Bastiat Capital Commentary

Another solution...

2009-06-25T12:43:00.004-06:00

Letter sent to Financial Times

Sir, Louis Hindery ("Obama must act to curb executive greed", June 25, 2009) suggests, "Congress should establish for all public companies, a ceiling on individual executive compensation as a reasonable multiple of average employee compensation..." This sounds un-American and unconstitutional. Two simple measures would burst the compensation bubble.

First, the IRS needs to withdraw the provision in the tax code that allows companies to deduct the discount at which they issue stock to employees. For years, companies have maintained that stock-based compensation was not an expense, but they have eagerly taken a huge tax deduction on that account in their tax returns.

Second, cash spent on buying back shares that were issued to employees in lieu of cash compensation should be reported in the operating section of the cash flow statement. If the IRS wants to grant companies a compensation deduction, then base it on these cash outflows. Cash outflows relating to stock repurchases should only be reported as a financing activity, i.e., an allocation of capital, once it has been shown that all dilution caused by stock-based compensation has been mopped up. Executives would have us believe that the stock-based compensation expense, as recognized in the income statement, is a non-cash expense. Cash spent on stock repurchases to combat dilution caused by stock-based compensation betrays this notion, and if properly disclosed as suggested above, would better inform shareholders of the true cost of share-based compensation.

Looking to Congress for a solution is a waste of time. Congress has been the corporate boardroom’s best ally in the long fight against any efforts to shed light on stock-based compensation expensing and other related disclosures.

December 2008 Commentary for the MIRZAM CAPITAL APPRECIATION FUND [MIRZX]

2009-02-02T16:38:00.006-06:00

Mirzam Capital Appreciation Funds posted a disappointing return of -32.92% in 2008. However, in comparison to a peer group of funds in the Mid-Cap value category that are managed by some of the largest firms in the industry, Mirzam is comparatively speaking in better shape.

Mirzam Capital Appreciation Fund Performance:

Peer Group* & 2008 Return
1 ING Mid-Cap Value -38.02%
2 Fidelity Advisor Mid-Cap Value -40.74%
3 TIAA-CREF Mid-Cap Value -40.66%
4 Blackrock Mid-Cap Value -38.71%
5 Putnam Mid-Cap Value -42.95%
6 MFS Mid-Cap Value -41.90%
7 Principal Mid-Cap Value -42.69%
8 Rydex Mid-Cap Value -43.91%
9 T Rowe Price Mid-Cap Value -39.69%
10 Franklin Mid-Cap Value -36.86%

Russell Mid-Cap Value Index -38.44%

S&P500 Index -38.50%

Mirzam Capital Appreciation Fund -32.92%

* For the peer group, we consulted the websites of some of the most well-known companies that manage mutual funds and selected their Mid-Cap Value funds for comparative purposes. Despite the enormous resources at their disposal, only one of these funds outperformed the S&P500 and only two outperformed the Russell Mid-Cap Value Index. Mirzam Capital Appreciation Fund outperformed both the Russell Mid-Cap Value and the S&P500 Mid-Cap Value Indices and all ten funds comprising the peer group.

Although, we have outperformed many of the best money managers in the US, some by a huge margin, we are not pleased with this year's performance. We own a fair amount of foreign companies, comprising more than half the portfolio. After the Lehman Brothers bankruptcy, investors sold their foreign holdings to seek safety in US Treasuries. This meant an appreciation of the dollar of more than 20% against the major currencies. As a consequence, approximately ten percentage points of the returns are not so much a negative reflection of the underlying fundamentals of the companies we own, but purely a function of currency translation. In addition, foreign stock exchanges materially underperformed US indices, particularly in the second half of 2008 when the US enjoyed huge inflows of funds. With this in mind, our returns, albeit negative, compare well against all indices. All things considered, our performance could have been far worse, but we believe our ability to find great companies with enduring competitive advantages stood you in good stead.

The MSCI Emerging Market index dropped a stunning 43% in October. However, emerging markets still hold a gain of 86% from their 2002 low, while the S&P500 was only 14% above its October 2002 bear market low. It is worth noting that the MSCI EM has still outperformed the S&P500 by more than 200% since 1998.

Stock Options

One of our investment strategies is to shun companies that rely on stock-based compensation to remunerate employees. This seemingly trivial distinction has kept us from being hurt by technology companies and, most recently, the financial sector. Both industries have grossly abused stock options to enrich executives beyond measure.

Nothing better demonstrates the huge transfer of wealth from American workers to their undeserved bosses than an article by the WSJ, November 20, 2008, under the headline: "Before the Bust, Some CEOs Took Their Money Off the Table."

During the period 2003 to 2007, Richard Fuld of the now defunct Lehman Brothers cashed in $184.6 million. He systematically sold stock to luckless investors. This was before the firm's catastrophic bankruptcy that triggered an earthquake in global markets. Bear Sterns' CEO pocketed $163.2 million. Countrywide's CEO raked in $470.7 million. Ken Lewis of Bank of America who rescued the drowning Countrywide had a more "modest" payday of $81.0 million. Daniel Mudd and Dick Syron from Fannie Mae and Freddie Mac picked up $23 million and $33 million, respectively, in compensation for their last two years of service, arguably the two men who did the most to stoke the housing bubble and throw the two companies into the arms of the US taxpayer. Charles Schwab tops the list with compensation of $816.6 million during this period.

The WSJ documented the compensation of 25 CEO's of the nation's largest financial and home-building companies. In the aggregate, they received $4.891 billion, or $195.6 million per CEO, and $39.120 million p.a. per CEO during the five year-period 2003 to 2007, the bulk of it through the use of stock options. You can't make this up if you try.

Where did this money come from? CEO's exercise stock options, paying a nominal amount for the stock which they then flipped by selling mainly to fund managers who indiscriminately allocated capital to the companies represented by these CEOs under the presumption that they were making an investment, when in fact they were paying the egregiously high compensation of CEOs with cash provided by the retirement funds of Americans. Executives are unremittingly and anxiously monetizing their stock options. Such transactions effectively transfer the hard-earned savings of workers to the bank accounts of executives. The regulators and politicians are well aware of this, but care less.

Current Holdings

Currently, the top 12 holdings in the fund comprise 40% of the portfolio. Fifteen percent of the portfolio was in cash at the end of 2008. The performance of the fund in 2009 will depend to a large extent on how well these 12 companies perform over the next 12 months. We are providing a short summary of each company. We encourage our Mirzam shareholders to visit the websites of these companies for more information.

- Teva Pharmaceutical - 4.41% of the portfolio; dividend yield 1.16%

Teva is a global pharmaceutical company, specializing in the development, production and marketing of generic and proprietary branded pharmaceuticals as well as active pharmaceutical ingredients. Teva is the world's largest generic drug manufacturer and among the top 20 pharmaceutical companies in the world.

- China Mobile - 4.39% of the portfolio; dividend yield 3.40%

China Mobile is the world's largest mobile phone operator with more than 400 million subscribers. An investment in China Mobile is a way of tapping into the growth of consumerism in China.

- Telefonica - 4.37% of the portfolio; dividend yield 5.87%

Telefonica is the world's third largest telecommunications company, with more than 240 million customers. It has a 75% market share in Spain, but also has a commanding presence in Europe, the United Kingdom and in Latin America.

- Syngenta - 4.23% of the portfolio; dividend yield 2.29%

Syngenta, a Swiss-based company, is a global agribusiness, a leader in crop protection, and the world's third largest high-value commercial seed producer. It has operations in more than 90 countries.

- TransCanada - 3.73% of the portfolio; dividend yield 4.31%

TransCanada owns North America's largest network of natural gas pipelines (36,500 miles in total), that taps into virtually all major gas supply basins in North America. It is one of the continent's largest providers of gas storage and related services. As a growing independent power producer, TransCanada owns, controls, or is developing approximately 10,900 megawatts of power generation.

- StatOil - 2.95% of the portfolio; dividend yield 4.93%

StatOil, a Norwegian company, is one of the largest net sellers of crude oil in the world, and a major supplier of natural gas to the European continents and the United Kingdom. The company is engaged in exploration and production in 40 countries.

- Nestle - 2.70% of the portfolio; dividend yield 3.43%

Nestle, a Swiss-based company, is one of the world's largest packaged food companies, with operations and sales in virtually every country in the world.

- Emerson Electric - 2.61% of the portfolio; dividend yield 3.75%

Emerson Electric, a US-based company, was incorporated in 1890. The company manufacturers a wide variety of electrical products used primarily by other manufacturers and those who build networks associated with telecommunications and other types of data networks. It generates more than 50% of its revenues from abroad.

- Southern Copper - 2.60% of the portfolio; dividend yield 7.90%

Southern Copper is a fully integrated copper producer with significant byproducts of molybdenum, zinc and precious metals, the fifth largest copper mining company in the world. Revenues from byproducts effectively pay for the cost of mining copper.

- Pfizer Pharmaceuticals - 2.60% of the portfolio; dividend yield 7.38%

US-based Pfizer is the world's largest pharmaceutical company.

- Unit Corporation - 2.53% of the portfolio; dividend yield 0.0%

Unit Corporation is a diversified energy company engaged in the exploration and production of oil and natural gas, the acquisition of producing oil and natural gas properties, the contract drilling of onshore oil and natural gas wells, and the gathering and processing of natural gas, all in the US.

- Johnson & Johnson - 2.52% of the portfolio; dividend yield 3.14%

Johnson & Johnson is a 120-year old US-based company with operations across the globe. It specializes in consumer products, pharmaceuticals, medical devices and diagnostics.

2008 Meltdown

With a dismal 2008 behind us, everyone has an opinion about what caused the meltdown. However, there is general consensus that the bankruptcy of Lehman Brothers was the global economy's cardiac arrest.

When confidence evaporated, investors began acting irrationally and sold assets without regard to price. The market deeply discounted great companies, many selling below book value. The most admired US companies were trading at scrapheap values.

Everyone's Hurting

The smartest money managers in the world are currently looking at deeply discounted portfolios. The S&P500 declined 38.5% in 2008. The commodity markets recorded their worst ever performance. The Reuters-Jeffrey CRB index, which started in 1956, fell 36% in 2008. The S&P GSCI index, the most widely followed benchmark for commodity investors, dropped 46.5%. Nasdaq Composite declined 40.5% and the Dow 33.8%.

Predictions

Currently, there is no shortage of experts predicting how long the world will suffer through a recession, how deep that recession will be, and how prudent it is to load up on gold. The fact is hat economies are complex, dynamic, and non-linear systems where small changes in the many factors that effect growth can result in significant differences in predicted outcomes. The future is unknowable.

We agree with Zachary Karabell, who writes in the WSJ, "Economic News Isn't All Bleak" (Dec. 26, 2008), that predictions about a long and painful recession lying ahead are based on past recessions that were caused by events that occurred over the course of years. "What happened since the collapse of Lehman on Sept. 15 was a global, synchronous cessation of all but nondiscretionary economic activity in the wake of the near-collapse of global credit markets. And it happened over the course of weeks not years...

