Monday, September 05, 2005

Dedicated short sellers

Barron Interview with Lee Mikles and Mark Miller Partners, Mikles/Miller Management


THESE TWO LONGTIME partners in $100 million-plus Mikles/Miller Management, based in Los Angeles, are a rare breed today: dedicated short sellers. Though last year was their most dismal on record, down 13% net of fees, they've overall provided an important hedge for investors. So far this year, returns are break-even. If the dire predictions they make in this interview come true, look for short selling to be back in vogue and for these savvy practitioners to lend an assist in protecting capital.

Barron's: What makes a couple of very private guys want to go public with their views?
Mikles: We think we are at a huge inflection point that needs to be talked about. It is really misunderstood, or as we like to say, under understood. We think we've got something very important to say and are willing to say it for the first time in a very long career. Collectively, we've been in the securities industry 45 years and we've been in the hedge fund business as partners for 15.

Q: Why do you think we are at an inflection point?
Mikles: Bottom line, the consumer is broke and he doesn't know it yet. But he is about to find out. All the buckets that propelled consumer spending are empty now, whether it is the increase in mortgage debt, the increase in consumer debt or the reduction in the savings rate. No one statistic will tip the scale at the end of the day. But one very obvious and very curious statistic is that we have dipped into a negative savings rate for the first time. That is not only unsustainable, it is sustainable only for a few months. That's important to note because it tells you consumers are borrowing money to make debt payments. The U.S. consumer has become payment driven. He is driven not by the aggregate amount of debt he possesses but by the amount of the payment. And now the consumer has not only taken his savings rate to nothing, it has turned negative.

Miller: Every month there is some increase in consumer borrowing that has to occur just for the consumer to stay level. The consumer is treating his balance sheet much the way the government is treating theirs, but, of course, the consumer can't create currency like the government can. The point is the consumer cannot continue to borrow to make his debt-service payments for very long. How did we get here? We got here because of the huge differential between wage growth and what we spend and what we consume.

Mark Miller

Q: What about the argument that consumers may not be saving but the appreciation they have seen on their houses is a form of savings?
Mikles: The consumer doesn't know he is broke because his house hasn't stopped going up yet. It hasn't starting going down, it just hasn't stopped going up. Once it stops going up, the consumer will immediately -- and I mean a matter of months -- find out that he is, in fact, broke.

Miller: We have been studying wage growth in relation to housing. In the 30 years starting in 1971 and ending in 2001, home-price appreciation shadowed wage growth. They were both up 138% in that period. Since then, home prices have exploded and wage growth hasn't. The housing explosion has made people think of their house as an investment class. But it is a two-sided argument, and people only see it as an investment class when house prices are going up. As soon as they start going down, houses will be considered shelter. The problem with viewing houses as shelter is that it doesn't allow you to tap your house for a mortgage refinancing to make your credit-card payments or any of your debt payments.

Mikles: The argument is really pretty simplistic. If you consider housing as an asset class, then it makes sense to run the math as you would on any other asset class. It costs about 8% in the current environment to carry a home: That's mortgage, insurance, taxes, maintenance and ultimately a disposition cost. That's a conservative estimate. What it means is the home has to double every nine years for that consumer to stay even. Every year that house doesn't appreciate 8%, the consumer is losing ground if he is going to call it an investment. With wage growth at 2%, that's unsustainable. Common sense tells you house prices and wage growth have to track one another. All of a sudden they have monstrously decoupled. Just look at San Diego. House prices there are up over 150% since 1996. Wage growth during the same period in the same metropolitan area is up 22%. In the last five years we have the biggest disconnect we have ever had since these statistics have been compiled.

Lee Mikles

Q: So what's the fallout from this scenario?
Miller: Housing construction is about 5% of gross domestic product. That will fall. If housing construction fell off by the levels it did in 1981 and "82 that would imply a direct loss of two points of GDP. About 70% of GDP is consumer driven. You have to factor in an additional drop in GDP due to a falloff in consumer spending. So if housing just stops going up, we could pull 4 1/2 points from GDP, which would define a recession for sure.

