Investment Harvard College
Magazine Winter 2010
RECOVERING THE EUROZONE What’s Next For Europe: Divided It Fails The Eurozone: A Long-Term Short?
Plus:
Being Realistic About Individual Stock Investing In The Long-Run
Solving The Chicken And The Egg Problem Of The Wall Street Job Search
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Harvard College
Investment magazine winter 2011
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The Harvard College Investment Magazine (HCIM) is a semi-annual publication devoted to presenting the significant and current topics of investment and finance. Blending professional articles, interviews, and academic research, the magazine offers a comprehensive array of commentary to the investment field, serving as a platform of intellectual exchange between the professionals and the Harvard academic community.
WINTER 2011 STAFF BUSINESS BOARD Richard Hwang DIRECTORS
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EDITORIAL BOARD Connie Lee DIRECTORS
Ike Greenstein
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COPYRIGHT 2010 (ISSN: 1548-0038) HARVARD COLLEGE INVESTMENT MAGAZINE. No material appearing in this publication may be reproduced without written consent of the publisher. The opinions expressed in this magazine are those of the contributors and not necessarily shared by the editors. All editorial rights reserved.
EMERITUS ALUMNI Jonathan Greenstein BOARD Matthew Lee Zachary Rosenthal Stanley Chiang Jennifer Y. Lan Kuanysh Y. Batyrbekov
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3 Harvard College Investment Magazine
Charleton Lamb Sara Plana Melissa Wong
Benjamin Y. Lee Rika Christanto Michael Hoschild Biran Kozlowski Anna H. Yu
Jeremy C. Stein Winter 2010
Dear Reader, Welcome to the Winter 2011 issue of the Harvard College Investment Magazine. In this issue, we are excited to bring you analyses of recent economic events, both domestic and international, and insightful interviews with finance professionals and business people. In this issue, we, our writers, and our guest contributors have written articles about recent about key developments in Europe and the United States. Our last issue was about the aftermath of the financial crisis in the United States, whereas this issue includes articles on the same in Europe. We have also included an two advice articles with effort to become increasingly relevant to our audience, one on how to go building one’s own intellectual capital in getting hired for Investment Banking on Wall Street, and one about rethinking individual stock investing as a long term personal finance tactic. We still, however, highly encourage stock investing as an educational (and we hope, lucrative) hobby for students and others and we see extreme value in a career in equity investing and research. To assert this, we have decided to publish two stock pitches by our friends at CollegeStockPicks.com, a student group here on campus. Remember to take a look at our past issues on www.harvardinvestmentmagazine.com. We’ve added new online magazine display capabilities on our website earlier this year.. We hope you enjoy viewing our HCIM Archives, comparing where we were before to where we are now, with issues dating back 6 years to Spring 2004. Finally, we want thank everyone who dedicated their time to putting this issue together. We are proud of all the intellectual capital and resources that have been gathered to bring you this issue, and on behalf of the entire Harvard College Investment Magazine staff, guest contributors, design team, and Emeritus Alumni Board, we hope you turn the page and enjoy this issue!
Sincerely, Eva Sadej and John Du Editors-in-Chief
harvard college investment magazine
letter from the editors
The Eurozone: A LO N G - T E R M
SHORT? By Marc Steinberg
S
ince the beginning of 2010, financial headlines have been dominated by Europe’s ominous reports of financial instability. In early 2010, news of Greece’s near insolvency and distressed fiscal condition sent debilitating shockwaves throughout the Eurozone, Europe’s sixteen member currency union. Although Greece’s $150 billion bailout of May was able temporarily to relieve Greece of its potentially crippling obligations and also buoy the rapidly depreciating Euro, the issue of rising and unsustainable sovereign debt has once again reared its ugly head,
further destabilizing European markets. Although Ireland has recently accepted a roughly $110 billion joint EU-IMF rescue package, many fear that this most recent bailout measure will be unsuccessful in assuaging investor uncertainty. The contentious debate surrounding the Euro area’s long-term viability has recently gained popularity as many feel that Eurozone nations will be unable to fully shore up their balance sheets and will therefore be forced to restructure their debt and impose substantial haircuts upon creditors. As a result, many
5 Harvard College Investment Magazine
hedge funds and asset managers, in a manner similar to the fortuitous and prescient few who successfully bet against the subprime housing market, have recently taken bearish positions on the Euro and the European debt and equity markets as many foresee a troubled future for the Euro area.
AN OMINOUS BUILDUP The Euro area enjoyed tremendous economic growth in the years leading up to the global financial crisis. In fact, many of the nations which are now most afflicted by burgeoning debts and Winter 2010
illiquidity were those which were most prosperous prior to recent years. Greece’s economy, for example, grew at a rapid rate of roughly 4% per annum from 1995 to 2005 while Ireland’s economy expanded at an astounding rate of more than 7.7% annually, thereby earning the title “Celtic Tiger.”[1] This period of economic growth, however, appears to have resulted from a confluence of unsustainable macroeconomic conditions which are now weighing heavily upon the nations of Europe. The most glaring manifestation of Europe’s unsustainable habits is found in the tremendous Winter 2010
accumulation of sovereign debt which occurred over the past decade. As less prosperous nations such as Greece, Ireland, and Portugal adopted the Euro, they simultaneously witnessed a precipitous drop in the yields demanded on their sovereign debt. With government bond yields converging to the relatively low Eurozone average, many of these nations which were previously priced out of the public debt market took on large sums of debt. Italy and Greece, for example, currently maintain debt to GDP ratios of nearly 120%, double the maximum allowance of
debt as a percentage of GDP permitted in the EU’s guiding Treaty of Maastricht. [2]
TEETERING ON A CELTIC DEFAULT? Ireland is the most recent European nation to fall under international scrutiny as a potential culprit of default. Yet unlike Greece, Ireland’s primary problems stem from the unsound financial situation of its domestic banks and not from its national government which is actually fully funded through the middle of 2011. As a result of, inter alia, a
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collapsing asset bubble, stagnating international growth, and reckless lending during the overinflated real estate bubble of the preceding decade, Irish banks have sustained precipitous declines as of late. These banks, which remain by beleaguered unsustainable losses and insufficient capital, have grown addicted to central bank liquidity, accounting for nearly 25% of outstanding ECB liquidity. Moreover, Ireland is planning to pump more capital into its troubled banks as €10 billion of the €85 billion bailout are to be used immediately to recapitalize Irish banks while another €50 billion will be devoted to meeting the state’s debt obligations. Many believe that without this recent emergency aid, many of Ireland’s largest banks would have collapsed, thereby dragging down the economy as a whole.
THE INEVITABILITY OF RESTRUCTURING The two aforementioned bailout plans were able to, at least temporarily, ameliorate financial market turmoil via their ability to forestall restructuring or default. Many economists and financial analysts nevertheless view the present state of the Euro area’s finances as unsustainable. It is argued that restructuring is inevitably for
7 Harvard College Investment Magazine
those European nations with the most unsustainable debt trajectories, such as Greece, Ireland, and Portugal. In fact, German Chancellor Angela Merkel acknowledged in October the realistic possibility of sovereign restructuring when she advocated for private-sector involvement in public debt restructuring. In a move which rattled financial markets and prompted a sell-off of much high-yield government debt, Merkel contended that investors might be forced to take a haircut to their payments so as to prevent the full burden of restructuring from falling on the taxpayers. [3] Moreover, a recent proposal by Germany, France and several top European officials proposes that after 2013, creditors of countries which are labeled “insolvent” would face restructuring. [4]
FEAR AND CONTAGION Many investors fear that the greater threat to Europe’s economic growth stems from the contagion of sovereign debt woes. If funding problems spilled over onto larger economies such as Spain or Italy, a bailout would no longer be practical. In the absence of a viable bailout, many fear that such spillover would ultimately result in widespread restructuring which would inflict substantial losses upon those holding such debt. The
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effects of such haircuts are compounded by the fact that many of the largest creditors to these struggling nations are in fact European banks. One indicator reflecting the riskiness and level of investor confidence in sovereign debt is the price of credit default swaps used to insure against losses on government bonds. The costs of insuring Irish, Portuguese and Spanish debts have all risen to near record levels recently. [5] Moreover, the iTraxx SovX Western Europe index, a basket of derivatives insuring the debt of 15 developed E.U. nations, is nearing its all-time high of 180 basis points.[1][6] Investors are therefore fearful of potential restructuring taking place throughout the entire Eurozone, not just those nations which have recently come under fire for maintaining large sovereign debts.
DÉJÀ VU In his 1998 novel The Crisis of Global Capitalism: Open Society Endangered, legendary Hedge Fund manager George Soros, who gained international acclaim in 1992 when he made more than $1.1 billion by shorting over $10 billion worth of British pounds and contributing to the Bank of England’s withdrawal from the European Exchange Rate Mechanism, stated, “The financial crisis that originated in Thailand in 1997 was particularly unnerving because of its scope and severity.... By the
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beginning of 1997, it was clear to Soros Fund Management that the discrepancy between the trade account and the capital account was becoming untenable. We sold short the Thai baht and the Malaysian ringgit early in 1997 with maturities ranging from six months to a year.” Soros’ rationale for shorting the currencies of Southeast Asian countries would certainly be apropos in justifying bearish positions on the Euro and European equities today as the financial health of many European nations remains uncertain.