"And yet, if things come to a halt more quickly than ever before, they could also restart more quickly than ever before. This is not to say they will, only that the possibility is more than marginal...

"The last months of 2008 will go down as one of the most severe economic reversals to date and on a global scale. But it is foolish to assume that this period provides a viable guide to what lies ahead."

Our Strategy for 2009

Our position with regard to equity investments has always been that (i) we perform fundamental due diligence on the companies we intend to buy; (ii) we do our best to acquire these equities at prices that capture a discount to the intrinsic values of the companies; (iii) we invest in these equities with the intention to hold them for a very long time; (iv) our selling decisions are based on business model issues that indicate permanent impairment and (iv) in executing the above, we follow the investment principles of Warren Buffett that have withstood the test of time. While some investors were recklessly dumping stocks and thereby destroying their capital, we stayed rational and unemotional. It goes without saying, loss of capital is guaranteed when selling takes place in an environment where sellers hugely outnumber buyers. We do not buy in May to sell in August. The secret to capital preservation is buying stocks and owning them over the long-term. It is time in the market that matters, not market timing.

We do not allow ourselves to be unduly troubled by the pessimists. We continue finding great companies, with enduring business models and with people at the helm who care about shareholders and not their own pocketbooks.

It is easy to paint a dismal picture for 2009. The media will no doubt continue to spew out grim headlines for a couple more months. We will be told ad infinitum about job losses, foreclosures, bankruptcies, and recessions. The US economy could contract by 5% in 2009. Commercial mortgages could follow residential mortgages. Corporate bonds are currently deeply discounted, which raises the possibility of substantial defaults. The auto industry is on its knees. The Federal Reserve is responding with unprecedented measures to support the financial system and provide liquidity. Hank Paulson is providing financial relief in the form of direct equity investments to loans and other bail out packages. The incoming president is promising huge amounts of infrastructure spending that could see next year's deficit as high as 12.5% of GDP. The big fear now is a downward spiral of falling asset prices, rising bankruptcies, foreclosures and unemployment, all feeding on each other. We could go on, but like spring follows winter, de-leveraging will come to an end, excesses will be cleared out, and demand will return. Buy-and-hold investors, like us, will be the beneficiaries of any major rebound in indices, while the fear stricken will rue their panic selling and subsequent indecision.

Conclusion

The events of 2008 and their temporary impact on stock prices have not rendered unsound the investments that we made in the portfolio. For the most part, these businesses dominate their industries, have global reach, and are well positioned to profit from major economic trends that are sweeping the globe. The events of 2008 have postponed the realization of these profits but have not in any material way undermined or impaired the future prospects of the companies we own. Increases in their stock prices during the past six weeks have already given some indication of their buoyancy relative to the major indices. We look forward with confidence to 2009. There is an old saying that you make all your money in bear markets, you just don't know it until later. We trust you view your portfolio in the same frame of mind as Shakespeare's Merchant of Venice who said, "My ventures are not in one bottom trusted. Nor to one place; nor is my whole state upon the fortune of this present year; therefore, merchandise makes me not sad."

October 2008 Commentary for the MIRZAM CAPITAL APPRECIATION FUND [MIRZX]

2008-11-18T16:50:00.004-06:00

Performance At the end of October 2008, the S&P500 was down -16.8% for the month and -34.0% for the year. Only four periods in the last 100 years (two of them during the 1930s) match the -46% slide since the S&P500 reached an all-time high in October 2007. Mirzam could not withstand the downdraft either and registered a -16.34% decline for the month and a -31.63% decline for the year-to-date.

Volatility Performance statistics are difficult to interpret in an environment where the market moves as much as ten percentage points in a day. For example, one day after closing at a 5 1/2-year low, the Dow Jones Industrial Index leapt +10.88% on October 28, 2008 to 889.35, which followed the +11.08% increase registered on October 13, 2008, when it closed at 936.42. On November 13, 2008, The S&P500 traded down -3.9% after the open, only to finish the day +6.9% higher - a +10.8% swing from trough to peak. These moves were short-lived and only accentuated the extreme volatility in the markets.

In seven trading days, October 24 to November 4, Mirzam ramped +19.9%. The S&P500 was up +14.7% during the same period. The fund has pulled back since then in sympathy with the market, but in these volatile markets a -30% year to date decline could become a -10% decline in a matter of days.

Such dramatic swings have caused investors to experience profound psychological shock and distress. Volatility, a statistical measure of how much stocks move unexpectedly in a year, is usually in the 15%-range, but daily volatility in October was 75% on an annual basis. The month of October, especially, saw lots of de-leveraging, disintermediation and forced selling. Investors who bought stocks on margin or pledged shares as collateral on loans were forced to sell in a weak market. Some, such as defined-benefit pension funds and university endowment funds with backstop commitments were forced to capitulate to honor their commitments. Others just sold because they could not stomach the volatility and losses, turning the selling frenzy into a rout.

Main Themes While our returns do not make for good reading, these are still relatively early days for the fund. We have been investing the bulk of the fund's assets during the past six months as the markets fell to unprecedented levels. There is method in our madness. Our portfolio is built around a couple of main themes.

We believe that the emerging markets have a lot to offer the global economy, especially the four dominant countries in this space: Brazil, Russia, India and China - the so-called BRIC countries. Over the long-term - and we are long-term investors - economic growth in these countries will continue to spur urbanization. This will lead to improved communication and transportation services, and increase the demand for commodities, food and medicines. The need for energy, especially oil and gas, will become ever more critical.

We have serious doubts about the current resurgence in the value of the dollar, relative to other currencies. This has hurt our portfolio returns of late, but over the longer term the dollar is bound to lose its luster. The emerging summit of the G-20 (20 advanced and emerging market economies) nations met in Washington in November 2008 in search of a permanent solution to the credit crisis and the impending global economic slowdown. One of the demands, the pundits surmised, would be an acceptance of a substantially weaker US dollar over the long term. Apparently, the Fed is content with the notion that such a downward adjustment at an orderly pace will have to be part of the global-adjustment process.

We also shun companies that use stock-option compensation as a means to over-compensate executives without the necessary transparency that accompanies cash compensation. As a consequence, we have found better and more responsible companies in places like Canada and Europe, where the interests of shareholders are still paramount. We have great confidence in the companies we own in the light of how these broad themes, mentioned above, are playing out, even though news headlines are currently contradicting such optimism.

Emerging Markets The MSCI Emerging Market index dropped a stunning 43% in October. However, emerging markets still hold a gain of 86% from their 2002 low, while the S&P500 was only 14% above its October 2002 bear market low. According to The Lex Column (Financial Times, October 29, 2008), emerging markets seem far better positioned to weather the current global crisis than in past crises. We quote, "Massive official reserves accumulated during the boom and financial institutions that are partial insulated from the developed market credit crisis are two reasons for this. And while developed markets look tempting, emerging markets are at their lowest trailing earnings multiple ever… Much of the discount comes from a lack of a large local investor base in certain countries and the impact of hedge fund liquidations that had little regard for value."

For the week ending November 5, 2008, there was a net inflow of $413 million into emerging market stock funds, compared to net redemptions of $1.6 billion the previous week, and outflows of $750 million two weeks earlier. Year-to-date, the outflows are estimated at $45 billion, nearly 40% of the cumulative inflows from 2003 through 2007. Much of this explains the decline in the stock markets of emerging economies. It is worth noting that the MSCI EM has still outperformed the S&P500 by more than 200% since 1998. We are confident that the index will continue to show this type of long-term performance, although we do not invest in indices. Rather, we believe that our due diligence allows us to identify the best stocks in an index, which if successful leads to above-average returns over the long-term.

Since the turn of the century, there has been a gradual increase in trading between emerging nations, which lowers their exposure to a slowdown in the US. In fact, the US portion of emerging market exports has declined by a third since 2000. Measured in terms of the last 12 months' exports to the US as a percentage of the BRIC countries' Total 2007 GDP, the ratios for Brazil, Russia, India, and China are only 2%, 2%, 3% and 5%, respectively.

One of the ways we tap into the growth of consumerism in emerging markets is through our investments in telecommunications companies, which together serve more than a billion mobile phone subscribers. These companies have high profit margins and, consequently, produce huge amounts of cash flow, the lifeblood of any investment.

Urbanization Over the past 30 years, the world's urban population has risen from 1.6 billion to 3.3 billion, and over the next 30 years cities in the developing world are set to grow by an extra 2 billion. The average population of the world's 100 largest cities now exceeds 6 million. In 1900, it was only 700,000. Between 1985 and 2005, the urban share of the population of developing countries rose by 8% points. Urbanization is accelerating, turning emerging countries from agricultural to industrial base economies.

The US has 9 cities with populations exceeding one million. India has 23 and China 160 (30 with more than 2 million).

Urbanization has been one of the driving forces behind China's growth. For example, the speed of China's motorization is stunning - some 30,000 miles of expressway were built the past decade as part of a plan to extend the system to 53,000 miles compared to the US interstate roads comprising 47,000 miles. China has roughly the same land area as the continental US. The US Interstate Highway System radically altered the American economy. The US has 898 automobiles per highway mile. The statistics in China and India are only 136 and 138, respectively.

Urbanization requires infrastructure investments, including highways, railroads, airports, telecommunications, water and electricity works, etc. This means ongoing demand for metals such as steel, copper and aluminum. The fund has invested in companies that produce copper, steel, specialty metals and other materials that are crucial to urbanization in the emerging economies. Currently, these investments are hugely out of favor, but we see this as a temporary phenomenon.

Energy The energy sector embraces more than oil and gas, but these two sources of energy still dominate the energy landscape. In November 2008, the International Energy Agency (IEA) issued a report predicting that the price of oil will be $200 per barrel by 2030. Under-investment in exploration will cause an oil supply crunch between now and 2015. The era of cheap oil is over. The current oil price, now below $60 per barrel, is a temporary effect of the economic crisis, according to the IEA. Crude oil was $147 per barrel in July 2008. This dropped to $56 per barrel in November 2008.

The world faces escalating energy costs as companies scramble to find new oil fields and extract more production from aging fields. The current global trends in energy supply and consumption are patently unsustainable. Companies will have to invest $26 trillion between now and 2030 - this includes $350 billon a year on new oil and gas projects - to keep abreast of rising energy demand, with about half going towards exploration and developing new sources of oil and gas. (The industry spent a total of $390 billion during the period 2000 to 2007.) The other half will be spent on increased power generation and distribution. Rising demand and production declines in existing fields will require oil companies to add 64 million barrels a day in capacity over the next 22 years, more than 6 times Saudi Arabia' current production and representing a growth rate of 2.98% p.a. The average annual decline rate of the world's existing oil fields that are past peak production is 6.7%. The world's oil fields (not including unconventional energy sources such as tar sands, ethanol, oil from coil, etc) currently produce 70.4 billion barrels per day. The world consumes 87 million barrels a day.