Q: Any other evidence for why we might be heading into a recession?
Mikles: The big hook has been set. And the big hook is the following: Corporate America is flush with cash. The economy looks very strong. There doesn't seem to be any evidence of any hyperinflation anywhere. The scenario looks very good and the markets could get very excited about this and head to some short-term blowoff top. But at the same time, the consumer has just tipped over and the bells are ringing, but nobody is hearing it. The big lie in the economy has been the following: that the consumer was smart to elongate his liabilities and lower his payments by taking other consumer debt and putting it into his mortgage. He has got a lower payment now that is a 30-year liability and not a revolving liability. Well, statistically and empirically, that's incorrect. In the last 10 years, consumer debt is up 77%. Mortgage debt has more than doubled. There are hundreds and hundreds of billions of dollars of cash-out refis that have taken place and that money has all been spent. It's already in the gross domestic product retrospectively. Prospectively, where is the money going to come from to pay the obligations that remain?

Miller: As in every cycle, the consumer will panic. Consumers will look to increase their savings rate at any cost. That in itself will lead to a reduction in spending that will have a substantial impact on GDP. The consumer is going to get his very own 12-step spending program: de-leverage, increase savings and live within your means. All the things our parents told us about but no one has listened to for the last 20 years. That's the trap. The only saving grace could be that rates start going down again. But if rates go down, it will be because we are going to enter into a recession.

Q: Isn't wage growth trending up?
Miller: Yes, but only a couple of% a year.

Q: But if the job market gets tighter, won't wages grow faster? Would that offset your thesis?
Milkes: We would have to get in excess of an 8% wage growth rate, which is implausible because of globalization. The pressure is on wages. Wages are getting more attractive for the employer not the employee.

Q: Does the impact from Hurricane Katrina affect your outlook?
Mikles: It is too early to know. Our past experience suggests events like this give air cover for a period of time to previously established trends.

Q: What do you make of the burgeoning number of hedge funds? Are hedge funds partly responsible for convergence of asset classes and the low-return environment?
Miller: That's a broad and difficult question to answer. It has substantially increased volatility in specific, individual stocks. There are those who are shorting stocks and making decisions based on models that are quite dissimilar than we've had in the past. There is increased volatility associated with that type of decision making. That's where we've had to really work on our business and our ability to manage a portfolio. This is a change, and it is a big change in the course of the last five years. We didn't have a very good year last year, and part of it was because of the proliferation of new hedge-fund managers and the amount of money in hedge funds and increased volatility, and at the end of last year it really ripped our heads off.

Q: So how have you positioned your portfolios now?
Miller: We can't make money specifically from GDP declining 4%. We can make money from individual stocks and the analysis that we do specifically on those stocks and the events that make them go up and down. I'm not going to mention any of the small stocks we're invested in because hedge funds can whip them around and make life miserable. There are some more liquid big-economy-type names and themes that I think will play out. We've seen a big crack this year in the auto industry. General Motors [GM] and Ford Motor [F] have had a tough time, and Ford has been working for three years trying to fend off a credit-rating downgrade, but they've done everything they can possibly do. They have taken $2 billion out of their suppliers' pockets to try to make their auto operations profitable and they still lose money selling cars. Going forward, Ford is in serious trouble. If you look at Ford and GM, they are both losing market share. GM has a leg up on Ford because they have a fantastic product line coming, and they hired Robert Lutz at the right time. His fingerprints are all over General Motors now. Ford has serious pressure and serious problems. Ford is a money-losing auto operation and a finance company. An increasing-rate environment is going to be very difficult for Ford.

Q: Haven't Ford shares come down quite a bit this year?
Miller: Yes, the stock is down quite a bit. But the economy is as good as it's going to get, in our view. Ford has done everything they can, to this point. They made all these restructuring actions, and their credit was still downgraded because the bottom line is they have overcapacity. They have bad contracts and they have legacy costs. They can't operate their business profitably. That's not going to change. It is going to be very difficult for them to make it out of this. We'll see if they can do a kick save. Among the suppliers, Lear [LEA], which makes seats, gets more than 40% of their revenues from Ford and GM. They're just seeing the first cracks of this production decline. They were unprepared for the decline. The bullish guys on the Street are thinking the restructuring actions are somehow going to save Lear. The fact is, when we get down to some sustainable level of auto sales, Lear's earnings power will be substantially less than what people expect. I'm not trying to make a case for Lear going out of business, but their level of business will be much lower than what people think.