THE ATTACK OF THE BEARS Many hedge funds have recently begun betting against the Euro and European industries. They have taken bearish positions on government bonds of the Eurozone’s many troubled economies as well as equities in those industries most closely tied to a country’s economic performance, such as financials, construction, real-estate, and industrial. It is argued that the rising funding costs of governments will ultimately spill over into the private sector and thereby result in a higher cost of capital for banks and Eurozone companies. The world’s second largest hedge fund, Bridgewater Associates, stated in February, “As expected, the Spanish government decided to run big budget deficits that have been funded with big borrowings, but the more the debt increases, the closer this
Harvard College Investment Magazine 8
approach is to coming to an end… We judge Spanish sovereign credit to be much riskier than is discounted because it seems to us that there is a high risk that Spain won’t be able to sell the debt that it needs to fund its deficits.” [7] Another bearish bet attracting recent attention concerns banks in peripheral countries. These banks have drastically increased their holdings of domestic, government debt and must now muster up increased
collateral to compensate for the declining prices of such debt.
A FUTURE OF UNCERTAINTY The future of the Euro area presents in and of itself a paradigm of both certainty and uncertainty. It is without a doubt that the Eurozone countries must reform. Their debt trajectories are presently untenable and they therefore must take imme-
diate action to shore up their fiscal health. Nevertheless, the mechanism for achieving this end result of a healthier public balance sheet remains yet to be seen. While some argue that European nations will be forced to restructure their ballooning sovereign debts, others contend that the synergy of emergency relief funds and ambitious austerity measures will be sufficient. Moreover, some economists even argue
“ I t i s w i t ho ut a do u b t th at th e Eu r ozo ne c o unt r i e s mu st re fo rm. Their d eb t t ra j ec t o ri e s are pre se n tl y u n tena b le a nd th e y th e re fo re mu st ta ke i m m ed i a te acti o n to sh o re up t hei r fi scal h e al th .” that the fundamental construct of the Eurozone is destined for failure insofar as a monetary union cannot function efficiently without an accompanying mechanism of fiscal centralism. Regardless of which road the countries of Europe ultimately follow on their way towards economic recovery, the future of Europe will likely be one of increased uncertainty, for in the words of ECB Chief Economist Juergen Stark, “We are likely to experience more volatility in macroeconomic variables than in the pre-crisis period.” [8] Although this increased uncertainty and volatility is apparent, what remains to be seen is whether the Euro area will emerge as a sustainable and prosperous currency union or a feasting ground for the doubting bears.
References 1. “Ireland GDP Growth.” World Bank. World Development Indicators. November 24, 2010. 2. “Treaty of Maastricht on European Union.” Summaries Of EU Legislation. October 7, 2007. 3. “EU Backs German Call for Debt Mechanism, Spars on Restructuring.” Bloomberg Businessweek. October 29, 2010. 4. “Europe Sets Bailout Rules.” Wall Street Journal. November 28, 2010. 5. “Ireland Leads Rise in Government Credit-Default Swaps in Europe.” November 2, 2010. 6. “iTraxx SovX Western Europe Hits All-Time Wide Of 187BPs – Markit” Wall Street Journal. November 24, 2010. 7. “Contagion fears over ‘too big to bail’ Spain.” Financial Times. November 17, 2010. 8. “Eurozone growth unlikely to reach pre-crisis levels: ECB.” The Economic Times. November 16, 2010.
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Winter 2010
WHAT’S NEXT FOR EUROPE?
by Guest Contributors: Louise Laciny, Alex Breinin
T
he recent financial crisis may have originated in the US, but its impact was much worse in Europe than many realize. The financial crisis exposed vulnerabilities in the policy framework of the Eurozone. Europe’s previous economic initiative, the Lisbon Agenda, intent on accelerating European economic growth to match that in the US, has been deemed a massive failure, largely because of its inability to get the necessary political traction. Now, Europe must correct their existing framework and strengthen its Europe Winter 2010
2020 strategy if it is to halt its contin- cal stimulus. In some countries, automatic stabilizers like unemployment ued decline relative to the US. insurance increased their deficits, and expansionary fiscal policy was used to prop up their economies. THE CRISIS IN EUROPE While these policies initially enjoyed relative success and, arguably, The situation in Europe, while simi- avoided a second Great Depression lar to that in the US, at first appeared in Europe, in reality, only monetary to be less severe and hence received a similar policy response. European policy worked well. Fiscal, competiauthorities restored banks’ liquid- tiveness, and banking policies all exity and capital, cut interest rates, perienced crippling failures. In fact, provided lender-of-last-resort facili- the housing bubble was larger in the ties and implemented the European Europe than in the U.S. and “some Economy Recovery Plan (EERP) fis- large European banks were even more Harvard College Investment Magazine 10
highly leveraged” than U.S. banks. Individual countries in the Eurozone could not save their banks that “were both massively overleveraged and holding important quantities of toxic assets” with monetary policy just as could the U.S. Fed (Baldwin, 11). The crisis revealed extraordinary problems within the Eurozone. Countries had signed the Stability and Growth Pact, which stated they would keep their deficits below 3% of GDP and debt levels below 60%; yet, this pact could not be enforced. Many countries, such as Greece, Ireland, Portugal, and Spain that had high inflation rates (due to their booming economies) accumulated large current account imbalances and debt. Banking policy failed to ensure adequate capital ratios and so other banks in Europe held their debt. Particularly, French, Spanish, and Italian banks aggressively expanded lending. (Baldwin, 4). Additionally, EU governments failed to follow the US practice of stresstesting banks (C13). Therefore, when Greece needed to refinance 54 billion Euros in May 2010 but could not afford it, the IMFv gave Greece a bailout worth 110 billion Euros realizing that “a failure in Greece, especially if it triggered failures in Spain, threatened a systematic banking crisis in the Eurozone core nations such as Germany and France” who held their debt (Baldwin 13). A week later the European Central Bank (ECB) began buying “public debt only of fiscally ‘challenged’ countries” with its “securities market programme” (Baldwin 15). Europe’s
impressively coordinated and decisive response, the “securities market program,” allowed the ECB to buy GIPS (Greece, Italy, Portugal and Spain) debt. While this arguably saved Europe from disaster, it left the Eurozone Policy Framework, which forbade ECB purchases of sovereign debt, in tatters. The IMF established a 750 billion Euro Special Purpose Vehicle to serve as bailout money if more would be needed. Still, as Richard Baldwin
“
predicted growth rates for the Euro area are extremely low and may still be too optimistic. Countries in the Eurozone believe that their GDP growth rates will improve to approximately 1.5 percent by 2013. However, Europe’s sustained failure to develop IT innovation may prove these estimates too high. (Jorgenson, 2010).
OUT WITH THE OLD: THE LISBON AGENDA The Lisbon Agenda, adopted by the Lisbon European Council in March 2000, came in response to a worrying divergence between the US and European growth rates from 1995 onwards after years of narrowing the gap. Its aim was to make Europe “the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion” by 2010 (europa.eu). This meant focusing on high-skill workers, IT intensity, and innovation – the three components of a knowledge-based economy. While it is now clear that the Lisbon Agenda has failed, the obstacle to progress was politics rather than economics. Between 1973 and 1995, The EU-15 nearly closed the gap with the United States in terms of labor productivity. By 1995, the labor productivity gap between America and the EU-15 was only 1.7 percentage points (van Ark et al., 2010). However, from 1995 to 2004, the annual average growth rate of labor productivity in the Untied States doubled that of the EU (van Ark et al., 2010). Data released from the EU KLEMS (capital, labor, energy, materials and services) research project in 2008 allow us to compare contributions to economic growth from different inputs across individual industries. Of the three components of the knowledge economy, it is not
Europe may continue to suffer additional problems from the sovereign debt crisis, and currently, the predicted growth rates for the Euro area are extremely low and may still be too optimistic.