The fund owns oil and gas companies, oil and gas drillers, gas pipeline companies, and other companies that are closely related to the oil industry, such as Tenaris, a Luxembourg-based company, that supplies specialized piping to oil and gas companies. Shell is currently installing the world's deepest offshore floating oil rig 200 miles out in the Gulf of Mexico in water starting at 7,500 feet deep, with the oil lying another mile below the seabed. This trend to drill deeper is a huge positive for Tenaris.

Commodities October was the worst month on record for commodity markets, with the Reuter-Jeffries CRB Index falling off almost 24% - the largest monthly decline since the index was created in 1956. On October 31, 2008, the Financial Times reported that the brutality of the reversal over the past six months has left the most seasoned mining executive in a state of shock. The fall in the price of metals such as copper, platinum and aluminum has been exaggerated by the forced-selling by hedge funds that had to liquidate positions in commodities to cover losses elsewhere. As an example of the indiscriminate selling that took place, Xstrata, the Switzerland-based diversified mining group, has lost 78% of its value. At October month-end, the price of aluminum at $2,094 per tonne is down 37% from its 2008 peak, copper ($4,498 per tonne) down 49%, nickel ($12,807 per tonne) down 62%, platinum ($841 per troy oz.) down 63% and zinc ($1,216 per tonne) down 57%. Since October, prices have dropped even further.

In the commodities space, we mainly own copper, steel and aluminum. Our stocks have born the brunt of this sell-off. Again, we believe the current situation is not driven by fundamentals. There is no need for concern.

BRIC In terms of the Decoupling Theory, emerging nations are being weaned off US economic dependence and, thus, should cope better with a US recession than in the past. The slide in global stock markets seems to contradict this notion. This is certainly the case in the short-term, but we believe the Decoupling Theory is still very much in place. Stock markets tend to overreact. They sell on rumors and ask questions later. Over the long-term, economic fundamentals will prevail. Despite downward revisions in the growth rate of the BRIC countries, the IMF still expects Brazil, Russia, India and China to grow in 2009 at 3.0%, 4.0%, 6.3% and 8.5%, respectively. This means that the size of the US economy relative to the global economy will shrink. This is undeniable, and as such, economic distress in the US will have a diminishing impact on world economies, although this might not be too evident today.

The stocks of companies in these markets are trading at compelling values. The current trailing P/E multiples for Brazil, Russia, India and China companies are 7.3, 4.1, 11.1 and 8.2, respectively. The 12-month forward P/E multiples are lower at 6.5, 4.0, 9.9 and 7.7, respectively, demonstrating that these economies are still growing and will grow in 2009, although not at 2008 levels. Estimated dividend yields for companies in the indices of these four countries are 4.9%, 4.2%, 2.0% and 4.3%, respectively.

China In November China unveiled a $586 million (four trillion Yuan) economic stimulus program to bolster domestic demand and help avert a global recession. The plan includes spending in housing, infrastructure, agriculture, healthcare and social welfare and tax incentives or capital spending. This amount represents about 16% of China's economic output last year, and is roughly equal to the total of all central and local government spending in 2006 and a substantial commitment against China's six trillion Yuan annual budget. This would be equal to the US spending $2.3 trillion on a similar package. The US pushed through a $168 billion stimulus package earlier this year, equal to about 1% of GDP. The Chinese government also cut taxes on a large number of export items. China's biggest banks announced that they will increase their lending as part of the effort to encourage economic growth.

The money China intends spending will come out of the government's $2 trillion treasury. The stimulus packages that US politicians crow about are nothing of the sort. The US Treasury sits with $10 trillion in debt. To stimulate the US economy, the government has to borrow the money and that means higher interest costs for taxpayers to absorb and heavy debt repayment burdens on future generations. On November 17, 2008, Bank of America, a recipient of the Treasury's largesse towards US banks, announced its intention to increase its stake in China Construction Bank from 10.75% to 19.1%, by exercising options it currently owns - so much for helping the beleaguered domestic banking community.

The decline in the price of gas from $4.14 a gallon in July 2008 to $2.26 in October amounts to an annual saving of $282 billion - a de facto tax cut that doesn't need Congressional approval and does not increase the budget deficit.

Nobody questions the fact that China's economy is slowing down. For example, China's The National Bureau of Statistics announced in November that monthly electricity output declined 4% in October 2008 from a year earlier, the first such monthly decline in four years. On the other hand, value-added industrial production rose 8.2% in October from a year earlier, which was far slower then September's 11.4% gain. The comparisons are really difficult because production grew nearly 18% in October 2007. Chinese merchandise exports rose 19.2% in October year-over-year, compared to a 21.3% growth rate reported in September. The October trade surplus was a record $35.24 billion. China's National Bureau of Statistics also reported that consumer prices rose 4% in October from a year ago, below 4.6% in September, and down from February's peak of 8.7%.

Against this backdrop came the news on November 14, 2008 that Chinese automobile sales and production figures showed that October 2008 production of passenger vehicles rose by 10% year-on-year. Experts are predicting auto sales in the world's second largest car market to be in 5.8 million units in 2008 and 2009. Annualized car sales in the US are now 10.5 million units - the lowest since 1983. The median American car is 9.3 years old, 50% older than in 1990. There are 981 vehicles per 1,000 driving-age people on the road in the US. The same statistics for China, Brazil and Russia are 24, 138 and 230.

The Chinese economy grew at double-digit rates in each of the past five years. This has been the cause of the run up in commodity, energy, food prices and the like. A slowdown - obviously not a recession or sharp decline - in growth in China is actually a welcome development.

Experts believe that China's exports may suffer much less damage than first thought in a global recession because of their price competitiveness. The country is comparatively well-placed to deal with a slowdown. The boom years allowed China to clean up its banking system, return state enterprises to profitability and shore up government finances. The country's financial system remains largely unscathed by the global credit squeeze.

India Our fund has no exposure to India, but economic growth in India is very important in the context of the BRIC analysis and what happens in commodity markets, including oil and gas. India's industrial production increased 4.8% in September, which is well below the 9.5% recorded a year earlier, but nonetheless strong growth by international standards.

India's infrastructure deficit is greater than most countries. After five years of average economic growth of 9%, its national networks of highways and power plants are overwhelmed, choking growth.

The Indian government is forecasting a growth rate of 7% and has promised public expenditures to help buoy growth. Goldman Sachs has pared its forecast for the Indian economy to 6.7% in 2008-2009 from an earlier 7.5%.

Brazil Brazil is the largest and most populated country in South America, and the fifth most populated country in the world. Brazil is the world's tenth largest economy and the ninth largest in purchasing power. In 2007, Brazil launched a four-year plan to spend $300-billion to modernize its roads, power plants, and ports.

Brazil's economy has grown strongly since the turn of the century. It has brought its financial house in order. It is a stable democracy that has seen the standard of living of its people rise significantly in recent years as the global economy has expanded. Despite the current turmoil in the global markets, the IMF is still projecting a healthy growth rate for the country's economy in 2009, in the 3.7%-range, which is down from the previous 4.5% estimate. It has $250 billion in foreign currency reserves, which means it has become a creditor nation, quite a change from the old regime that was chronically in debt and financial turmoil.

Brazil has a wide range of exports that include aircraft, coffee, automobiles, soybean, steel, ethanol, textiles, footwear, electrical equipment, and of course commodities, especially iron ore.

Anecdotally, The Economist (November 15, 2008), reported on Casa Bahai, a Brazilian furniture and electrical goods retailer. The company with 550 stores in Brazil dismissed the global economic slowdown and projected revenues of $ $6.1 billion in 2008, up from $5.6 billion in 2007, an 8.9 % increase, with more to come in 2009.

Our exposure in Brazil is mainly in telecommunications, through our investment in Telefonica, the Spanish telecom giant.

Russia Russia's current woes stem from its excursion into Georgia and the sharp decline in oil prices. It is evident that there are still many in the media fighting the Cold War, which makes it difficult to obtain unbiased reports on Russia. The Economic Intelligence Unit of The Economist predicts that Russia's economy will grow 6.8% in 2009.

A recent letter in the Financial Times points out that Russian's foreign exchange reserves at $515 billion exceed the total dollar value of all ruble deposits in the banking system (roughly equivalent to $390 billion). No other country in the world is as well protected.

Our direct exposure to Russia is limited to our investment in the second largest mobile phone operator in Russia. However, if growth in Russia, together with the other BRIC countries continues to be positive, the global economy will benefit and with that many of the stock we own, especially in the energy and commodities sectors.

Be Positive Warren Buffett contributed an op-ed piece to the New York Times on October 17, 2008: "Buy American. I Am." Buffett acknowledges that fear is widespread, gripping even seasoned investors, but companies will again, as in the past, deliver "new profit records." The current setback is not unique in US history. Following each setback, the country's economy recovered and investors did well with the DOW climbing from 66 to 11,497 during the past century, despite periods of deep despair. Still, many investors lost money during this time period. Who were these investors? "The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy," according to Buffett.

He highlights a very important investment principle, so much so that he mentions it twice, namely that he cannot predict the short-term movement of the stock market. "I haven't the faintest idea as to whether stocks will be higher or lower a month - or a - year - from now," he writes. Again, "I have no idea what the market will do in the short term."

In other words, he does not buy stocks in May to sell them in August. He buys for the long-term. We, too, are buy-and-hold investors. Nobody ever lost money holding a good stock for a reasonably long period of time.

These are unusual times, but we are confident that the market will stabilize. Just as stocks fall to ridiculous levels, they also tend to rise to ridiculous levels. We have thoroughly researched the stocks that we own. We know them well and we have great confidence in their future. There are many variables that impact the value of a stock and influence the failure or success of a company's business strategy. We believe that thorough due diligence goes a long way to avoid investment failure. The fund's portfolio is well-placed to benefit once economic growth recovers in the world's major economies.

Stocks rise long before economic activity picks up. Equities always lead the economy out of a recession. Since 1893, there were 11 periods when the US economy contracted by 2.5% or more. On each occasion, the stock market recovered before the economy picked up. If you had bought the S&P500 at the end of 1932, when things looked their bleakest, you would have gained 86% after five years, 120% after 10 years and 926% after 20 years. It is time in the market that matters, not market timing.

"We... [did not] let fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist [our emphasis].

Stock prices will continue to fluctuate - sometimes sharply - and the economy will have its ups and downs. Over time, however, we believe it is highly probable that the sort of businesses we own will continue to increase in value at a satisfactory rate." - Warren Buffett, 1994 Letter to Shareholders.

June 2008 Commentary for the MIRZAM CAPITAL APPRECIATION FUND [MIRZX]

2008-07-23T15:30:00.004-06:00

No Joy in June The month of June was horrendous. The S&P500 closed down -8.6% for the month. In the early days of July 2008, the S&P500 dropped another -2%. There seems to be no end in sight. Only four of the 30 DOW stocks are positive for the year. Both the S&P500 and the Dow indices are down -15% since the end of the second quarter of 2007.

Even Warren Buffett's Berkshire Hathaway has not weathered these storms very well. Berkshire Hathaway was down -9.78% this quarter and down -14.72% for the year to date. On July 2, 2008, the Bloomberg news service noted that Berkshire was down -19% since closing at an all time high of $149,200 on December 2008, compared to a -15% slide of the S&P500 during the same period. Has the maestro lost his touch? Absolutely not, but even revered investors like Warren Buffet can't avoid the volatility of a market in virtual free fall.