Q: What about other suppliers?
Miller: Visteon [VC] and Delphi [DPH] have to survive. They're super-leveraged to each of the manufacturers because they are spinoffs from each of them. Visteon is trying to renegotiate with the United Auto Workers and Delphi has jumped on that same bandwagon. Both Visteon and Delphi are companies making products that Ford and GM have to have. You can't put those guys out of business. You can restructure them all you want, but they are not closing down. At $4 a share or so, Delphi is something I would be long, not short.

Q: What else are you shorting?
Mikles: When you look at the mortgage industry contracting the way it is and you look at the pain that is going to be dealt the consumer in this 12-step program, the way to go is to determine who owns the risk. All companies say they've laid off their risk by securitizing it on Wall Street. But someone owns this risk. Those are the guys you want to be short. Now whether it is a Wall Street firm or a mortgage originator or a mortgage wholesaler, whoever owns this stuff at the end of the day is the guy that is going to get stabbed in the back.

Q: Who do you think has most of the risk?
Milkes: When a lot of these aggressive mortgage originators converted to mortgage-REIT status, that was the last-ditch Hail Mary play. Whether it be New Century Financial [NEW] or NovaStar Financial [NFI], everybody down that food chain will be affected pretty dramatically. Quarter by quarter we are starting to see margin compression in these companies, but they keep reaching for volume. New Century and NovaStar will be the first targets to be picked off, and then you could go right down the line to everyone else who holds these last-in-cycle mortgage creations on their balance sheet. Everybody has the same bet on: house appreciation.

Q: Any other areas to highlight?
Miller: An area I'm focused on that dovetails with our overall thesis is the airlines. Things can't get much better economically, and yet everyday we are reading in the paper about the potential for bankruptcy. Right now it is because of oil prices. Well, oil prices are high because economies are doing so well. It isn't because of speculators or anything else. I talked recently with a friend in China who said in southern China they are limiting people to five gallons of fuel and people are waiting two hours in line to get the fuel. This isn't fake demand. The airline companies that are fully hedged on oil prices over the course of the next three to six months have a chance realistically to knock the others off. Southwest Airlines [LUV] and Jet Blue Airways [JBLU] both have excellent fuel-hedging programs. American Airlines [AMR] has no fuel-hedging program. They're paying spot prices for fuel. All the bankrupt carriers are in the same boat. They won't let them hedge forward because they don't know if they are going to be in business in two months. If oil prices don't put the airlines out of business first, eventually their customers will stop showing up at the door. People buying airline stocks today on the premise that their restructuring will be successful have their timing off. Realistically, two years from now things will be quite a bit different. The way we fly will change.

Q: No one could accuse you of being contrarian.
Mikles: We are very stock-specific and balance-sheet-and event- specific. Most people think short sellers are inherently bearish. We are not bullish, nor are we bearish. The environment is what it is. To think Ford is cheap because it is $10 and it was $30, you know, could be a mistake. Stocks often are much better shorts at 10 then they ever were at 30.

Q: What would prevent or delay this scenario from playing out as you think it will?
Miller: As I said earlier, if rates go down somehow, this can all be sustained. But that is going to have to happen relatively soon, and it doesn't appear to be in the cards. The history of decision makers at the Federal Reserve is that they always overshoot in each direction. I doubt we are at that point of overshooting yet. They are raising rates so they have the ability to lower them later. And so taking them back from 4% is probably not what they had in mind. It is very, very difficult to figure out a scenario by which we wriggle out of this trap. Maybe oil goes back to 50, but then if oil goes to 50, it is only because the economy stopped or something really big happened. The bigger question is whether our timing is right.

Q: What if the savings rate turns back up?
Miller: It would actually encourage our suspicion that we are right, because it would imply to us that the consumer is pulling back and trying to do the right thing.

Mikles: In 1989, the savings rate was 9 1/2%. In the 10 previous years, it was 8 1/2%. We drove that number to negative territory, so we've stolen all the money we can.

Q: Thank you, gentlemen.


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