”
and Daniel Gros stated in June 2010, “The crisis is not over. Eurozone bank systems – in both the core and periphery members – are in a parlous state…. Massive shocks could come from any number of sources” (Baldwin 17). Europe may continue to suffer additional problems from the sovereign debt crisis, and currently, the
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Winter 2010
labor composition but multi-factor productivity, or innovation, and IT capital input, which have contributed most to this difference. Breaking down the data even further reveals that the sector contributing most to the divergence is market services, an important industry that counts for 40% of US GDP. While market services’ contribution to EU growth has fallen from 0.7% to 0.5%, the contribution to US growth has jumped from 0.8% to 1.8%. Such an improvement in US market services has been the result of vast productivity growth within the sector, made possible by high investment in IT and a growing participation of high-skilled workers in market services (Jorgenson, 2010). Indeed, the share of high-skilled workers in market services was 30.6% in the US in 2004 compared to just 8.0% in Germany. (van Ark et al., 2010). High investment in IT is particularly significant given its effectiveness; IT contributes as much as 40-60% of private sector growth despite only making up 3% of GDP. Additionally, IT enables innovation and thus higher growth in the long run. In particular, IT enables a new kind of innovation founded on four main drivers: measurement (firms can collect more data on their current operations), experimentation (firms can also collect data on tests of new strategies), sharing (communication within firms is quicker and easier) and replication (new strategies can be rolled out across firms much faster). Thus in the year 2000 the EU found itself seriously lagging behind the US in terms of Winter 2010
the knowledge economy (high-skill workers, IT intensity and innovation). The EU concluded that the slow uptake of the knowledge economy was due to large bureaucracies that stifled risk-taking, inefficient public sectors and social policies, wasteful unemployment, and fragmentation and protectionism (C09, 2009). So the
policies outlined in the Lisbon Agenda had the ambitious aim of bringing about major structural reform in Europe intended to hasten the development of the knowledge economy. They looked to create a European “single market,� deregulate the labor markets, and stimulate an environment conducive to innovation.
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These were worthy, if difficult to achieve, goals. Firstly, the single market would encourage trade, labor mobility, and research collaboration across borders. Mario Monti described “making the single market more efficient” as “Europe’s best endogenous source of growth and job creation” (Brand, 2010) Forming a single market within the ten years of the Lisbon Agenda may have been overly ambitious, but that is not to say that at least some progress could not have been made. Deregulation would have made the European labor markets more efficient, reducing unemployment and getting the people with the relevant skills into the right jobs. This is especially important in Europe, where syndicalism (a system based on powerful trade unions) is rife and thus barriers to entry into many professions are prohibitively high. In
Greece for example, around 70 professions, such as law, are still closed. Lastly, creating an environment conducive to innovation would also have laid the foundations for higher IT investment and future growth, as explained earlier. Schumpeter’s “creative destruction” would allow highIT firms to replace the less productive low-IT firms. (Jorgenson, 2010) While the Lisbon Agenda was economically feasible, it failed because of politics. This problem was identified as early as 2004. The Kok report claimed of the failure of the Lisbon agenda that its progress had been disappointing due to lack of determined political action. Additionally, the Bolkestein Directive, which called for a single market, would greatly help Europe achieve its goals as a single market with less restrictive trade policies could help unify business practices. They discuss Blook’s
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and Van Reenen’s finding in 2007 that “significant cross-country differences in corporate management practice” exist throughout Europe and U.S. firms are better managed (van Ark et al., 2010). Therefore, if the Lisbon Agenda had been instituted it would have allowed for IT to have a much greater effect on increasing multifactor productivity in Europe, and for the Lisbon Agenda to have achieved its goals today (Jorgenson, 2010).
IN WITH THENEW: EUROPE 2020 Thus looking forward, Europe has a lot of work to do in terms of building a new, more effective policy framework. Baldwin, Gros and Laeven stress that the European policy response has not gone far enough. There are still several weaknesses in the European economy, such as the continued mess in Greek financWinter 2010
es and the fragility of the banks, which Europe still has to address. In addition to the immediate crisis response, Europe also has Europe 2020 to enhance and replace the failed Lisbon Agenda. It has three priorities: smart growth (expanding the knowledge economy), sustainable growth (promoting “green” technologies), and inclusive growth (increasing employment and improving social cohesion), and outlines seven initiatives to achieve these goals. Significantly, however, Europe 2020 omits the two most urgently needed reforms: completion of the single market and fiscal consolidation. Europe must stop avoiding these harder political challenges and face up to the fact that failure to address them will only widen the gap between Europe and the US. Indeed, the US is a fast-moving target. The Obama Innovation Strategy has over $100 billion of funds to stimulate innovation and economic growth in the US. To compete with this, European government must remain strong. Winter 2010
REFERENCES: 1. van Ark, Bart, Mary O’ Mahony and Marcel P. Timmer (2008), “The Productivity Gap between Europe and the United States: Trends and Causes,” Journal of Economic Perspectives, Vol. 22, No. 1, Winter, 25–44. 2. Baldwin, Richard and Daniel Gros (2010), “Introduction: The Euro in Crisis: What to Do?” in Richard Baldwin, Daniel Gros, and Luc Laeven, eds., Completing the Eurozone Rescue: What More Need to Be Done? London, Centre for Economic Policy Research, June, pp. 1-24. http://www.voxeu.org/reports/EZ_Rescue.pdf 3. Brand, Constant. “Monti stresses need for full single market.” May 10, 2010. http://www. europeanvoice.com/article/2010/05/monti-stresses-need-for-full-single-market/67933.aspx 4. C09: European Energy Regulators’ 2010 Work Programme. (2009). 5. C12: Directorate General for Economic and Financial Affairs (2009), Economic Crisis in Europe: Causes, Consequences and Responses, Brussels, European Commission, pp. 1-22. http://ec.europa.eu/economy_finance/publications/publication15887_en.pdf , http://europa.eu. 6. Summary of EU Legislation: Growth and Jobs. http://europa.eu/legislation_summaries/ employment_and_social_policy/growth_and_jobs/index_en.htm 7. Information Society on “Facing the Challenge” (the Kok Report, November 2004). http:// ec.europa.eu/information_society/tl/essentials/reports/kok/index_en.htm 8. Jorgenson, Dale W. (2010) Economics 1490: Growth and Crisis in the World Economy. Harvard University, Cambridge, MA.
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By Ravi N. Mulani
H
igh unemployment takes extremely aggressive manner . a disastrous human toll. There is a great deal that the People who have lost jobs federal government should and must for long periods of time lose skills do to combat high unemployment. necessary to re-enter the workforce. The stimulus bill was an enormous While they are unemployed, they step in the right direction, saving and are unable to provide necessities for creating millions of jobs [1] through their families, pay for their kids’ edu- public investment, targeted job crecation, and lead even reasonably tol- ation programs, and strengthening erable lives. Some might be inclined the safety net for the poorest, but to think these problems are ones of it was not nearly large enough, and personal responsibility, and while this must now be followed by more accold perspective lacks compassion or tion. A worthwhile first step would empathy, it ignores the enormous mac- “There is a great deal that the roeconomic prob- federal government should and lems that high unmust do to combat high employment causes as well. Less people unemployment.” with steady incomes leads to far less demand for products, be to pass a large aid package to states which prevents businesses from in- and local governments; over the last vesting in new employees or expan- few months [2], the private sector has sion of businesses. This dangerous been slowly adding jobs while the cycle is the reason why today’s level public sector has been quickly shedof unemployment is absolutely un- ding jobs. Such a change in the jobacceptable from a human and eco- less picture is unhealthy and reduces nomic perspective, and must be dealt aggregate demand, slowing down with by the federal government in an our recovery. Other worthwhile ini15 Harvard College Investment Magazine
Winter 2010
tiatives should include passing bills to invest in infrastructure, clean energy, early childhood education, and other job-producing projects that are essential for the future of our economy. Many in the world of economic punditry would argue that fiscal recovery measures should not be passed when the deficit is relatively high. They argue that borrowing by the federal government will create uncertainty and raise interest rates, thus crowding out private investment. However, in this reasoning they are making a common logical error that has been prevalent since the times of the Great Depression. When there is a high demand for loanable funds, public borrowing might crowd our public investment. But when there is a large supply for loanable funds and low demand, public borrowing and investment does not crowd out private investment, but rather replaces the lack of private demand and fills the output gap between America’s current weak output and its potential output. This is especially clear from the low yields on American bonds Winter 2010
right now, at 2.14% for ten year bonds, significantly lower [3] than in 1989 (9.09%), 1993 (6.6%), and 2001 (5.16%). Not only this, but the best and most effective deficit reduction strategy is higher GDP growth: a .5% increase in annual GDP growth would reduce the deficit by 40 to 50%. Finally, fiscal stimulus through jobcreation and investment measures would be have a much more profound impact on the economy and be significantly less expensive than an extension of the Bush tax cuts, which would cost hundreds of billions of dollars with little help to the economy at large. The only entity that has the power to significantly reduce unemployment right now is the federal government. The impact of monetary policy is important, but even Ben Bernanke has said [4] that his measures will only have limited effectiveness without fiscal expansion, because in the end, quantitative easing is implemented with the end goal of encouraging more spending.
Unemployment is not merely a humanitarian issue: the lack of demand it causes has very real consequences for the health of our economy. It is in the interest of the business world for unemployment to significantly decrease, and the federal government must take further action to make this a reality.