Portfolio Characteristics In times of such market upheaval, the best medicine is to set aside one's emotions and consider what stocks are in a portfolio. The MIRZX portfolio is a collection of businesses acquired during a time when the market was in free fall. We bought these fractional ownership interests as others sold in panic. A year from now, we'll be able to tell how close we came to buying these stocks at their 52-week lows.

Our fundamental research-focused approach leads us to companies that trade at compelling valuation multiples, more so in times when the broad market sells off. We are attracted to companies that dominate their industries, benefit from strong secular trends, are relatively immune to economic cycles, and enjoy a virtual monopolistic position in the market place.

We own a number of positions in mobile phone companies in countries where they command huge market share, where competition is minimal, and where they mainly operate on a prepaid business model, which eliminates a lot of credit risk and generates huge amounts of cash flow. The mobile phone is one of the most significant inventions of our time.

In general, we avoid companies that don't pay dividends. We also like to add companies to our portfolios that are committed to relatively high dividend payout ratios. Often these companies are not great growth stories, but the cash flow that they produce for a portfolio comes in handy. Warren Buffett always says that Sees Candy has not grown much in the years that he owned it, but the cash flow it produced has been invested very profitably.

Ultimately, we invest for the long-term, which means our portfolio turnover is minimal. We look for companies that will not only be around ten years from now but will maintain their competitive advantage and preferably enhance their market dominance. In the short-term, market declines will have a negative impact on our portfolio, but our experience is that if you own the right companies, with most of them paying attractive dividends, the portfolio will recover more swiftly than the broad market.

Oil and Gas At June 30, 2008, oil and gas related stocks comprised 20% of MIRZX's portfolio. There currently exists a delicate balance between production and consumption of oil and gas, with oil and gas companies having to drill deeper and in more unconventional fields to replenish dwindling reserves. We own companies that are prominent in oil and gas exploration, that provide seismic data to oil and gas companies on land and sea, that manufacture and supply seamless steel pipe products and associated services to the oil and gas, energy and other industries, that own the largest natural gas transmission lines on the North American continent. We also own some oil and gas producers, as well as oil and gas royalty trusts that pay dividends on a monthly basis.

Foreign Telecom Another large component of the portfolio comprising 14.6% is foreign telecom companies serving over 800 million subscribers in Asia, Eastern Europe and South America. In 2007, the companies in Mirzam's portfolio reported year-over-year revenue growth in the aggregate of 18.8%, which translated into EBITDA growth of 35.7% and growth in cash generated by operations of 28.3%. The weighted average EBITDA margin expanded to 46.4% in 2007 from 40.7% in 2006. Subscriber growth was 21.4%. Based on trailing 2007 EBITDA and the current combined enterprise value (EV) of the companies, the EV/EBITDA multiple is 7.55. The weighted average dividend yield of these stocks is 2.52%. If we assume that a 15% increase in revenue in 2008 will translate into EBITDA growth of 22.5%, the EV/EBITDA multiple will drop to 6.1 at current enterprise values. The dividend yield will rise to approximately 3.1%. On the other hand, if the market responds favorably to these growth numbers and current market valuation multiples are maintained, the value of the portfolio will increase by more than 20%.

Steel and Metals Eleven percent of the portfolio is invested in the steel and metals industry. We own some of the world's largest steel and aluminum companies, alongside companies that process nickel, titanium, chromium, iron scrap and other metal alloying elements.

Copper Growth in China and India is driving the demand for electricity, which in turn calls for the construction of power generators, as well as tons of copper wire to transmit the electricity to consumers. We own stock in the two largest copper producers in the world.

Food and Agriculture Companies involved in the Food and Agricultural sector comprise another 3% of the portfolio.

High-Dividend Yield Twelve percent of the portfolio comprises high dividend yield stocks with a current weighted average dividend yield of 11.4%.

Pharmaceuticals The largest position in the portfolio (3.4%) is in a company that manufactures and distributes generic drugs in 50 countries. The fundamentals of the generics industry are very favorable as governments, health insurers, corporations and individuals seek more affordable drug prices. Governments across the globe are passing legislation that encourages generic drug companies to challenge the patents of brand name drugs on expiration. Ageing populations and the significant number of patents that have attracted huge revenues expiring over the next couple of years have given management the confidence to project a doubling of the company's business over the next five years.

The remaining 18% of the portfolio is invested in thirteen companies that comprise on average less than 1.5% of the portfolio. There are 43 stocks in the portfolio, with foreign companies making up 64% of equities.

The value that the market is currently placing on these stocks certainly plays on one's mind, but in an environment of panic selling, even great companies inevitably trade below their intrinsic values. Our approach, however, is not to sit on cash and time the market. The time to judge the most recent purchases that make up about half of total stocks in the fund is a year from now when hopefully the market will be back to some semblance of normality. Whatever the current state of the market, we believe Mirzam's equity portfolio represents a collection of stellar businesses, with superior fundamentals and considerable competitive advantages. We are holding onto them for a very long-time.

May 2008 Commentary for the MIRZAM CAPITAL APPRECIATION FUND [MIRZX]

2008-05-31T10:15:00.002-06:00

Here Today, Gone Tomorrow Here today and gone tomorrow is every retailer's dream, but not if you're an investor exposed to the S&P500. The S&P500 fought its way up from a close of 1,385.59 at the end of April, 2008, to a high of 1,426.63 by mid-month, only to retrace its steps to 1,400.28 by the end of May 2008; up +1.07% for the month. Unfortunately, the next day it was back to 1,385.67, a mere 8 basis-points above its April 2008 close. Thanks mainly to a stellar +4.75% rise in April, the S&P500 slide for the year to date has been contained to -4.63%. The first quarter's decline of -9.9% was a hard pill to swallow.

Fund Performance Mirzam [MIRZX] was up +3.33% for the month. Year-to-date, the fund is up +8.82%. Since the inception of the fund, August 20, 2007, to the end of May 2008, the S&P500 declined -3.12%. The fund, on the other hand, shows a positive +14.80% return. We had some decent inflows of cash during the month, but we were able to allocate capital at a rate that made inroads into our cash balances. The fund was 46% in cash at the beginning of the month, a ratio that was brought down to 35% by the end of May. Our investment strategy is not to sit on cash, nor to time the market, nor to trade in and out of the market. Instead, we allocate capital slowly and deliberately. This approach entails an enormous amount of due diligence before we invest in a particular business. The investment process is not driven by the size of our cash holdings. Our somewhat larger than normal cash holdings are a function of the size and short lifespan of the fund. Favorable investment returns are also attracting healthy inflows of cash. However, we will not make hasty investment decisions that would force us to short circuit an investment approach that has served investors so well in the past. The reason we believe so strongly in this is not because we are the fund managers, but because we are shareholders. A substantial portion of our wealth is invested in Mirzam Capital Appreciation Fund.

Portfolio We increased our equity holdings by 35% in May. At the end of May 2008, the fund's equity holdings were split 65%:35% between foreign and domestic stocks, respectively. The average dividend yield on the equity portion of the fund's portfolio is currently 3.08%. This compares well against the 1.94% yield of the S&P500. All things being equal, a decline of 37% in the value of the S&P500 would raise the dividend yield to 3.08%.

The Transparency of Cash Compensation

On May 28, 2008, MSN Money, in an article under the title "Make Buck by Shunning Fat Cats," featured our investment strategy. Here is the link for those who haven't seen it:

http://articles.moneycentral.msn.com/Investing/CompanyFocus/MakeABuckByShunningFatCats.aspx

In the same vein, everybody knows Mark Cuban as the owner of the Dallas Mavericks, but there is much more to Mark than his love for basketball. He is also a very astute observer of the stock market. This is evident from a guest column that he wrote for the Dallas Morning News (May 11, 2008), under the title "With CEO Lottery Ticket, Workers Lose." It was also published on the newspaper's website under the title "My 2 Cents on CEO Pay." Here is the link to this insightful piece that mirrors our longstanding tirade against the excessive compensation of US executives and the use of stock options, or lottery tickets as Cuban calls them:

http://www.dallasnews.com/sharedcontent/dws/bus/stories/DN-cubancol_11bus.ART.State.Edition1.4618495.html

To whet your appetite, here is a quote from Mark Cuban's column:

"...put CEOs in the cash zone. Make companies generate 100 percent of their compensation in cash that will be 100 percent expensed in the quarter paid.

"That's not to say the CEOs can't own stock. Hell, yes, they can own stock. But make them buy it on the open market or as part of a program that's available to every company employee on the same terms. They are getting paid enough, and if they believe in their ability to run the company, they can put their money where their mouth is.

"Shareholders tend to ignore how much stock goes to management, but they don't ignore cash..."

Mark-to-Market: Part 3 In part 1 of this series, we noted the "doomsday device" label that some pundits assign to mark-to-market accounting. Many experts and especially CEO's of companies that have been hit by the sub-prime mortgage meltdown, use less flattering language when asked in private. Those in favor of mark-to-market accounting are mainly found in the world of academia and among those who make the rules. The "defenders of the faith" argue along these lines: "Reports must be informative and truthful... financial information is favorable if it unveils truth more completely and faithfully instead of representing an illusory better appearance... Accountants must forego misbegotten efforts [like SFAS123 and SFAS123R perhaps?] to coax capital markets to overprice securities, especially by withholding truth from them... failing to provide value-based information forces markets to manufacture their own estimates." (Paul Miller, Journal of Accountancy, May 2008)

First, CPA's don't certify that financial statements are "truthful." They don't even care if the information is unreliable and irrelevant (case in point, look no further than stock based compensation information). This is because these sentiments are embodied in FASB's Conceptual Framework, which is not part of Generally Accepted Accounting Practice (GAAP) - go figure. Second, these ideals of transparency over obfuscation are being applied selectively. Stock-based compensation has avoided fair value accounting for decades in the financial statements, although the true economic cost (marked-to-market) is still meticulously deducted for tax purposes. Third, when considering whether the accountants should decide on fair value, Peter Wallison (the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute) remarked that it is too important an issue to be left to the devices of accountants, reminding us of Clemenceau's remark that war is too important to be left to the generals. "Fair value accounting also has a one-size-fits-all quality that mimics the inflexibility of over-regulation... Given its impact on institution and whole economies, common sense suggest that we consider whether one means of measurement is the only one we should be looking at. The world view of accountants at a particular time should not determine the answers to these questions." (Financial Times, May 1, 2008). It is absurd for accountants to believe that they can devise rules that will produce fair values for assets for which there is essentially no market.

Of course criticism of fair value accounting must not be seen as a campaign to keep investors in the dark. We just don't think the rule makers foresaw the impact of the rules in the context of the current credit crunch - to some extent fanned by fair value accounting - when they drafted the rules.

