associated benefits. The public also shares in the wealth by having the opportunity to invest its savings in those same corporations. If this link is broken, public support for capitalism will wane, and the United States could go the way of Argentina.

Already, the signs are ominous. In 1961, individual investors accounted for 62% of the total value traded on the NYSE. By 2009, this had fallen to two per cent. Block trades of 10,000 or more shares in a single transaction accounted for only three per cent of the NYSE trading volume in 1961; today they account for around 25% of total U.S. market volume. By itself, this evolution is hardly worrisome; much of it can be attributed to the rise of mutual funds and similar vehicles, which have become the preferred investments of many individual investors and which can offer better risk-adjusted returns than those less sophisticated investors could produce on their own. But accompanying this trend is the rise of high frequency trading, which now accounts for over 70% of all U.S. equity trades. High frequency trading, based on sophisticated computer algorithms, involves holding large positions for a very short time – often fractions of a second – to generate huge returns. Their practitioners argue that they provide liquidity and reduce bid-ask price spreads, which may be true, but the banks and hedge funds employing such strategies are playing with their own capital and that of wealthy investors. Your average individual investor, who may have a portfolio of a couple hundred thousand dollars or less, does not play in this sandbox.

The stock market, which has forever been likened to a casino, has truly come to resemble one, and I am not referring to the two-dollar blackjack tables in Reno. It has become much more like the exclusive, velvet-roped areas where the likes of James Bond and Asian billionaires play baccarat or high stakes poker for millions of dollars.

Felix Salmon, the Reuters financial blogger, writes in an excellent op-ed piece in the New York Times, “The stock market is becoming increasingly irrelevant — a trend that threatens the core principles of American capitalism. These days a healthy stock market doesn’t mean a healthy economy, as a glance at the high unemployment rate or the low labor-market participation rate will show… What’s good for Wall Street isn’t necessarily good for Main Street… the glory days of publicly traded companies dominating the American business landscape may be over. The number of companies listed on the major domestic exchanges peaked in 1997 at more than 7,000, and it has been falling ever since. It’s now down to about 4,000 companies, and given its steep downward trend will surely continue to shrink… Put another way, as the number of initial public offerings steadily declines, the stock market is becoming little more than a place for speculators and algorithms to compete over who can trade his way to the most money.”

Even the NYSE, the one-time flagship of the American capitalist system, is becoming marginalized, as its recent acquisition by Deutsche Börse indicates.  According to John Gapper of the Financial Times,  in 2005 79 per cent of the volume in NYSE-listed shares was traded on the exchange itself. By March 2010, that figure had fallen to 23 per cent. Gapper writes, “The NYSE has been squeezed out not only by upstart exchanges such as BATS (an electronic trading platform, established in 2005, which now ranks as the third-largest exchange in the United States) but by ‘dark pools’  – private exchanges on which institutions trade with each other in large blocks – and by banks making transactions internally. The two now account for about a third of US equity trading.”

As long as individual investors can invest in the markets and feel that everyone, big or small, is playing by more or less the same rules and that the markets are essential to the income and jobs on which we depend, capitalism will thrive. When that connection is broken, and people come to believe that capitalism is a game rigged in favor of a small elite, it won’t. The alternatives to capitalism, for the most part, are too awful to contemplate, so  the markets have to be reformed – soon –  for the system to survive.

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Last week’s announcement that Goldman Sachs had invested somewhere around $450 million in Facebook, giving the social networking giant a notional value of $50 billion, reveals the shortcomings of the Dodd-Frank financial reform law passed last year.

The “Volcker Rule,” proposed by former Fed Chairman Paul Volcker and incorporated in the new law, aims to limit banks’ ability to engage in proprietary trading – using their own funds to trade securities, potentially in conflict with the interests of the clients whose assets they manage. The Volcker Rule itself was something of a compromise measure. Ideally, the largest banks – those like Goldman Sachs, Citigroup, and J.P. Morgan Chase, which are deemed “too big to fail” would have been broken up and prevented from ever again becoming so big that the collapse of even one of them could threaten to bring down the entire global banking system. But that ideal was strangled at birth by legislators on both sides of the aisle, whose relationships with the banking sector can generally be described as “cozy.” [click to continue…]

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When two leading strategy consulting firms, each of which prides itself on rigorously independent analytical thinking, release reports in the same week on roughly the same topic, there are only two possible conclusions: either they have been afflicted by the same kind of groupthink that led those famously independent Wall Street firms over the precipice of subprime mortgages, or they are onto a real and important phenomenon. I suspect a bit of both.

On June 2, Boston Consulting Group (BCG) released a report “The African Challengers: Global Competitors Emerge from the Overlooked Continent.” That same week,  the McKinsey Quarterly, the journal of McKinsey & Company consultants, released its summer issue with a cover story and several additional articles devoted to “Africa’s Growth Story.” Having spent much of my career in Africa, and having written fairly extensively in this blog and elsewhere about both the promise and the frustrations of the continent, I am gratified to see an alternative take on Africa to what many call the “CNN Effect,” which focuses on poverty, starvation, and armed conflict to the exclusion of almost everything else. Still, it’s not clear that these reports fully meet the test of truth, originality, and relevance.