References 1. http://www.cbo. gov/ftpdocs/106xx/ doc10682/11-30-ARRA.pdf 2. http://yglesias.thinkprogress. org/2010/12/the-conservative-recovery-2/ 3. http://www.federalreserve. gov/releases/h15/data/ Monthly/H15_TCMNOM_ Y10.txt 4. http://www.nytimes. com/2010/12/01/business/economy/01fed. html?partner=rss&emc=rss
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Solving The Chicken And The Egg Problem by Eva Sadej
e h T m o sights Fr
In
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ou can’t get a job until you’ve got experience. You can’t get experience until you’ve got a job. As in a good number of career paths, the chicken and the egg scenario is prevalent in the financial services industry, particularly in investment banking. The reasons why are two-fold. Firstly, your job involves dealing with complex transactions and sensitive client relationships with very high stakes—situations in which no one will trust you unless you have already proven yourself in some relatable way. A poor choice made in recruiting can be costly for an investment bank in terms of the opportunity cost of not hiring the candidate behind you who may have perhaps been a little more enduring, tactful, or quicker. Secondly, the best preparation for investment banking is performing
actual investment banking work. Universities, even those with business and finance programs, do relatively little to prepare you compared to the tried-
“
What we’ve done as finance practitioners is harness the ultimate blend of theory and practice. - Pearl
”
and-true corporate training programs available at major banks and the priceless experience of learning by doing. So how do you beat the odds?
17 Harvard College Investment Magazine
Knowledge and presentation. By knowing as much as you possibly can in the most cohesive manner that you can. By knowing the details but predominantly by being able to keep track of where they fit in the bigger picture and having examples to back this up. By learning how to speak “I-banker.” Written by two current Wall Street bankers, Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions breaks new ground in explaining how the pros perform valuation, M&A, and capital markets analysis. It is already being used as training material at numerous investment banks and business school programs around the world. Additionally, the book is currently the top selling valuation and corporate finance text in the world. We at HCIM interviewed the authors, Joshua Rosenbaum and Joshua Pearl to learn more about their motivations in writing the book and whether this book is indeed appropriate for our audience. Joshua Rosenbaum is a Managing Director at UBS Investment Bank in the Global Industrial Group, where he advises on, structures, and Winter 2010
h c r a e S b o J t e e r t S l l of the Wa
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eO l b i B e h t ors of
Auth
originates M&A, corporate finance, and capital markets transactions. He received his AB from Harvard and his MBA with Baker Scholar honors from Harvard Business School. Joshua Pearl is a Director at UBS Investment Bank in Leveraged Finance, where he structures and executes leveraged loan and high yield bond financings, as well as leveraged buyouts. He received his BS in Business from Indiana University’s Kelley School of Business. After the interview, we are overwhelmingly positive that this is absolutely critical for anyone who wants to get an edge in the Wall Street job search, be that in investment banking, private equity, hedge funds, investment management, research, corporate finance, or even the Treasury or the office of the CFO. How does your book fill a niche? What makes it different from other books like it? Pearl: Other books available in the market are predominately written by finance professors. These books are far less applicable to the real world of finance as practiced on Wall Street. What we’ve done as finance practitioners is harness the ultimate blend of theory and practice – quite literally, as the finance techniques revealed in our book reflect contributions from both academic and Wall Street leaders. Winter 2010
g
in k n a B t n nvestme
The number and diversity of people that edited this book is astounding, reflecting an elite group of bankers, private equity investors, hedge fund professionals, corporate lawyers, and financial analysts. In short, this is the book we wish had existed when we
were trying to break into Wall Street. Rosenbaum: Investment banking is highly specialized. Even the best business schools don’t quite teach the exact skill set you need. The curricula they teach may be accurate and provide a foundation, but there is still a
“Investment Banking provides a highly practical and relevant guide to the valuation analysis at the core of investment banking, private equity, and corporate finance. Mastery of these essential skills is fundamental for any role in transaction-related finance. This book will become a fixture on every finance professional’s bookshelf.” Thomas H. Lee President, Lee Equity Partners, LLC Founder, Thomas H. Lee Capital Management, LLC
“This book will surely become an indispensable guide to the art of buyout and M&A valuation, for the experienced investment practitioner as well as for the non-professional seeking to learn the mysteries of valuation.” David M. Rubenstein Co-Founder and Managing Director, The Carlyle Group
Purchase your own copy today! www.amazon.com/ dp/0470442204 Please direct advice and feedback to josh@investmentbankingbook.com
http://investmentbankingbook.com/ Harvard College Investment Magazine 18
“Rosenbaum and Pearl succeed in providing a systematic approach to addressing a critical issue in any M&A, IPO, or investment situation—namely, how much is a business or transaction worth. They also put forth the framework for helping approach more nuanced questions such as how much to pay for the business and how to get the deal done. Due to the lack of a comprehensive written reference material on valuation, the fundamentals and subtlety of the trade are often passed on orally from banker-to-banker on a case-by-case basis. In codifying the art and science of investment banking, the authors convert this oral history into an accessible framework by bridging the theoretical to the practical with user-friendly, step-by-step approaches to performing primary valuation methodologies.” --Joseph R. Perella Chairman and CEO, Perella Weinberg Partners
“As a practitioner of hundreds of M&A and LBO transactions during the last 20 years, I recommend this book to advisors, financiers, practitioners, and anyone seriously interested in investment transactions. Rosenbaum and Pearl have created a comprehensive and thoughtfully written guide covering the core skills of the successful investment professional with particular emphasis on valuation analysis.” --Josh Harris Managing Partner, Apollo Management, LP disconnect between theory and practice, including specific techniques, frameworks, and real-world application under intense time pressures. Our book allows you to self-teach everything you need to know to get your foot in the door with both feet ready to go. For example, at a recent corporate finance workshop I gave at Wharton, it was very gratifying to see that nearly all the students in the audience had the book. That in of itself speaks volumes about its importance as a Wall Street training tool. So Harvard does not prepare you for finance. Do you regret the experience? Rosenbaum: Oh, absolutely not. As a graduate from Mather House, I wouldn’t trade it for the world. Harvard offers one of the best liberal arts educations that you can get…period. That will stay with you for life, no matter which career path you choose. It also has a world-leading economics department and offers a wonderful theoretical foundation. In fact, one of the inspirations for writing this book was to better prepare Harvard and other liberal arts students aspiring for a career in finance. I have been
working with the Harvard Office of Career Services on that front over the past couple of years and will be giving an Investment Banking 101 presentation on campus at Harvard on January 25, 2011. The Harvard Coop also stocks our book, including several signed copies. Every year, I invest a great deal of time in recruiting from Harvard and other target schools. How would a student go about reading this book? How long would it take? Pearl: It depends on how deep you want to get into the material. The valuation chapters begin with a summary of the basic concepts if you want the book to simply make you fresh for the interview. But if you really want to get into the details and nitty-gritty, it can take you up to six weeks. Somewhere between two and six weeks is ideal to develop a solid foundation. The book is only 300 pages and is filled with tons of graphics. I heard it took you 5 years to write this book. Is this true? Rosenbaum: At least. Writing this book was a herculean effort. We are both full-time investment bankers, and after working full days and half
19 Harvard College Investment Magazine
of our nights, we used any free time we had to write this book and coordinate with our network of industry veterans and academic contributors, even some lawyers, to edit it down to perfection. Late nights, holidays, and a lot of sacrifices was our formula. How have the messages you intended changed over the time frame of your writing? Pearl: A lot happened between the time when we decided to write the book and when we finished the final manuscript. We began writing at the beginning of a bull market with market color and insights reflecting that reality. Then the markets came down from unprecedented peaks and we adjusted accordingly. For example, we adapted our two chapters on leveraged finance and leveraged buyouts. I believe that our timing in writing the book was actually very beneficial in that we were able to incorporate the events of 2008 and therefore capture the “new normal” that ensued and continues today. In general, our book emphasizes that while the fundamentals of valuation are timeless in the sense that mathematics and certain other scientific principles are endurWinter 2010
“Investment banking requires a skill set that combines both art and science. While numerous textbooks provide students with the core principles of financial economics, the rich institutional considerations that are essential on Wall Street are not well documented. This book represents an important step in filling this gap.” --Josh Lerner Jacob H. Schiff Professor of Investment Banking, Harvard Business School Coauthor, Venture Capital and Private Equity: A Casebook ing, their practical application is very timely as it needs to reflect prevailing market conditions, which can be highly volatile. The way we think about the book is that it provides you with the financial anchor that will allow you to weather any storm that the markets bring your way. Does the book apply to areas of finance other than investment banking? What about the buyside? Rosenbaum: The basic skill set across the financial industry is pretty universal. This book has applications across all sectors of the financial industry because valuation is a fundamental skill that all financial professionals need to understand and use. In fact, we have a significant readership among private equity and hedge fund professionals, and we know this from the amazing feedback we received and their encouraging remarks during the editing process. Any comments about investment banking as a career in general? Pearl: Investment banking is the ultimate apprenticeship program. You Winter 2010
enter a neophyte and after two years are expected to be an expert. After two years you can continue working as an investment banker or pursue other career options. Numerous analysts choose to pursue careers in pri-
I firmly believe that an investment banking analyst program is the ideal training ground for a career in finance. What you learn is priceless for the buy-side, the office of the CFO, business development, start-ups, or anything else you decide to do later on. And our book is focused on preparing you for that career in finance. At the same time, students need to understand that it is a challenging and demanding job – in most cases, it is actually pretty self-selecting and students should do their homework beforehand. Will there be another edition coming out? Pearl: We certainly hope so. It’s typical in professional finance publishing that after a few years of strong sales, a revised edition gets underway. I vate equity or alternative asset man- would expect a revised edition in the agement. Some choose to start their future with updated data and potenown business or pursue graduate tially some expanded topics, but the school. Whatever the path, the two fundamental valuation methodoloyear analyst program on Wall Street is gies and lessons will apply. one of the best stepping stones. HCIM would like to especially thank Rosenbaum: I’ve been doing re- Joshua Rosenbaum and Joshua Pearl for cruiting for a number of years and this exclusive interview.