We'll have to let the matter rest, but we'll give Christopher Whalen, co-founder of Institutional Risk Analytics, the last word. "Fair Value accounting is a utopian concept that traces its intellectual roots back to the same origins as efficient market theory, the wellspring for most of the discredited quantitative models employed by the global banks to create the sub-prime mess. Unfortunately, the proponents of fair value accounting ignored the invocations of classical theorists who stated that liquid markets are a necessary condition for using market prices, either as a surrogate for measuring risk or for valuation.

"Fair value accounting is a good idea in theory, but like most good ideas it is difficult to implement. Sylvain Raines, a lecturer at Baruch College in New York, told a meeting of the Professional Risk Managers International Association last September: 'The Chicago School of Economics has been telling us for a century that price and value are identical... If we do not recognize the fundamental difference that exists between price and value, then we are doomed.'

"While it may be reasonable to apply fair-value rules to actively traded securities, for the vast majority of assets that are illiquid, historical cost remains the only reasonable and consistent way to report the value of financial assets." (Financial Times, March 6, 2008)

March 2008 Commentary for the MIRZAM CAPITAL APPRECIATION FUND

2008-04-29T16:30:00.002-06:00

Mark-to-Market: Part 2 Last month, we touched on the mark-to-market or fair value issue that has turned into a doomsday device as far as the financial markets are concerned. The debate is ongoing. This month, we view some comments of executives in the industry. Note that on the last day of the first quarter, the SEC publish guidelines that give firms leeway to value illiquid asset-backed securities in cases where market prices or other relevant pricing information cannot be obtained.

In the third quarter of 2007, Swiss Re marked its asset-backed securities in the form of collateralized debt obligations down to zero and its sub-prime securities down by 62% of their original value. Jacques Aigrain, chief executive of Swiss Re, attributed the severe write-downs to the lack of a true liquid market for these securities. Management concluded that these extreme write-downs are not predictive of future realized losses that might ensue.

In a recent conference call to investors, AIG's CEO, Martin Sullivan, noted that in valuing some of the company's securities, the company "could not find observable data points in this highly disrupted and illiquid market... We continue to believe that the unrealized market valuation losses on this Super Senior Default swap portfolio are not indicative of the losses AIG may realize over time... Even while retaining their investment grade ratings, these securities where priced at a severe discount to book. This despite our continuing intent and ability to hold them and despite structures that would indicate a substantial amount will continue to perform in accordance with the original terms... any realized losses in the portfolio will be materially below the GAAP fair value."

At the end of February 2008, Claude Bebear, one of the most influential voices in French capitalism, launched a stinging attack on international accounting rules. Mr Bebear, founder and chairman of Axa, told the Financial Times that the introduction of accounting rules that required companies to state assets at the latest market prices had helped contribute to global financial market volatility.

Henri de Castries, chief executive of Axa, backed the chairman and said that this manner of fair value accounting was a "conceptual mistake... It is not because your neighbor is selling his house at a distressed price that your house is worth a distressed price if you don't need to sell it." According to Castries, the system had created accounting losses that were not necessarily economic losses. He was "pretty convinced" that a significant proportion of write-offs would be reversed in a few years. "The accounting systems in the economy are the thermometer, and I'm not sure their measurement scale is the right one today," he said.

MBIA, the bond insurer, was forced to take mark-to-market losses in one quarter that were more than three times higher than the total amount paid out in losses to policyholders over the past 33 years. Management explained that these accounting hits are "not predictive of future claims" and "should reverse over the remaining life of the insured credit derivatives," with actual losses not exceeding $200 million. The company's CEO reiterated that much of the eye-popping credit losses exist only on paper. MBIA has not actually unwound credit swaps or paid out settlements on them. MBIA is the controlling party and there is nothing to compel the company to cash in before maturity. "No serious analyst expects that we will have $7 billion of economic losses on our portfolio." Yet, GAAP rules say otherwise.

Steve Forbes, Editor-in-Chief at Forbes, writes in an editorial, "It's preposterous to try and guess what these new instruments are worth in a time of panic. Such assets are being marked down to increasingly arbitrary low levels… when forced by panicky regulators and lawsuit-fearing accountants to write down the value of these securities, institutions will dump assets in a market where there are temporarily few or no buyers. The result is a spiraling disaster. So let's have a time-out on markdowns until we actually have real experience in what kind of losses are actually going to occur."

If and when these losses reverse, as promised by these executives, we will brace ourselves for another asset bubble in financial stocks as the pendulum swings to the other extreme. In due time, the Financial Accounting Board (FASB) will revise these much maligned mark-to-market rules, but they will take no responsibility for the mayhem they have caused in the markets.

There is another side to the story, FASB's side. We'll review that next month and connect the dots. In the mean time, the defenders of mark-to-market accounting of which there are many, still need to explain to management and investors why the mark-to-market losses lack predictive value, a qualitative characteristic of accounting information that is vital to the investment process.

February 2008 Commentary for the MIRZAM CAPITAL APPRECIATION FUND

2008-03-14T12:14:00.008-06:00

Mark-to-Market: Part 1 Those who know us well are aware of our cynicism about the way in which Corporate America interprets and applies the accounting rules. Recently, in his letter to shareholders, Warren Buffett pressed the point. He writes, "Former Senator Alan Simpson famously said, 'Those who travel the high road in Washington need not fear heavy traffic.' If he had sought truly deserted streets, however, the Senator should have looked to Corporate America's accounting."

The questionable application of accounting principles has manifested itself in the financial sector with devastating results. First, it is a fundamental concept that financial information should have predictive value. For example, when a company allows for doubtful debts, it is on the strength of a sound and rational prediction that certain receivables on the balance sheet will ultimately not be collected. If the resultant charge for doubtful debts lacks veracity, the financial information will lose its predictive value. Management writes off or depreciates an asset over, say, ten years, because it can fairly estimate that the asset's useful life will not exceed ten years. If it willy-nilly changes this estimate to five or fifteen years, the financial information loses its predictive value, and this undermines its value to investors.

In the current situation, the blame for the questionable application of an accounting rule does not rest with Corporate America - a welcome change. The Financial Accounting Standards Board (FASB) determined that companies should mark financial assets (securities, derivatives and other financial instruments) on their balance sheets to market, that is, they must carry these assets on the balance sheet at market values. This rule works fine when financial assets trade on exchanges where market prices are transparent and where liquidity is not an issue.

Doomsday Device However, when it comes to illiquid structured securities that are rampant in the sub-prime market, the inflexible application of the mark-to-market rule morphs into a veritable "Doomsday device," as described by John Dizzard in the Financial Times (February 26, 2008). In illiquid markets, management has to rely on indices and models that take into account a number of variables, for example, interest rate spreads.

In the current environment, this exercise has caused financial institutions to write-down loans and other financial assets to the tune of billions of dollars at a time. Understandably, the market responded negatively, which, in turn, threw financial models and indices into disarray. Interest rate spreads widened even further, which set in motion a new round of write-downs, far greater in magnitude than the previous write-down. This pattern is repeating itself to the point where once highly liquid markets, such as the short-term municipal market, are now clamming up. The Doomsday machine has gone into overdrive and to date, aggregate mark-to-market losses on mainly illiquid structured securities have run in excess of $150 billion. This is not a material amount, but taken out of context and bellowed over TV is bound to send the market into a tailspin.

To gain perspective, it helps to review the response of those who are afflicted by the mark-to-market madness. Warren Buffet, again in his letter to shareholders, writes, "...accounting rules for our derivative contracts… will sometimes cause large swings in reported earnings, even though Charlie [Munger] and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings - even though they could easily amount to $1 billion or more in a quarter and I hope you won't be either." In other words, discount the predictive value of these losses.

Space does not allow us to quote from conference calls held by the financial institutions that are sweating under the current accounting regime. However, the unanimous conclusion from the management teams is that the unrealized market valuation losses are not indicative of the losses they will suffer over time. Hence most of these losses will reverse as the liquidity crunch abates and interest rate spreads narrow. The process is being hampered by an accounting regime that never envisaged the negative feedback loops currently experienced in the market.

Federal Reserve Chairman Perplexed Fed Chairman, Ben Bernanke, in a congressional testimony on February 28, said that the accounting rules may be forcing banks to put artificially low values on little-traded assets when they mark them to market. This lack of observable market values is "one of the major problems that we have... I don't know how to fix it. I don't know what to do about it," he said (Bloomberg, March 4, 2008). One analyst points out that these financial institutions are marking their securities against an index that predicts losses at 32 times the actual loss experience.

We'll revisit this topic next month. In the meantime, don't take these huge write downs at face value - accounting aberrations are masking the true underlying economic realities.

To learn more about the mutual fund visit: MIRZAM CAPITAL APPRECIATION FUND

October 2007 Commentary for the MIRZAM CAPITAL APPRECIATION FUND

2007-11-15T13:30:00.000-06:00

Corporate Democracy: Regulators Lose the Plot

There is a raging debate on whether corporations should be democracies or not, that is, should we applaud shareholder activism or is corporate oversight best left to a board of directors? American corporate law severely limits shareholders' rights. By comparison, shareholders live in an activist paradise in the United Kingdom. Lynn Stout, law professor at UCLA, recently pointed out in a Wall Street Journal commentary (September 27, 2007), that 13 of the world's largest corporations are in America. Japan, with a notoriously unfriendly legal environment for activists is runner-up with six of the largest firms. "Yet the U.K. is headquarters to just one and a half of the world's 30 largest companies, BP and Royal Dutch Shell. Even the tiny Netherlands has nurtured more great corporations (2.5 to U.K.'s 1.5). If shareholder democracy were good for corporations and investors, the UK would be a corporate powerhouse... Shareholder democracy is a shallow idea based on a fundamental misunderstanding of what makes good companies tick...," writes Ms. Stout, to illustrate the detrimental effects of allowing shareholders too much leeway in the boardroom. One could argue that size is not everything, but that does not negate her argument.

Alex J. Pollock, a clear thinker and Resident Fellow at the American Enterprise Institute, in a letter to the editor points out that people who demand a say because they are "shareholders" are usually not shareholders but hired hands pushing the agendas of their masters, "bearing their own load of self-interest agendas and agency conflicts."

We understand why some shareholders relish the idea of taking on a board of directors, especially when they seek to increase their chances of a favorable investment outcome by, for example, pushing the company towards a certain capital allocation decision in lieu of another course of action, which they see as detrimental to the welfare of shareholders. These shareholders are normally large institutional funds, hedge funds, or agents of special interest groups, such as employees, retirees, environmentalists, etc.

We placed emphasis above on "large" because management's rebuttal could always be that if you don't like what we do, sell your stock. In theory, disenchanted shareholders could just as easily dispose of their holdings and find investment opportunities in companies where the board and management acted in ways that better conform to their world view. There is a problem with this seemingly simple solution. An institution with a sizeable ownership interest in a company would find it difficult to dump the stock on the market without causing alarm and hence driving the stock price down. This is where Mirzam Capital Appreciation Fund comes into the picture. We would love to have the kind of problem described above, but our current size rules us out of any material ownership interests in even the smallest of small cap companies - although we generally cautious of small caps because of the inherent volatility in their stock prices. In addition, they are often just past the start-up phase and their business models have not withstood the test of time.