With respect to originality, both McKinsey and BCG are a dollar short and a day late. In May 2007, Stephen Jennings, the billionaire founder of Renaissance Capital, who made his fortune investing in Russia after the breakup of the Soviet Union, said, “If Russia was a once-in-a-lifetime opportunity, sub-Saharan Africa is a second once-in-a-lifetime opportunity.” Starting his first African operation in 2006, Jennings has put his money where his mouth is, establishing offices in Lagos, Nairobi, Harare, Accra, and Johannesburg, launching the $1 billion Africa Renaissance Fund, buying up African brokerage houses in several countries, and participating in scores of African mergers, acquisitions, and IPOs, most of them worth at least several hundred million dollars.

Also in 2007, Goldman Sachs, whose analyst Jim O’Neill coined the term “BRIC” in 2001, released a report “BRICs and Beyond,” which identified what it called the “Next 11,” large population countries, at least some of which could soon rival the G-7 countries in economic importance. Nigeria, the report predicted, could become the 10th or 11th biggest economy in the world by 2050, ahead of France, South Korea, Canada, and Italy, and just behind Japan, the U.K., and Germany. Though Goldman Sachs doesn’t agree, I have stated several times that by 2050 Nigeria is likely to have overtaken Russia as well.

Being first isn’t the only thing that matters, of course. Half a dozen people developed versions of the incandescent light bulb well before Thomas Edison, but without Edison their inventions might have remained an uncommercialized curiosity.

But do these reports tell us anything that is true, non-obvious, and useful? Let’s start with BCG’s report, whose scope is narrower than McKinsey’s. BCG examined 600 companies in Africa to come up with a list of 40 “Challenger” companies from countries it inevitably dubbed “the African Lions.” The Lions comprise Algeria, Botswana, Egypt, Libya, Mauritius, Morocco, South Africa, and Tunisia. I have always had a problem with the BRICs construct – there seems to be much more that divides than unites the four countries – but BCG’s grouping makes even less sense. “Great diversity exists among both the African Lions and the BRIC countries,” says the report, “but the development model for all of them rests on similar pillars: political stability, rule of law, property rights, access to capital, and public investment in education, health, and social services.” Really?

China, Russia, Algeria, and Libya may be long on political stability, but they come up woefully short on property rights and rule of law. Inconveniently for BCG, five of the 40 Challengers don’t even come from the Lion countries since BCG’s criteria for lionhood somehow weren’t elastic enough to allow them to include Angola, Nigeria, and Togo in the group. The exclusion of Nigeria, the continent’s largest country by population and second-largest by GDP, is particularly hard to explain, since according to the Heritage Foundation’s Index of Economic Freedom it scores well above Libya and China and the same as Algeria and Russia on property rights and better than all but China on corruption.

McKinsey’s analysis is altogether a more serious effort than BCG’s. It makes some true, if not terribly original, points, one of which is that as important as natural resources are to African economies, much of the economic growth in recent years has come from other sectors, including transport, distribution, telecommunications, manufacturing, and agriculture. McKinsey correctly attributes this growth not only to commodity price booms but also to better macroeconomic management, the sale of many state-owned enterprises, trade liberalization, and more business-friendly policies and regulations. The McKinsey report highlights Nigeria as “an example of an African oil exporter that has begun the transition to a more diversified economy. Natural resources accounted for just 35 percent of Nigeria’s growth since 2000, and manufacturing and services are growing rapidly.”

The McKinsey report also highlights the rapid growth of Africa’s population, its relative abundance of arable land, its rapid urbanization, growing domestic markets, and a higher rate of return on investment than other regions, concludes that “Global executives and investors cannot afford to ignore this. A strategy for Africa must be part of their long-term planning. The time for businesses to act on those plans is now.”

McKinsey’s analysts do have a point. It would be reckless to ignore Africa’s growing importance as a market and a source of much of what the world needs, but does that really mean that investors must act now? There’s no evidence that the first foreign companies to invest in China made any more money than those who waited to learn from their mistakes, and some evidence they actually fared worse. And does it mean that a single strategy for Africa, which consists of 53 countries instead of one (54 if you include Western Sahara, which is claimed by Morocco), makes any sense? McKinsey identifies several different groups among African countries – diversified economies, oil exporters, transition economies, and pre-transition economies – but provides precious little guidance to the corporate, institutional, or individual investor trying to make sense of it all.

If the ongoing crisis in the eurozone teaches us anything, it is that even countries that share a common market and a common currency are very different and offer the investor very different opportunities and risks. Germany and Greece were never very much like each other, but the chasm between them is now especially wide, with the spread between yields on German and Greek sovereign bonds rising to 8.5% this week.  They, however, are as peas in a pod next to the differences between, say, South Africa and Equatorial Guinea or Egypt and Angola.

Africa does not represent a single investment opportunity any more than Europe or emerging markets or the BRICs. There is a Facebook group called “Africa is a Continent not a Country, and no I Can’t Speak African,” which sums it up nicely. Both BCG and McKinsey grossly oversimplify matters. If these publications are any indication of the kind of advice these firms offer their paying customers, any company or investor trying to figure out how to approach Africa should probably look for a different set of advisers.

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