“
Everything you need to know to get your foot in the door with both feet ready to go. -Rosenbaum
”
Harvard College Investment Magazine 20
STOCK ADVICE: Being
REALISTIC About
Individual Stock Investing In The
Long-Run By Eva Sadej
A
nalyzing individual stocks is usually a job for trained mutual fund managers, investment brokers, and financial analysts. As Benjamin Graham advised in his acclaimed 1949 book The Intelligent Investor, never mix your speculation dollars with your investing dollars: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” What most people don’t realize is that when someone is saying “I have 20% of my portfolio in equities,” they are usually talking about equity indexes and mutual funds, not individual stocks. Your allocation is the biggest driver of your financial returns, much more important than picking any particular stock or mutual fund. Your individual stock choices only determine a sliver of your performance; the vast majority of your returns come from your portfolio allocation, often seen as a pie chart. Your allocation determines what kinds of returns you can expect over the long run and what kinds of returns you shouldn’t expect. It 21 Harvard College Investment Magazine
determines how much risk you’re taking, answering the question “How much money could I lose this year (or over the next 5 years)?” Along with just a few other key pieces of information, your allocation will help tell you if you’re going to be able to retire, or send your kids to the college of their choice, or buy that boat before you’re 50. The “Can I retire?” question may seem far away, but it may soon be important, seeing as the earlier you start investing your savings in tax-advantaged accounts, the more you’ll generally have saved up, and the earlier you can, in fact, retire. The old rule of thumb for people managing money on their own used to be that your age subtracted from 100 is the percetage of your portfolio that you should keep in stocks. For example, if you’re 20, you should keep 80% of your portfolio in stocks. If you’re 60, you should keep 40% of your portfolio in stocks. If you’re in you’re 80’s decrease your percentage accordingly. Now, with Americans living longer and longer, according to CNN Money, most financial planners are recommending that the rule should be closer to 110 Winter 2010
or 120 minus your age. This is because if you need to make your money last longer, you’ll need the extra growth that stocks can provide. Some people invest in individual stocks for the thrill. It can be a game, with emotions as volatile as prices of underlying stocks. But you really shouldn’t be spending your time picking individual stocks unless you really are willing to spend the time necessary to follow the market, don’t mind the brokerage fees, and have allocated the remainder of your portfolio wisely to pad against potential losses. Investing in individual stocks is almost always a loser after a few years as compared to sticking with index funds, unless you specifically in a field that analyses equities professionally or have enough spare time to spend on a side hobby. Let’s look at why the vast majority of investors invest in equities through funds, not individual stocks:
IT’S NOT EASY. Investing in individual stocks without the time or training necessary to perform fundamental analysis can cause you to jump in when at or near the peak of the stock’s performance. If you found a stock in a list of “hot” stock tips, it is likely that its growth phase is at or near decline.
IT COSTS MONEY. Every time you make a decision to buy or sell, it will cost you commission fees depending on your brokerage. These fees can range, depending on your brokerage house, from $4 to $30 or more. Your brokerage account will not count these fees as losses in your portfolio performance display, but you should when deciding whether to make a transaction or not. Lacking the fluidity of a day trader to make buy/sell decisions, it is possible that you may hold onto a stock far longer Winter 2010
than you should in order to avoid the transaction costs.
IT REQUIRES SELF DISCIPLINE: KNOWING WHEN TO SELL. Many investors have difficulty applying a strict sell discipline when investing in individual stocks. Emotional reasons make it hard to part with a stock that’s “treated you well” even as the justification that you had to purchase it in the first place is long gone. Furthermore, when a new holding starts falling immediately after purchase, many investors will root for the stock to “turn around” even though there is no justification for such a move. 1. Perhaps the company’s fundamentals have worsened. Think back to why you purchased the stock. If you consider yourself a value investor, did you invest in the business because it had strong fundamentals and have these fundamentals changed? Is there a new CEO who is professing to take the company in a new direction that you do not agree with? Have earnings declined for two sequential quarters? Perhaps a company that you believed could sustain itself is now being acquired? Has a product pipeline deteriorated? If the reason you bought stock in the company is no longer there, then you’re hanging on to is a poor move. Always know what you own and why. 2. Perhaps it has become too expensive. Perhaps you invested in the company because you believed that the stock price plummeted unduly due to investor fear with a new competitor entering the market. Perhaps you generally believed that the stock price was too low compared to competitors and that the company had excellent growth prospects. Has the P/E ratio gone out of whack? Perhaps now the Harvard College Investment Magazine 22
“
shock or a more permanent drop in performance. Ideally, you should have sold the stock before such a drastic decline but if you have not, look for a cause and determine whether selling is justified or not. Look to the future of the company, not the past, and reassess whether projected future cash flows regardless of the temporary paper loss warrant holding on to the stock . 5. Perhaps you just need the cash. Do you just need to raise cash for a major purchase or for living expenses? Your stocks are as much your money as your savings account. Liquidating your underperforming investments (but only those) is nothing to be ashamed of. Rebalancing your portfolio in this way is important stock price has reached a new height to have an allocation appropriate for and goals. and become overweight. Perhaps it your age has surpassed its true value and is now set up for a fall in price? If you THERE ARE TAXES TO PAY . invested for a great value, your motive is no longer there and though you may If you are debating whether to be proud of the stock, it is time to sell. hold onto the stock a little longer, consider the benefit of holding for 3. Perhaps it has a year so that you can avoid paying underperformed. Can you find a short term capital gains. However, better value elsewhere? If you are don’t hold onto a loser just because keeping your cash invested in an you want to hit the long-term capital underperforming stock, you are gains threshold. Your investment losing money due to both opportunity decisions should primarily be about cost and inflation. Once the stock your investment theses and adherence has hit sell price or wavered to a concrete selling strategy; tax around it for too long, you’ve lost implications should always be a enough money and cutting secondary consideration. your losses to put your money in a more profitable stock is probably IT LACKS DIVERSIFICATION. more worthwhile. Sometimes the best move is to just walk away. And rather The reason that mutual funds, index than adding more money into stocks, funds, and ETFs are less volatile it is best to sell the underperformers than individual stocks is not just and find new value propositions that choices are made by trained elsewhere. Don’t wait until you professionals; it is because profits and break even! You’ll get your money losses are diversified. An index fund back sooner if you don’t wait. which follows the S&P 500 owns stock in 500 different companies. If 4. Perhaps the stock price taken the price of one of the stocks drops a drastic downturn. This is tricky. significantly, the entire fund will be Try to understand what caused the relatively unshaken. You can purchase decline and whether it is a temporary 20-30 individual stocks for a similar
Reassess whether projected future cash flows regardless of the temporary paper loss warrant holding on to the stock.
,,
23 Harvard College Investment Magazine
level of diversification (yes, you get close to no benefit from owning more than 30 stocks) but actively managing a portfolio of 30 individual stocks will ring up brokerage fees and time. [1] Index funds and ETFs allow you to diversify relatively inexpensively, and lowering fees is key to generating higher returns. Counterintuitively, the better you do in the market, the riskier your portfolio becomes. This is because the better you do, the higher the percentage of your total portfolio is in stocks. Thus, even if you initially only wanted 10% of your portfolio to be made up of individual stocks, the more your stocks grow, the higher the percentage of individual stocks in your portfolio. Not only does the entire percentage of stocks in your portfolio increase when a single stock goes up, but so do your holdings in that stock, and, consequently, your risk exposure. This is why rebalancing each year is recommended. Don’t fall in love with a stock. If you just did really well, sell some stocks and rebalance. Creating and sticking to a coherent selling strategy can ensure that you lock in gains and minimize losses. It’s important to know your exit plan – be it account rebalancing or an eye on company fundamentals – for every position in your portfolio so you don’t get left behind. We recommend that instead of investing in individual stocks, you choose low fee ETFs and index funds that closely follow indexes such as the S&P 500 or the Russell 2000 to fill the quota of equity in your portfolio. You’ll sleep better at night and have more time to enjoy other activities in life, those beyond just making money.
BUT IF YOU’RE STILL DETERMINED TO INVEST IN INDIVIDUAL STOCKS FOR PROFIT INSTEAD OF FUN… Try a stock screener. A stock screener neither selects winning Winter 2010
stocks, nor keeps you focused on long-term goals. It does not screen more information than that which is contained in its databases, nor make any real predictions or absolute judgments. It merely links to a data source and sorts information based on the statistics you select. However, if you would like a quick way to choose which stocks are performing well and which companies are currently robust and which ones are failing, stock screeners are a great place to start to help narrow your list and save you time. A stock screener is a tool for narrowing a long list of stocks into a smaller list by numerous criteria such as Industry, Sub-sector, P/E ratio, Market Capitalization, Dividend Yield, Performance, Revenue, Margins, Valuation, Growth, ROE, etc.