Here's our perspective. The SEC requires that we keep a detailed record of all proxies we receive from companies in our portfolio. In addition, we are burdened by the requirement to carefully consider all the matters and resolutions that seek a shareholder vote. We need to tabulate details such as company name, ticker, security ID/CUSIP, a description of all matters or proposals, comparing management's proposals vs. shareholder proposals, and ultimately how we voted. The voting process in itself is a time-consuming exercise. The SEC deems all this bother and administrative burden a necessary consequence of what we consider a dubious campaign to democratize corporations. Regrettably, SEC requirements make no allowance for the size of a fund's ownership interest in a corporation. At this stage of our existence as a fund our proxy votes would not have the slightest impact on any shareholder resolution, yet we still have to allocate resources to this futile effort. The SEC wants us to believe that this is in the best interest of our fund and its shareholders. Our shareholders know better. Far from being helpful, these regulations hurt our shareholders. (Does this remind you of that saying, "I'm the government and I'm here to help you." - thanks, but no thanks) They would far rather have us spend our time and resources on finding and researching the best companies to invest in and be done with what Charles Dickens would have called "mountains of costly nonsense," to quote a Chancery judge in his novel Bleak House.

To learn more about the mutual fund visit: MIRZAM CAPITAL APPRECIATION FUND

September 2007 Commentary for the MIRZAM CAPITAL APPRECIATION FUND

2007-10-29T20:09:00.001-06:00

Last month we wrote a couple of paragraphs on Dell Computers. To clarify, it is not our intention to badmouth anyone in particular. Rather, we want to illustrate a point with reference to some real numbers that are readily available in SEC filings. Unfortunately, at times these numbers reflect unfavorably on the entity that publishes them. This is certainly the case with the topic under scrutiny this month. To keep our focus on the issues rather than on a particular company, we will hide the identity of the company in question behind the pseudonym, "Enigma."

If you believe management's earnings announcements and the subsequent media reports, "Enigma" is a very profitable company. Skeptical as we always are, we pulled the company's SEC filings, and in particular the balance sheet. Surprisingly, "Enigma's" balance sheet reports an "Accumulated Deficit" of $617 million. In other words, the company has not been profitable since the day it was formed. It has also never paid a penny in dividends to shareholders. Believe it or not, "Enigma" has a market capitalization in excess of $150 billion. Yes, billion with a "b."

What happened to the widely published profits of "Enigma"? First, understand that management has been very generous in handing out stock options to employees in lieu of cash wages. This practice created the illusion of profitability and left management with a choice: pay dividends or buy back stock. Management chose the latter. You see, it had to deal with a ballooning share count, the inevitable result of issuing approximately 1.8 billion shares to employees who cashed in their stock options. Unfortunately, management ran out of profits after buying back approximately 1.5 billion shares. In fact, management appropriated all the profits the company ever earned, plus another $617 million as it helped employees turn their paper wages (options) into cash wages (the buybacks).

What shareholders need to understand is that these types of share repurchases or stock buybacks are nothing more than compensation in disguise. It works like this: You first inflate the share count by issuing stock to employees and then you scramble to mop up the dilution by buying back stock. At the end of the day, shareholders are no better off than they were prior to the stock issues and the subsequent buybacks. Consider the fact that "Enigma" still has another 1.4 billion options (23% of the current share count), coming down the pike. Why does this company command a $150-billion plus market capitalization when the repurchasing of stock issued to employees seems to be its sole purpose? Stated another way, since inception the company has distributed all the profits it ever earned to employees through a marvelously deceptive practice of stock base compensation.

Here's the truly bad part of the above story, which explains why we are reluctant to name and shame the company. "Enigma," as we dubbed this company, recently announced an increase in its share buyback program, saying, "Today's decision to increase its share buyback program allows the company to continue to return cash to shareholders."

The truth is nothing of the sort. The buyback program sends a signal that the company is setting aside sufficient funds to enable it to buy stock at any time employees wish to sell. This helping hand provides much needed price support, because insiders are constant sellers of company stock. (Stock options are not yet legal tender at the mall.) This circuitous route of compensating employees returns cash only to a select group of shareholders, namely the employees. The company gets away with this misrepresentation because of (1) the way the accounting works, (2) the difficulty of tracking the cash flow and (3) because of the myth so readily believed by all, including the regulators, that stock buybacks are good for shareholders. After all, they "return cash to shareholders." Properly analyzed, the claim that "Enigma" returns cash to shareholders when it buys back its stock is a boldface lie, but don't expect the SEC to call them on it. On the other hand, be careful what you post on a Yahoo! Message Board. Stick to the truth. The SEC is watching and ready to pounce.

To learn more about the mutual fund visit: MIRZAM CAPITAL APPRECIATION FUND

August 2007 Commentary for the MIRZAM CAPITAL APPRECIATION FUND

2007-09-25T15:46:00.000-06:00

The following story underlines the reason for our aversion to employee stock options. On August 9, 2007, Dell Inc. announced that it made a - hold your breath - $48.5 million cash payment to former CEO Kevin Rollins relating to stock options that had vested at the time of his premature retirement.

On August 17, 2007, Dell owned up to past accounting problems that gave rise to a restatement of the past four years' earnings, effectively cutting such earnings by $150 million. The company "identified evidence that certain [accounting] adjustments appear to have been motivated by the objective of attaining financial targets." The company's new CFO, Don Carty, told analysts during a conference call to explain the restatements that "the ones [executives] who knew about it are the ones that are gone." As the size of gains garnered by the exercise of stock options are directly related to and enhanced by a rising stock price, the purpose of "attaining financial targets" is to buoy the stock price, so as not to imperil any potential stock option gains. In 2005, after completing our due diligence on Dell Computers, we issued a report under the title, "Perfect for your Dorm Room, but Bad for your Portfolio." Alas, when the best laid plans of management go awry and shareholders take the knock, executives walk away with a truckload of cash, thanks to stock options, that invisible enhancer of executive compensation. You won't find stocks of companies that use this form of obfuscation to transfer shareholder wealth to insiders in our fund's portfolio.

To learn more about the mutual fund visit: MIRZAM CAPITAL APPRECIATION FUND

No Stock Options = Better Performing Companies

2007-06-12T08:00:00.000-06:00

In August 2006, the Wall Street Journal did an article on us and our distaste for companies that use stock-based compensation. (See Seeking Out Firms That Don't Bother With Stock Options.) Herb Greenberg did a follow-up discussing the performance of the ten stocks mentioned in the original piece.

Options Update: Last August, in a column here headlined, "Seeking Out Firms That Don't Bother With Stock Options," Albert Meyer of Bastiat Capital said he would rather buy stocks of companies that don't offer stock options than those that do. "It's a no-brainer for money managers who don't want surprises of backdating and dilution and just the difficulty of analysis," he said at the time. Mr. Meyer had offered up a list of 10 stocks, including CompuCredit Corp., Pilgrim's Pride Corp. and Seaboard Corp.

How have they done? An investor who bought into each of the 10 stocks in late August would have seen their stake, including dividends, increase 29.4% through June 7, he says, compared with the 15.1% return in the Standard & Poor's 500-stock index over the same period. Why have these companies done so well relative to the market? "They do well because they have management that seeks the best for shareholders, proved by the fact that they shun the opportunity to make a quick buck for themselves through the use of stock options -- a practice that dilutes shareholders." Based on these returns, he may be on to something.

SEC Letters - Stock-Based Compensation Reporting Request

2007-06-11T07:33:00.000-06:00

The following is a series of three letters related to our request for better stock-based compensation reporting in financials.

Letter 1

March 15, 2007

Mr. Donald T. Nicolaisen
Chief Accountant
U.S. Securities and Exchange Commission
Washington, D.C. 20549

Dear Mr. Nicolaisen:

Re: Stock-Based Compensation Reporting

According to Mr. Holman Jenkins at the Wall Street Journal (A Typical Miscreant - II, January 3, 2007), expensing stock options "creates a junk number, of zero analytical value." A sad commentary, considering it took FASB 23 years to present the investment community with a 285-page document called FAS 123R: Share-Based Payment.

As an investment adviser and equity analyst, I tend to disregard FASB's required disclosures regarding stock-based compensation (SBC), whether in footnotes or on the face of the income statement. The key number for me has always been the actual SBC expense that a company reports on its tax return. Although it has not been a requirement to disclose this number, the dubious practice of reporting a so-called tax benefit through a debit to the tax expense line and a credit to shareholders' equity, comes in handy in calculating the SBC expense as it appears on the tax return. The tax benefit represents the difference between the SBC expense on the tax return and its counterpart in the income statement, multiplied by the tax rate. Prior to FAS 123R, companies did not expense SBC, which meant that the tax benefit dividend by the tax rate provided a decent approximation of the stock-based compensation expense reported for tax purposes. Importantly, this number is equal to the amount that employees report as gains on the exercise of stock options on their tax returns.

The SBC expense on the tax return is ultimately the only number that matters in this debate. It is easy to understand. Even a fifth-grader can comprehend the discount associated with selling a dollar's worth of candy for thirty cents. It is comparable across all companies, sectors and industries. It is neutral, because management bias is conspicuously absent in determining the cost. The number is easily verifiable. Employees, brokers, companies and the IRS verify the number without the help of experts. It faithfully represents economic reality, the true cost of issuing a marketable security below its intrinsic value. Perhaps Holman Jenkins chose to describe its income statement equivalent as a "junk" number because these qualitative characteristics of useful accounting information are absent from the SBC expense reported in accordance with FAS 123R.

There is another important reason why the SBC expense in the tax return is an indispensable number to the equity analyst. I have found a remarkably close correlation between the SBC expense on the tax return and the amount of cash (net of employee contributions paid on the exercise of options) that companies spend on buying back the stock issued to employees in lieu of cash wages. SBC is a circuitous form of cash compensation that results in the overstatement of reported income and cash flows.

Unfortunately with the advent of FAS 123R, it has become very difficult to calculate the tax benefit, which makes it equally difficult to calculate the SBC expense on the tax return. Take the 10Ks of the following randomly chosen companies, Adobe, Apple, Cisco, Cognex, EBay, Google, Lehman Brothers, Microsoft, Qualcom, Time-Warner, and Yahoo. Ask some of your most competent understudies to find the past three years' tax benefits for each of these companies. If their experience is anything like mine, you will land up with frustrated accountants unable to agree on which numbers best represent the tax benefit. This ought not to be so.

I respectfully request that you ask companies to disclose not the tax benefit but the actual SBC expense reported on their tax return, and to do so for all the years shown in the financial review - at least five years, preferably ten. It would be helpful if they could issue a special 8K with this information, rather than wait for the filing of the next 10K. Timeliness is now an issue in the light of the current confusion, as described above.

As an aside, the tax-benefit debit to the tax expense line is misleading. It reports an expense that does not conform to FASB's definition of an expense. It is tantamount to a hybrid deferred tax adjustment but curiously pertaining to a permanent difference. The more one studies FAS 123R, the less faith one has in it, hence the need for the only real number that represents, not a fair representation, but a true and fair view of the cost of paying employees with coupons that are later redeemed through stock buybacks. Cash outflows associated with stock buybacks that merely mop up the dilution caused by option exercises arguably belong in the operating activities section of the cash flow statement - another issue that could consume 23 years of deliberation. In the mean time, we will continue to make the adjustment ourselves.

Respectfully,

Albert J Meyer CA CPA
Bastiat Capital, President

Letter 2

The SEC responded to our letter and suggested that we take this matter up with FASB. Here is our response to the SEC's suggestion:

April 3, 2007

Mr. Conrad Hewitt
Chief Accountant
U.S. Securities and Exchange Commission
Washington, D.C. 20549

Dear Mr. Hewitt:

Re: Stock-Based Compensation Reporting

This is in response to a letter I received from Mark Barrysmith, written March 23, 2007, which was a reply to my letter dated March 12, 2007. I enclose copies of both documents for easy reference.

According to Mr. Barrysmith, it is "unlikely that we [the SEC] will be able to undertake a project that would fulfill your request... you may want to consider sharing your views with the Financial Accounting Standards Board (FASB)…"

As I pointed out in my letter of March 12, 2007, FASB spent 23 years to give us FAS123R - Share-Based Payment - which according to Holman Jenkins of the Wall Street Journal "creates junk number of a zero analytical value (A Typical Miscreant - II, January 3, 2007)." With respect, FASB is a dead-end; and I'm not alone in this opinion.

On March 9, 2007, Arthur Levitt, former SEC chairman, in the Wall Street Journal, argues that FASB has "fallen captive to constituent groups... As a result, standards fail to provide investors with transparent, comprehensive and understandable measures of resources or performance... It is now clear that the entire standard-setting structure needs to be reconstituted... intense interest-group lobbying has delayed action and severely compromised stock-option expensing... When the FASB falls prey to these compromises, the resulting standards can end up being overly complex and confusing."

It makes no sense for me, as an individual, to approach FASB about the matter, as outlined in my letter of March 12, 2007. I am up against the political influences that dominate the standard-setting process. FASB, to quote Arthur Levitt again, "still relies on donations from those for whom they write standards. Various constituencies in practice have board seats set aside for them: at the FASB, three from public accounting, two from corporations, one from academia and one financial analyst. Those who fill them, in turn, at times have lobbied for the groups that put them there. Exceptions are then thrown into the rule-making mix in order to create a compromise that pleases each and every constituent group. The result is a regulatory sausage that is hard for companies and investors to swallow... Over, time, vested corporate and other special interests have chipped away at that independence and undermine these organizations' commitment to meeting the needs of investors and the public."

As a registered financial adviser representing the interests of many investors and the public at large, I am making a reasonable request. Would the SEC mandate that companies disclose, in the annual proxy statement, the stock-based compensation expense that they report to the IRS?

With respect, Mr. Barrysmith mischaracterizes my request as the "undertaking of a project." There are no rules to be written, no definitions to be considered, no opinions to be debated, etc. The number is readily available on a company's tax return. The source of the information is not open to interpretation. It corresponds with the stock option gains on which employees were taxed for the year in question, and this is backed by documents supplied by independent parties, namely, brokerage firms. As explained in my letter of March 12, 2007, it is a number that even a fifth-grader readily comprehends.

In my first letter, I outlined the reason why the stock-based compensation expense reported to the IRS is so important to investors, and why the revised FAS123R has made it more difficult, if not impossible, for investors to derive this information from the revised disclosures.

There is no need to involve FASB. For example, if the SEC had relied on FASB to provide investors with information about executive compensation, as disclosed in the proxy statement, we would still be debating the issue. Instead, the SEC called for mandatory disclosures of executive compensation in the proxy statement, without any interference from FASB.

The way I interpret Mr. Barrysmith's usage of the word "unlikely" is that the door is still open for the SEC to act on this matter, but what would it take? I would appreciate a straightforward answer: No, we will not consider your request, or we will consider the matter but only under certain conditions, in which case, please provide the details and conditions.

Respectfully,

Albert J Meyer CA CPA
Bastiat Capital, President

Letter 3

June 11, 2007

The Honorable Carl Levin
Permanent Subcommittee on Investigations
340 Senate Dirksen Building
Washington, D.C. 20510

Dear Senator Levin,

Re: Permanent Subcommittee on Investigations on Executive Stock Options: Should
the IRS and Stockholders be given Different Information? - June 5, 2007

I want to thank you for initiating the above hearing with Senator Norm Coleman.

The following statement summarizes for me the written testimonies provided by corporate
finance: GAAP made me do it, and the IRS added the icing on the top.

I was particularly interested in your efforts to obtain information from companies with
regard to the stock-based compensation expense as reported to the IRS. You also solicited
this information for all US companies from the IRS.

Earlier this year, I wrote two letters to the SEC in which I pointed out that since the change
in the rules relating to stock-based compensation (SFAS123R), it has become more difficult
for investors to calculate how much a company reports as stock-based compensation on its
tax return.

Under the old regime (SFAS123), the so-called "tax benefit" number in the operating section
of the cash flow statement represented 35% of the amount that a company claimed as a tax
deduction for stock-based compensation. Under the new rules, a portion of the tax benefit is
now transferred to the financing section of the cash flow statement. The portion that
remains in the operating section of the cash flow statement, more often than not, is
aggregated with other numbers, thus making it impossible to arrive at a reasonable estimate
of the stock-based compensation expense in the tax return. I am enclosing copies of my
letters to the SEC and their response.

I asked the SEC to make it a requirement for companies to disclose in the annual proxy
statement how much they claimed as stock-based compensation for tax purposes in any
given year. If this had been in place, your task of gathering the required information for the
above-mentioned hearing would have been much easier.

The SEC argued (see copy of letter enclosed, dated April 6, 2007): "Had your request that
registrants disclose the share-based compensation cost reported in their tax return been
more widely shared among the investment community, the SEC and the SEC and its staff
would have further considered the matter."

One could hardly ask for a more influential user of this information than a US Senator, as
illustrated by this hearing. I have received support from various sources, including
investment advisors, mutual and hedge fund managers, academicians, and individual
investors for my efforts to gain access to this vital piece of financial information through the
proxy statement. However, as an individual petitioning the SEC, even with a band of
supporters, some prominent in the world of finance, I have no hope of making any progress,
no matter how much time and energy I devote to the matter.

I am providing you with copies of my correspondence with the SEC to date, hoping that you
will raise the issue with the SEC and explain to them how important it was for you to have
had access to this information; how much more then for the investment community at large.

Sincerely,

Albert Meyer
President

FASB's Folly

2007-01-08T11:19:00.000-06:00

Letter sent to Wall Street Journal

According to Mr. Jenkins (A Typical Miscreant - II, January 3, 2007), expensing stock options "creates a junk number, of zero analytical value." It took the Financial Accounting Standards Board (FASB) thirteen years to draft SFAS 123, instructing companies to hide the "junk number" in the footnotes, and another 10 years to issue a revised set of rules (SFAS123R), bringing the "junk number" out of obscurity and into the income statement. FASB owes an explanation to Mr. Jenkins and the investing public as to why SFAS123R - a 285-page document - deserves more respect. This could ease shareholders angst about paying public accountants serious money for wasting their time in the audit of "junk numbers." I predict a deafening silence from FASB.

Both Jenkins and FASB miss the point. Companies perform a straightforward calculation to arrive at a stock-based compensation expense for tax purposes, a real number that represents the net cash cost of buying back the stock dished out to employees in lieu of cash wages. The cost of stock repurchases that mop up the dilution caused by stock-based compensation is not a junk number. It is hard cash out the door akin to the settlement of a deferred compensation liability; and it blows the cover on this circuitous method of compensating employees with warrants - not "options." Let's use the correct terminology.

Sincerely,

Albert J Meyer

Stock Option Compensation: An Urgent Warning from Albert Meyer... Wall Street's # 1 Whistle Blower

2006-11-08T19:18:00.000-06:00

Mark Skousen of Investment U recently did an interview with Albert Meyer discussing stock option compensation. In the interview, Albert Meyer said:

"Stock option compensation is today's biggest scandal on Wall Street. If your favorite stocks are loaded up with stock options, prepare for disaster!"

The full article can be read HERE.

Four Companies That Don't Play Options Games

2006-10-25T11:04:00.000-06:00

To show the other side of the coin, MSN Money's Michael Brush worked with Albert Meyer to highlight high-quality companies that don't rely on stock options. Michael writes:

Meyer favors companies where options represent less than 5% of the shares outstanding. "It's a good signal that you are dealing with a management team that respects shareholders," he says. He finds this information in companies' annual reports in a table that summarizes stock options outstanding.

The full article can be read HERE.

Bundles of Options

2006-10-23T09:52:00.000-06:00

Letter published in Barron's 10/23/06 issue

To the Editor:

For those contemplating an investment in Cisco ("Cisco's Bundles of Joy," Oct. 9), bear in mind that Cisco spent the bulk of its profits the past 12 years to buy back 1.5 billion shares issued to employees in lieu of cash compensation.

Stock-option exercises dilute shareholders. Rather than shrink the share count, as Cisco's CFO claims, Cisco's buybacks merely stemmed the tide of dilution. Stock repurchases that combat dilution are a roundabout way of paying compensation.

Cisco employees hold another 1.4 billion stock options. A 22% ownership dilution threatens-not counting any future option grants-unless the company spends the next decade's profits on share repurchases. Cisco shareholders are on a treadmill to nowhere.

Albert J. Meyer

A Tricky New Way Companies Inflate Profits

2006-10-18T09:44:00.000-06:00

Michael Brush of MSN Money is at it again working with Albert Meyer to show how company profits are not quite what they seem when stock options are involved. Michael writes:

Look at semiconductor maker Broadcom. Its reported options expense fell by more than $200 million between 2004 and 2005, even though the company issued 36.1 million stock options last year compared with 19.9 million in 2004. A big reason for the expense drop: The company changed assumptions for how volatile its stock price would be and for how long those options would be in force.

The full article can be read HERE.

How Stock Options Rob Shareholders

2006-10-11T09:28:00.000-06:00

Michael Brush of MSN Money discussed stock options using Albert Meyer as a source. The article points out the following amazing fact:

From 1998 to 2005, Broadcom generated $725 million in free cash flow (essentially the cash thrown off by the company's operations, minus capital expenditures such as the cost of office buildings). But selling stock to options holders -- who have to buy stock at a strike price when they exercise options -- brought in $1.1 billion.

The full article can be read HERE.

Stock Option Fiends Revealed

2006-08-31T09:14:00.000-06:00

Letter sent to Wall Street Journal

Wall Street Journal columnist, Holman W. Jenkins (Stock Option Fiends Revealed, August 30, 2006) placed Nobel Laureates and Warren Buffett at opposite ends of the stock option expensing debate. This detracted from what otherwise was a useful contribution to the niggling question of why companies readily expense stock-based compensation in their tax returns, but reluctantly so in their financial statements. The last time Mr. Buffett found himself in a room with Nobel Laureates representing Long-Term Capital Management, they stood cap-in-hand seeking a bailout. Investors would do well to stick to Mr. Buffett's "equivocation fallacy" - as characterized by Mr. Jenkins - that "If options aren't compensation, and compensation isn't an expense, what is it?"