Free online stock screeners: [1] http://www.investopedia.com/articles/01/051601.asp [2] http://www.google.com/finance/stockscreener#c0=MarketC ap&c1=PE&c2=DividendYield&c3=Price52WeekPercChange&r egion=us&sector=AllSectors&sort=&sortOrder= [3] http://screen.yahoo.com/stocks.html [4] http://moneycentral.msn.com/investor/finder/ customstocksdl.asp [5] http://www.dailyfinance.com/investing/stockscreener/ [6] http://www.cnbc.com/id/15839076/site/14081545/ [7] http://screen.morningstar.com/StockSelector.html [8] http://www.iclub.com/products/NAIC_Stock_Analyst.asp [9] http://www.manifestinvesting.com/
Free online stock screeners appear on Google Finance [2], Yahoo Finance [3]2p0, MSN [4], Daily Finance [5], CNBC [6] and Morningstar [7], and some low-cost stock screeners are available from iClub Software [8] and Manifest Investing [9]. When choosing which stock screener to use, you should consider
how many and which stocks the screener covers, the selection of financial metrics it allows you to a screen using, as well as the clarity and timeliness of the data. In the next few pages, we’ve included two sample stock pitches from CollegeStockPicks.com.
In the next few pages, we’ve included two sample stock pitches from CollegeStockPicks.com. Winter 2010
Harvard College Investment Magazine 24
Sparks Networks (LOV) Operator of niche online dating websites, most notably JDdate.com
Contributors: Connor Haley, Rob Boling, Anuj Shah, Graham Topol, Arjun Mody, Ben Yu
W
ith downside protection from a recent buyout offer, an inflection point in number of subscribers, a strong likelihood for a higher buyout bid, and a ridiculously cheap valuation, Spark Networks (LOV) is my favorite current holding. Shares currently trade around $3.00, but I value them closer to $6. Even my most conservative estimate (which I share below) values them $4.21, or 40% undervalued. For those unfamiliar with this smallcap (70 MM), they operate several different niche online dating sites, most notably JDate.com. ONLINE DATING (ESPECIALLY NICHE DATING SITES) IS A GREAT BUSINESS ● Customers supply the inventory
(pictures of themselves)
● The
company has negative working capital benefit (subscribers pay monthly subscription upfront) ● Online subscription dating industry averages 20% operating margins (Match, Meetic, Spark) ● Subscription based dating is an attractive oligopoly: Top 5 control 80% of the market, generate $1.2bn in revenue with industry profits of $240mn+ annually. ● Attractive value proposition--avg sub pays $27.50 for JDate and $15 for other affinity ● 100mn singles in US (short cycle, high churn, very profitable business) ● Consumer behavior: many people subscribe to “yellow pages” of dating Match.com or eHarmony. com AND with something to their particular affinity. This was hard to find but the typical monthly churn
25 Harvard College Investment Magazine
rate of various paid subscription sites ranges from 25-35% on a monthly basis. Again this is a very large constantly churning market of 100 million daters that should generate about $1.2 billion in subscription fees. WHAT MAKES JDATE PARTICULARLY ATTRACTIVE • 80% come to the site organically (word of mouth referrals and high winback rates) • Spends only 33% of the industry avg in marketing (6-7% vs. 20%+) ● 13 years in business.... it dominates the Jewish dating market in major metropolitan cities in US. ● 1/3 of members make over $100K, 2/3 make over $55K ● 45% have graduate degrees ● 94% of subscribers have college Winter 2010
Stock Analysis degrees ● 55% women, 45% men ● 90-93% contribution margins = revenue less marketing ● JDate is one of the few sites for which parents will buy their kids membership fees ● Some synagogues have even bought bulk memberships to distribute to congregants.
The
numbers compare
Q1 2010
Jewish Networks Other Affinity Networks General Market Networks
93,235 68,124 7,813
84,644 64,393 17,810
Offline & Other Businesses
661
1,157
169,833
168,004
90,000 80,000 70,000
Average paying JDdate members
60,000 50,000
Linear (Average paying JDdate members)
40,000 30,000 20,000 10,000 0 2004
2005
2006
2007
2008
2009
This represents a CAGR in JDdate subscribers of 3.54% over the past six years. However, in their latest quarter (Q1 2010), JDdate subscribers were up 10.1% and the other affinity. Winter 2010
Q1 2009:
Average Paying Subscriber
Total Two recent events highlight JDate’s value. First, Great Hill Partners (GHP), a private equity firm which owns 44% of the shares from Great Hill Partners or even one outstanding, recently offered to of the bigger online dating services take the company private at $3.10/ such as Match.com, which would share, which represented a small then dominate the niche dating area. premium to the existing price. Online dating is highly scalable, and at Several big stakeholders, notably its current valuation, Spark Networks Osmium Partners, came out and would be a steal for one of the bigger urged the special committee to vote online dating players. Secondly, their most recent against the takeover, as they valued Average Linear JDdate (Average members paying members) quarter really shows the true the company atpaying $6-7 per share. The JDdate 69,833 unanimously 69096.95 bid2004 was rejected from turnaround in the company. JDate. 73804.64and they com is where the majority of their the2005 special 69299 committee, 2006 74983 hired Piper Jaffray 78512.32 to “pursue other value comes from and recently 2007 alternatives.” 94246 83220.01 strategic In essence, I they have been “running off ” 2008 90806 87927.69 think that there is a good chance that their general dating sites, such as 92635.38 we 2009 will see 86030 a higher offer--- either americansingles.com because it’s
100,000
with
simply too competitive a space. Their real advantage is in the niche dating sites such as Jdate. The run-off is nearly complete, and despite losing over 10,000 subscribers in the general market segment as part of this runoff, they actually had a net gain in subscribers with strong growth from JDate and their other affinity networks in Q1 2010. When valuing Spark Networks, the three key variables are obviously subscriber growth, average revenue/ user (ARPU), and operating margins. Since I have already indicated why I think they have reached a bottom, let me give you my reasoning behind my growth assumptions. I took a six year CAGR in subscriber numbers for JDate. While the other affinity segments are also important, JDate provides the most value. In addition, their growth tends to run very close with JDate. I believe that we will see higher than 3.5% growth going forward for two reasons. First, the past few years have been particularly tough for the financial sector (NYC), which has hurt their prospective Jewish member base harder than most. Secondly, with the run-off of their general market networks, the company can now solely focus on managing their affinity networks, which should lead to improved results. Industry estimates expect online dating to increase about 15%/annum for the next five years. However,
Harvard College Investment Magazine 26
my assumptions are much more conservative than that. In my most conservative scenario, I go ahead and model out 3.5% subscriber growth for the ten year model. Again, I think this is a very conservative assumption (industry estimates for online dating for the next five years are in the 15% ballpark), but I my research has led me to believe that niche dating sites will experience steadier and slower growth than the big players (Match. com and eHarmony). A good sanity check for these subscriber assumptions can be seen by looking at what percentage of Jewish singles you expect to be JDate subscribers. There are 1.8 million Jewish singles in the U.S. Currently there are over 86,000 subscribers, which represents 4.7% of the entire U.S. Jewish singles market. If we assume that 55% (their current mix) of subscribers in year 10 will be attributed to Jdate, then they will have captured 7% of the market, which seems very reasonable given their current dominance. Then the question of ARPU comes into play. This is the most difficult to model because it is tough to say how management will play this card because they could certainly slash ARPU to try and accelerate growth. However, given my ultraconservative subscriber growth estimates, I feel comfortable leaving ARPU steady at 2009 figures ($290/ year). Note that this averages to $24/ month, which is still considerably less than Match.com ($30/month), and eHarmony ($60/month). You could potentially take issue with my ARPU stance because their latest quarter ARPU dropped to around $247/ year on average, but I think is more of a temporary mix in subscriber preferences. If you do believe ARPU will go down, I think you have to believe in higher subscriber growth, which in the models I have created tend to cancel each other. Therefore,
in my model below, I keep ARPU steady at 2009 numbers of $290/ year. This just leaves one more key assumption: operating margins. Spark’s operating margins have fluctuated from 17% to 20% over the past few years. With their runoff of their general market segment, they should experience considerable margin improvement since the general market segment experienced much worse ROI due to increased competition. I model operating margins gradually improving from 17% to 20% by the end of the ten year DCF. This would put them right around the industry average. Again, I feel like this is very conservative because 1. JDate is such a dominant brand. 2. They are still building out
some of their other affinity networks, and as they start to let some of the less successful ones run-off, it will help tick margins higher. Then, with an 11% Discount Rate, net capex of zero, their negative working capital benefit, a 3% terminal rate, and their net cash, my most conservative DCF model still values them at $4.21, which is 21% above the current market price. So there you have it. An excellent business that has downside protection ($3.10/share offer from GHP), a strong likelihood for a higher offer, and is 21% undervalued even using my most conservative estimates. I actually believe shares are worth closer to $6, and that the current price represents little downside risk, but huge upside.
The Harvard College Investment Magazine would like to thank the
Harvard Undergraduate Council
for its grant in support of this issue.
27 Harvard College Investment Magazine
Winter 2010
Rosetta Stone (Rst) Contributors: Connor Haley, Rob Boling, Anuj Shah, Graham Topol, Arjun Mody, Ben Yu
W
hen researching Rosetta Stone, we learned that many of the company’s positives do not show up in their financials. While the stock’s performance in the short term is uncertain, we are excited about their long-term outlook. We especially believe that TOTALe, the new social-networking language software released by Rosetta Stone, is another step in Rosetta’s domination of the global language learning market. We believe that while there will be volatility in the shortWinter 2010
term in Rosetta Stone stock, longterm shareholders will be rewarded for their patience. We at CollegeStockPicks.com have an edge on the market. We understand companies from the perspective of college students, invaluable consumers of retail, fashion, food, technology, and gaming products. We also see firsthand the advantages and disadvantages of new developments in educational technology. Many college students are required to fulfill a language requirement, dreaded by
many. College language classes often lag behind the latest developments in technology. While more and more classes have been using electronic software to “enhance” learning, the current software used in classrooms is outdated. A quick survey of my Spanish class indicated that nearly all respondents (over 85%) felt that “Centro,” the McGraw-Hill based technology that we currently use for some weekly homework assignments, was the least enjoyable aspect of the course and a highly ineffectual use of their time. “Centro” cannot distinguish between a completely wrong answer and small mistakes. For example, if you miss an accent mark when answering a Spanish grammar question, your entire answer is deemed wrong. Furthermore, there are many glitches
Harvard College Investment Magazine 28
in “Centro.” You can technically see all of the answers on the homework and then do the questions over again. Our dissatisfaction with current language learning technologies inspired us to analyze Rosetta Stone (NYSE: RST), which had an IPO last year. In the past few months, however, its share price has taken a hit as a byproduct of disappointing sales numbers and the departure of two executives. These key events occurred during their recent product release, a new language software with tremendous potential: TOTALe. All of this uncertainty has led to significant short interest in the stock. This uncertainty only fueled our interest in the company and after doing our due diligence, we are excited about the long-term prospects. TOTALe allows users to communicate live with a tutor/language coach who pro-
vides personalized feedback to students, in addition to providing users with all of the components of previous Rosetta Stone products. Furthermore, TOTALe builds off new advances in social networking. TOTALe users learning one language can communicate with users learning the same language, offering the possibility of many synergies. We believe that TOTALe has tremendous potential and that it could take Rosetta Stone to the next level. Granted, TOTALe is expensive: it costs $1,000. But compared with the alternatives, such as taking a community college or university level language course, it is quite reasonable. The TOTALe user is clearly passionate about learning languages: he or she will want to learn a language fluently, and such fluency cannot be built through reading a knockoff book or pamphlet. Furthermore, the pricy alternatives to TOTALe likely teach languages the same way as middle schools, high schools,
29 Harvard College Investment Magazine
and colleges do today: through rote memorization of vocabulary and grammar rules, and with little emphasis on oral development. TOTALe offers at the most competitive price the best language learning
It is very rare that is still a method: through direct immersion, the same process that babies use to learn languages fluently. We believe that there are no alternatives to direct immersion and that direct immersion offers the best process to developing fluency. One of the best features of TOTALe is Rosetta Studio, which consists of a network of native speakers hired by Rosetta to support and coach Rosetta Stone users. This makes TOTALe even more comparable to taking a university course or hiring a private tutor, both of which cost more than using TOTALe. We also see this network of language coaches as increasing the competitive advantages in the foreign language learning market over the long term. As the network expands, it will be very difficult for a rival to rebuild a network as large as Rosetta’s. Although RST has taken a beating on Wall Street in the past few months, the company has tremendous room for growth. According to the Nielson research firm, the language learning market is valued at $82 billion, and the self-study language learning market is valued at $32 billion. Rosetta Stone’s market capitalization is a mere $418 million, a mere fraction of the value Winter 2010
Stock Analysis of the total market. The company has only expanded slightly into the international market; international sales accounted for only 8 % of total revenue in fiscal year 2009-2010, and the company is quickly expanding in-
its magazine ads and the yellow boxes have done more to expand its brand than its late-night Michael Phelps endorsements. With recent international hires, it is likely that Rosetta will market successfully in emerging
better educational products that the traditional not-for-profit establishment. Furthermore, one must keep in mind the current budget crises of many states. Cash-strapped states have been forced to cut funding to
that one encounters a small company dominant brand in a huge industry. ternationally by establishing offices in South East Asia and Europe. The company’s CEO, Tom Adams, was born in Stockholm, grew up in England, and has worked as a commodities trader in countries ranging from China to the Philippines. He undoubtedly knows what international consumers want, and we have faith that he’ll continue Rosetta Stone’s stunning 58% annualized growth rate by expanding internationally. When we at CollegeStockPicks. com analyze a company, we seek dominant brands and products. We want to find products that are so ubiquitous that one could identify the industry with that product, just as one can identify Google with the search engine industry and Facebook with social networking. Although some analysts have criticized Rosetta for incurring large fixed costs as a result of marketing, the yellow boxes and the magazine ads have made Rosetta the dominant language learning brand in the United States, explaining for the companies stunning growth in revenue. Recently, RST’s share price has taken a hit since the cost of running the company’s television ads increased, but these television ads did little to add to Rosetta’s prominence; Winter 2010
markets and establish the same level of dominance internationally that it has domestically. Furthermore, TOTALe’s subscription-based payment model is much more attractive than the one-time yellow box sales. The subscription pricing model could greatly increase the revenue Rosetta receives from institutions, inclu ding schools and the U.S. government, who have high switching costs in changing language-learning software. One cause for concern is the reaction amongst university-level language professors towards TOTALe and Rosetta Stone. Some professors are hesitant to approve Rosetta’s products as an alternative to traditional rote memorization and grammar study. The fact is, however, that traditional language learning is on a decline. As can be seen from the success of for-profit universities, the education industry in general is moving away from a costly university model, where a student pays for cost unrelated to his or her direct instruction such as benefits for tenured faculty and research expenses. Our recommendation on Rosetta Stone reflects our idea that education will follow a Moore’s law development, with lowcost for-profit companies providing
public schools, reducing the budgets of many school districts. As a result, Rosetta Stone may be the best option for many school districts for language learning. Instead of hiring more teachers, schools could use Rosetta Stone as the main facilitator in language instruction. There are substantial costs involved with building out the network of live language coaches, creating offices around the world to spur international growth, etc. This company is “growing up” from just selling yellow boxes to creating the dominant language learning brand in the world. We believe the is currently too focused on the small bumps they have run over recently (executive departures, poor advertising decisions) and is losing sight of the big picture, giving patient long-term investors an excellent opportunity to buy shares of this fast-growing, dominant brand with increasing competitive advantages at a serious discount to intrinsic value. It is very rare that one encounters a small company that is still a dominant brand in a huge industry; Rosetta Stone thus seems to be a serendipitous find. With its quality management, effective marketing, and enormous potential, we think it’s a good long position.