Sincerely,

Albert J Meyer

Seeking Out Firms That Don't Bother With Stock Options

2006-08-27T07:57:00.000-06:00

In a recent article in the Wall Street Journal, Herb Greenberg discussed our firm's approach of avoiding companies loaded with stock options. The article notes:

Mr. Meyer focused on options long before they became a lightning rod in the market. In 2003, while at his own research firm, he penned a piece that argued eBay's real free cash flow was negative after deducting the amount needed for options-related purposes; it led to a Harvard Business School study. "I always start my research at the proxy statement," Mr. Meyer says. That's his first line of defense on companies to avoid; it's also how he finds companies he might want to buy.

Those with a subscription to the Wall Street Journal online, can read the full article HERE.

Albert Meyer Interview

2006-08-07T11:49:00.000-06:00


Albert Meyer, President of Bastiat Capital, discusses the true cost of stock options with host Spencer McGowan of Net Worth Radio on Dallas KLIF 570am.

Is Dell Profitable?

2006-06-27T09:52:00.000-06:00

Letter sent to Business Week

Business Week, July 3, 2006, lists Dell as the second most profitable company among its Information Technology 100. Investors are more sanguine. The stock has declined 40% from a year ago. More to the point, the stock is down 58% from its all time high of $59.69 achieved in March 2000. Investors who bought this stock back in July 1998 are still more than 10% in the red - so much for Dell’s profitability. During the past 10 years, Dell supposedly earned $19.5 billion; but shareholders' equity increased by only $3.1 billion. The anomaly can be explained. Dell paid employees in stock and then applied its inflated profits to repurchase the same. The cost of paying wages in kind did not show up on the income statement, and the cash expensed to repurchase the stock showed up on the cash flow statement as a financing activity, a pseudo-allocation of capital. The divergence between Dell's GAAP-based profitability (a mirage) and the performance of its stock price (a reality) is an indictment. The accounting process with its many participants delivers fatuous information. In ranking technology companies, Business Week should consider disregarding financial information in favor of more reliable and relevant criteria, however hard to find.

Albert J Meyer

Stock Option Shenanigans

2006-05-03T08:54:00.000-06:00

Letter to Financial Journalist

Your report that focused on the shenanigans that take place when it comes to estimating the volatility estimate was most welcome indeed. The problem with stock-based compensation is not necessarily the implied subjectivity of the estimate; although by no means acceptable to me.

Accounting is an art riddled with subjective estimates. However, these estimates eventually face what I would call, a catch-up adjustment; a truing up exercise. For example, assume a company buys a $90 million machine which has a true useful life of five years, but management charges straight line depreciation of $10 million each year, because it estimates the useful life at nine years. The true depreciation charge, based on an economic useful life of five years should have been $18 million per annum ($90/5). By the end of the 4th quarter of year five management's low-ball estimates comes to light as it scraps the machine and takes delivery of its replacement. Assume the scrap value was only $5 million. During the past five years, the company reported a total depreciation charge of $50 million. After scrapping the machine, it has to report a loss on disposal of $35 million. The $35 million loss is the catch-up adjustment; the truing up of the depreciation expense.

Eventually reality catches up with subjectivity. I could have used numerous other examples for illustrative purposes, but just to belabor the point, assume management provides an allowance for doubtful debt of $5 million against a $100 million portfolio of receivables. Once all the receivables have been collected, management is force to compare total collections against the initial value of the portfolio. Assume management only collected $91 million. This means the $5 million allowance (estimate) fell short by $4 million. An additional $4 million in doubtful debts would have to be written off. There is no way management can say: "Too bad, we underestimated the true expense, but thankfully we don’t have to admit to this error in judgment."

When it comes to stock-based compensation, FASB violates accounting conventions as they relate to estimates and says there is no need to true up the expense. Assume management grants options to an executive to purchase 40,000 shares at a strike price of $15 per share. Assume the executive exercises the option when the stock price is $35 per share. The executive gains $800,000 ($35-$15*40,000) on the exercise. Note that this is the amount that the company claims as stock-based compensation on its tax return - the true economic cost of selling stock to an employee at a discount. FASB wants the company to recognize this expense over the period that spans grant date to exercise date, in the same way that it wants the company to recognize the cost of using a machine over its useful life. The Black-Scholes model provides an estimate of this expense. The estimate is highly subjective, in fact so much so that this subjectivity has been one of the main arguments that executives relied on to stall the recognition of the expense in the income statement. There is no need to argue about subjectivity if in the end, FASB stayed true to principles applied to other estimates and mandated that companies true up the expense at exercise date.

Assume Black-Scholes places a value of $500,000 on the above mentioned option grant. By rights, at grant date, another $300,000 should have been required as a catch-up adjustment. That way, management would have been forced to apply a dose of reality to its estimates, in the same way that it has to do when it comes to estimating depreciation and bad debt allowances. The deceit of FASB as it colludes with management to trick investors is fascinating if not disturbing. Unfortunately, when it comes to stock-based compensation FASB has imposed such a tangled web of contradictions and deception that even those well versed in accounting lore are mislead by the numbers. I have highlighted but one of many.

On the same subject, you are no doubt aware that in anticipation of the implementation of the new rules, companies accelerated the vesting of out-of-the-money option. That way, it could avoid having to recognize any future expense relating to these options. Again, a simple requirement to true up the expense at date of exercise would have invalidated such slight of hand. I notice some companies are now issuing out-of-the money options. At first, this appears to be laudable; almost the antitheses of the scandal exposed by the WSJ relating to back-dated option grants. Ever the skeptic, I was wondering whether such out-of-the-money options received special treatment in terms of the new rules, which could mean the recognition of a lower expense that never has to be trued up! It is worth looking into. I might be wrong, but I have serious doubts when it comes to management's actions in general and more so when it comes to accounting.

Three companies that I think do well when it comes to accurately reflecting the underlying economics of their business in their financial statements are Boeing, Gentex and TechData. I'm sure there are others, but here are three that you can use as a point of reference. Linear Technology's CEO is on record saying that the company will never take one-time charges. This is in sharp contrast to other companies, inside and outside of the chip industry that have no problem in identifying one-time charges to try and dress up the numbers. Perhaps one should add Linear Technology to this list.

Albert J Meyer

What are Stock Buy Backs Really?

2006-03-03T09:42:00.000-06:00

Letter to Financial Journalist

"I enjoyed your column on stock buy backs. If I may, I have a comment or two. You wrote: "It's true that buybacks can offset new shares emanating from employee stock options."

It is actually the other way round. First, companies issue stock to employees and then they go and buy them back. Here is the issue: Management claims that stock-based compensation is not an expense. Now that they have to expense stock-based compensation, they claim that the expense is a non-cash event and as such should be added back, or ignored. Cisco and Broadcom, among others, take this view.

Seeing you made reference to Dell, I'll use it for illustrative purposes. During the past 12 years, Dell took a stock-based compensation expense of $15.6 billion on its tax returns. This is also what it would have cost the company to buy back the stock it issued to employees at the time of the option exercise, net of employee strike price contributions. If stock-based compensation is not really an expense, how come it turns up as one on the tax return?

As for the non-cash nature of stock-based compensation, this is where stock buybacks come in. At the beginning of 1995, Dell had 2.432 billion (split-adjusted) shares outstanding. At the end of 2005, it had 2.485 billion shares outstanding, an increase of 53 million; or net decline of 247 million, not counting the 300 million shares issued with the conversion of preferred shares. During this period the company repurchased 1.078 billion shares. One could argue that the bulk of the repurchases related to stock previously issued to employees. From 1995 to 2005, the company granted employees approximately 770 million options and a similar amount of options were exercised by employees. During the period 1999 to 2005, the company spent $16.8 billion on stock buy backs, but net of employee strike price contributions of $7.2 billion, the cash outflow was $9.6 billion. As the share count has hardly moved, despite all this buyback activity, one has to question the assumption that these expenditures were truly an allocation of capital.

To labor the point, consider a shareholder who owned, say, 10% of Dell back in 1995. Today, this shareholder owns 9%. However, if Dell's stock repurchases truly accomplished what we are all lead believe, the same shareholder would have had a 15% ownership. The share count would have been trimmed from 2.3 billion to 1.5 billion. Under the stock-based compensation regime, the billions of dollars spent on stock buybacks kept the share count more or less stable; ergo, these buybacks are not an allocation of capital. We should not allow FASB's defective reporting standards to fool us so easily.

FASB, ever eager to please management, has written accounting rules that kept stock-based compensation out of earnings, even though a hefty stock-based expense lands up in the tax return. In addition, FASB ruled that if management spends real hard cash to buy back all or some of stock it issued to employees in lieu of cash wages, the cash outflow should be reported in the financing section of the cash flow statement. Forget about accounting rules and think like a fifth grader. If management gives employees a "coupon" instead of cash wages, which it later redeems, why is that redemption not identified as compensation expense? The cash outflows that go merely to mop up the dilution caused by stock option exercises should by rights be reported as a reduction of operating cash flow. However, because it lies hidden in the financing section of the cash flow statement, we write about these buy backs as if they represent capital allocation decisions. I would argue that the billions of dollars Dell spent on stock repurchases were for the most part nothing more than a compensation expense in disguise - call it the settlement of a deferred compensation liability. There are analysts on Wall Street that make this argument, e.g., David Zion at CSFB. If financial journalists were take this stance and adjust earnings and cash flows of the Dells of this world for the cost of buying back the stock that they issued in order to avoid reporting a realistic compensation expense, the capital markets would discover that these darlings of the tech world are only half as profitable as the accountants would want us to believe. Such journalism would add serious value and help investors allocate capital on a more rational basis. It would also show up FASB's deceit.

Did Google Make Taxes a Scapegoat?

2006-02-03T09:40:00.000-06:00

Letter to Wall Street Journal

The reference to Google's "30% tax rate" [Did Google Make Taxes a Scapegoat? February 3, 2006], is misleading. Although not unique to Google, it is worth pointing out that two-thirds of Google's tax expense is pure fiction. The company deducted stock-based compensation of $1.2 billion dollars on its tax return in 2005, which lowered taxable income to the point where its actual tax rate was only 11%. In accounting parlance, the stock-based compensation expense in the tax return is a permanent difference because it never shows up in the income statement. Nevertheless, to hide such a low tax rate from the public, FASB allows these stock option laded companies to debit the tax expense line and credit shareholders' equity with the tax effect of the stock-based compensation deduction taken in their tax returns. Accountants will readily recognize that both the debit and credit ultimately ends up in shareholders' equity, making it a wash and nothing more than pure window dressing. Two-thirds of Google's tax expense, which is reported in the cash flow statement as a "tax benefit," is not an expense by any stretch of the imagination.

Albert J Meyer