Harvard College Investment Magazine 30
Outside the Rules:
The Role of the Taylor Rule in the Financial Crisis of 2007-2010
W
hile there has been a great deal of debate on what precipitated the financial crisis of 2007 to 2009, the main cause of the crisis likely lay in three primary factors: the Federal Reserve’s monetary policy from the end of 2001 to 2006, U.S. government policies that facilitated the home ownership of low income families, and the deregulation of 2000. Hindsight also suggests that the U.S. government and the Federal Reserve failed to respond appropriately to these root causes of the crisis, ignoring the solvency crisis caused by toxic assets. Before the end of 2001, the Federal Reserve had set the interest rate at a level very similar to the rate called for by the Taylor rule, which calculates a suggested federal funds rate using the current inflation rate along with the present GDP value. But in late 2001, the Federal Reserve responded to the
By Alex Breinin recession from November 2000 to October 2001 by setting the funds rate lower than that suggested by the Taylor rule. Whereas the Taylor rule called for the federal funds rate to be increased during the time period between the end of 2001 and 2004, the actual federal funds rate was lowered by the Federal Reserve (Jorgenson, 2010). The deviation from the Taylor rule greatly contributed to the housing bubble. Because the real interest rate on most mortgages, greatly influenced by the federal funds rate, became “persistently less than zero, thereby subsidizing borrowers,” (Taylor, 2010a) the public began to seek large mortgages. In comprehensive study of the financial collapse, John Taylor, the architect of the Taylor rule, concluded that following the Taylor rule would have prevented a large portion of the huge
31 Harvard College Investment Magazine
spike in housing starts, though there still would have been a small increase peaking in mid 2003 (Jorgenson, 2010). However, Taylor’s assertions have drawn criticism from the Chairman of the Federal Reserve, Ben Bernanke, who disputed Taylor’s conclusion that the low federal funds rate contributed to the housing boom. Bernanke argued that if inflation forecasts are factored into the Taylor rule, then the interest rate suggested by the Taylor rule nearly mirrors the actual federal funds rate. Bernanke also stated that the Federal Reserve has never intended to follow a specific rule for setting policy. Offering an alternate explanation for the housing boom, Bernanke pointed to the global savings glut as the root cause of the lowered interest rate. Asian and Latin American countries invested their money in the U.S. after their financial crises, potentially lowerWinter 2010
ing the U.S. interest rate. However, the overall level of global savings has decreased on average over the last thirty years, making Bernanke’s theory extremely unlikely. Furthermore, international evidence is highly supportive of Taylor’s argument, with many studies showing a significant positive relationship between deviations from the Taylor rule and change in housing investment (in GDP) in European countries. While the deviation from the Taylor rule played an important role in the housing bubble, it cannot account for the entire phenomenon. Another important contributing factor to the housing boom was government policy that actively encouraged home ownership for low income families. The National Homeownership Strategy led by the Department of Housing and Urban Development and Regulation in 1995 forced banks to make a specific number of loans to borrowers who previously did not qualify for loans. Thus, the number of subprime and Alt-A loans increased substantially. In 2006, 32.7 percent of the loans made were subprime or Alt-A compared with 21.1 percent in 2001. As a result, Fannie and Freddie loosened their standards and started “accept[ing] loans with characteristics that they had previous rejected” (Wallison, 2009). The new demand for subprime mortgages also raised their value. However when the housing bubble collapsed, many homeowners owed more on their houses than what the houses were worth. Not surprising, homeowners began defaulting leading on their mortgages, causing home values to plummet (Jorgenson, 2010). But deregulation was what drove the housing bubble to develop into a financial crisis. In 2000, the Clinton administration passed legislation ending the separation between commercial and investment banks and also deregulated over-the-counter derivative trading. This allowed banks to beWinter 2010
come heavily leveraged and acquire a far greater amount of mortgage derivatives. Furthermore, the novelty of the derivative instruments meant that the risks of mortgages flowing into the derivatives were not weighted correctly and that the derivatives compiled were rated far less risky than they actually were. Therefore, when the housing bubble collapsed, it tremendously affected the banks’ balance sheets, as well as Wall Street where the derivates were being sold. Worse, U.S. government policy during the financial crisis of 2007 to 2009 was extremely poor in addressing the problems facing the economy. Throughout 2007, the liquidity risk in the market gradually increased and remained present until September 2008. In August 2007, counterparty risk also greatly increased as the Libor-OIS spread moved from 0.1 percent to 1 percent during the same month. To try to combat the sudden rise in the Libor-OIS spread, the Federal Reserve in December 2007 created a term auction facility (TAF) which gave financial institutions direct access to liquidity. While the Libor-OIS spread did fall substantially during the first two months in which TAF was instituted, the spread quickly returned to its former level. Thus, the institution of TAF probably had no effect on the LiborOIS spread, with only a small effect on the liquidity problem affecting banks during late December 2007. The next major policy undertaken by the government during the recession was the American Recovery Act signed into law by President Bush in February 2008. The government sent
“
households tax rebates increasing their disposable income. Yet the policy did little for the economy as personal consumption did not noticeably change. This occurrence suggests the economy may be governed by New Keynesian economics, which predicts people do not change their expenditures if they receive a fiscal stimulus because people are aware that they will pay for the stimulus with higher taxes in the future. The Bush administration had crafted the American Recovery Act under the assumptions of Keynesian economics, which predicts that people spend a portion of the increase when they receive a sudden increase in income Four days after the failure of Lehman Brothers on September 19, 2008, the government announced the Trouble Assets Relief Program (TARP). Between the announcement of TARP and its implementation, the Libor-OIS spread significantly increased, signaling great counterparty risk in the market. This supports John Taylor’s conclusion that the announcement of TARP only added to the fear on Wall Street, as people began doubting which assets banks held had significant value and which did not. Indeed, the announcement of the TARP equity plan on October 10, 2008 significantly and suddenly increased the Libor-OIS spread, suggesting the crisis was due to counterparty risk and not liquidity. Yet TARP only “inject[ed] equity into the banks” and the government did not buy up the toxic assets due to fears that people would know that the banks were insolvent (Taylor, 2010b). In the last three months of 2008, the Fed-
The deviation from the Taylor rule greatly contributed to the housing bubble.
,,
Harvard College Investment Magazine 32
eral Reserve’s reserves increased from about $900 billion to $2.2 trillion as it acquired many assets from banks including foreign currency, private portfolios from the bailout of banks, and loans from TAF among other assets. But very little of TARP actually helped the banks, and instead it only increased people’s fears that the economy was in a meltdown. Later, the Federal Reserve took up quantitative easing (increasing banks’ reserves) in the fall of 2008 before the federal funds rate hit 0. This meant that the Federal Open Market Commission was not setting the target funds rate. Although the Federal Reserve had an opportunity to help the
economy by lowering the funds rate with open market policies, it instead pursued quantitative easing that did not address counterparty-risk. In early 2009, the Fed began buying mortgage backed securities (MBS) from banks under the assumption that not doing so would substantially increase the interest rate. By the middle of 2009, it had acquired $450 billion dollars of MBS. These purchases were for the most part unnecessary. As John Taylor concluded, not purchasing them would have barely affected the difference between the 30-year fixed mortgage rate and the 10-year treasury rate (Jorgenson, 2010). The last major government inter-
vention in the economy was the American Recovery and Reinvestment Act of 2009. The ARRA included purchases of goods and services to states, transfer payments to state and local governments, transfer payments to individuals, and business tax incentives among other expenditures. The total amount allocated was $787 billion. One of the major problems with the ARRA is that little of this money was spent before the recession was declared over in June 2009. Furthermore, New Keynesians like John Taylor have predicted using the Smets/ Wouters model that the multiplier on the stimulus is much smaller than that the government predicts. Government purchases may significantly crowd out consumption and investment, resulting in an extremely small impact on GDP. In sum, U.S. government policy during the financial crisis up to the present has been extremely poor in addressing the current problems facing the economy today. While the U.S. was experiencing a liquidity crisis in late 2007, nothing was done to address the fact that it was also experiencing a solvency crisis due to the toxic assets held on banks’ balance sheets.
References: John B. Taylor (2010a), “The Fed and the Crisis: A Reply to Ben Bernanke,” Wall Street Journal, January. Peter Wallison (2009), “The True Origins of This Financial Crisis,” American Spectator, February. John B. Taylor (2010b), “Macroeconomic Lessons from the Great Deviation,” May. Jorgenson, Dale W. (2010) Economics 1490: Growth and Crisis in the World Economy. Harvard University, Cambridge, MA.
33 Harvard College Investment Magazine
Winter 2010
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Investment Harvard College
Magazine Winter 2011
Harvard College Investment Magazine is a semi-annual
publication devoted to presenting the pertinent and current issues in corporate finance, corporate governance and investment research, serving as a platform of intellectual exchange on investment between Wall Street professionals and the Harvard community. Harvard College Investment Magazine is officially recognized by Harvard College with the purpose to educate both Harvard students and the greater community about the pressing topics of investment. From its inception, Harvard College Investment Magazine has stayed true to its purpose by blending professional articles, interviews, and academic research to offer a comprehensive array of commentary to the investment field, making the magazine accessible to students, investors, and businesses.
A R T I C L E S
A T
A
RECOVERING THE EUROZONE What’s Next For Europe: Divided It Fails The Eurozone: A Long-Term Short?
Plus:
Being Realistic About Individual Stock Investing In The Long-Run
Solving The Chicken And The Egg Problem Of The Wall Street Job Search
G L A N C E
“Recovering the Eurozone” Issue The Eurozone: A Long-Term Short? Stock Advice: Being Realistic About Individual Stock Investing in the Long-Run Stock Analysis: Rosetta Stone (RST) Outside the Rules: The Role of the Taylor Rule in the Financial Cricsis of 2007-2010
What’s Next for Europe: Divided It Fails Solving the Chicken and Egg Problem of the Wall Street Job Search Stock Analysis: Sparks Networks (LOV) Jobs, Jobs, Jobs
Notable Previous Interviews Jeff Bezos Warren Buffett Mohammed El-Erian Ken Griffin W I N T E R • • • •
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Chairman and CEO of Amazon.com Chairman and CEO of Berkshire Hathaway Inc CEO of PIMCO, Former CEO of the Harvard Management Company Founder and CEO of the Citadel Investment Group A T
A
G L A N C E
Door-dropped at Harvard College. Delivered to media distribution centers at Harvard Business School, Law School, and MIT. Distributed at the beginning of the Recruiting Period for full-time hires and summer internships. Promotion: Student Activities Fair, business/finance student organizations.
UNIVERSIT Y HALL, FIRST FLOOR H A R VA R D U N I V E R S I T Y CAMBRIDGE, MA 02138
C O N TA C T Eva Sadej at esadej@fas.harvard.edu or John Du at xdu@fas.harvard.edu