Here’s what happened. Yesterday, Citigroup analyst Prashant Bhatia wrote an extremely negative report on E*Trade based on their announcement of exposure to mortgage securities where he put the likelihood of bankruptcy at 15%. How he calculated this, I don’t know. Maybe he estimated their exposure and risk curve for their portfolio, and then he ran monte carlo simulations of possible futures. More likely, he squinted his eyes, held up his thumb, and said “1 in 7″.

More coverage here in Business Week.

In any case, I’ve had a few people email me today about whether or not their money is safe at E*Trade.

Here is what I know:

1) If you have bank accounts, they are FDIC insured up to $100,000. So if E*Trade folded tomorrow, you’d be able to open up a new account elsewhere, and the FDIC would wire money in (up to $100,000) within a matter of days.

2) The brokerage accounts are protected by SIPC up to $500,000. Not sure how the re-imbursement works, but I’m guessing it’s something like an insurance claim.

3) The brokerage accounts are protected by a separate insurance policy for up to $150M per brokerage account.

None of these scenarios are likely – other brokerages & banks would be completely moronic to not buy E*Trade or it’s accounts for customer acquisition. E*Trade’s brokerage and bank business is doing quite well at this point.

In fact, here is an article suggesting that this might be a great buying opportunity for the stock.

So, unless you have more than $500K in securities at E*Trade and $100K in bank deposits at E*Trade, you are fine.

Update (11/13/2007): Wow. While E*Trade stock is now up almost $1.00 per share right now on Wall Street, I must not be the only one getting email on this issue. Look at what greeted me when I logged into E*Trade today:

Update (11/14/2007):  The following letter was updated on E*Trade today, which details the complete protection of brokerage accounts up to $150M.

To All E*TRADE Customers:

The old adage “there is no such thing as bad publicity” does not apply to E*TRADE FINANCIAL this week. Seemingly by the stroke of a pen… or a few clicks from a keyboard… a Company with a core business that has generated impressive growth quarter after quarter has been bombarded by rumored reports of its imminent demise.

Well, we want customers to know that the entire E*TRADE team has come together with resolve and commitment, taking appropriate and decisive action to manage through this issue and to ensure that E*TRADE FINANCIAL continues to deliver the best value in the marketplace for our customers.

I have spoken with scores of customers over the past week. Many of you have openly expressed your confidence in E*TRADE. It is genuinely gratifying to know that our retail customers—the heart of our business—understand the value in our model and the strength of the franchise.

Many of you have also asked me about asset protection, so to be clear—your money is safe at E*TRADE FINANCIAL. Here are the facts:

• FDIC insures all E*TRADE Bank accounts to at least $100,000 and Extended Insurance Sweep Deposit Accounts to $500,000.
• SIPC protects E*TRADE Securities customers up to $500,000 (including $100,000 for claims for cash).
• Additional E*TRADE Securities protection provides up to $150 million per brokerage account, underwritten by London insurers (aggregate $600 million).
• E*TRADE is well-capitalized by regulatory standards.

E*TRADE was founded on the concept of empowering the individual investor. This value is still at the heart of our business. We look forward to continuing to provide you with the products, pricing, service and functionality you have come to expect in order to help you manage your financial world.

We haven’t lost focus on our customers, our business or our future. The credit crunch has had a tremendous impact, but we are taking appropriate and decisive action to manage through it.

Thank you for your continued business,

—Jarrett Lilien
President, COO and Director, E*TRADE FINANCIAL

VMWare, after its IPO at $29 per share, crossed over $100 today to close at $101.61. Since they have 383 Million shares outstanding, that’s a market cap of $38.91 Billion. EMC closed at $21.81, and with 2.1 Billion shares outstanding, their market capitalization is now $45.75 Billion.

On the surface, that looks like a generous valuation for EMC. P/E of 26 on 2008 earnings projection, which is more than double their 5-year expected growth rate of 12%.

But, let’s factor out a few assets here.

They have over $4.5B in cash. They also hold a 87% stake in VMWare, which at today’s close, is worth $33.85 Billion.

So that means, you are basically buying all of EMC right now for $7.4 Billion, which gets you a $12B+ revenue business with a net margin of 10.8%.

That just doesn’t make any sense, on its surface. My guess is you are seeing two factors at play here:

1. There are liquidity issues with VMW, which are pushing up the valuation artificially. No options, no real shares to short. As a result, the EMC valuation is discounting the VMW stake to a more realistic value.
2. VMW valuation is being driven largely by large consumer interest, and that interest just isn’t doing the math on EMC which is broadly held by professional investors and indexes.

Personally, my trade in this area has been a winner, but still disappointing. Since I couldn’t get VMW IPO shares, I used a put spread (Jan 2009) on EMC, 17.5 and 25, to capture value as EMC appreciated, and to generate the cash to buy EMC 17.5 calls at a 10:1 ratio of my desired VMW position. I closed out the put spread last week, and now just have the calls which are deep in the money. Overall, the position has returned 80+%, which is great, but doesn’t quite capture the 300% return of VMW post-IPO. Of course, this is because it’s clear that EMC was pricing in the IPO in the run-up from 12 to 19 ($14B worth) from the Feb IPO announcement.
So the only question remaining is, when will VMWare be worth more than EMC?

VMware (VMW) has begun its official IPO roadshow, and has set tentative pricing of it’s IPO at $23 to $25 per share.  EMC will be retaining an 87% stake in the company.  The shares released to the public will be Class A shares, while EMC will retain Class B shares that have a 10:1 voting ratio to Class A shares.

That structure tells me that EMC wants to maintain control of VMware, while reserving the ability to liquidate a majority of the shares.  With that voting ratio, EMC could liquidate its stake down to just 9.1% of the company, while still maintaining control.  More details are available from 24/7 Wall Street:

The final pre-IPO range is for 33 million shares of class A common stock at an expected price range of $23.00 to $25.00.   That price can change ahead of the IPO and is not set in stone.  Book runners are Citigroup, J.P.Morgan, and Lehman; co-managers are listed as Credit Suisse, Merrill Lynch, and Deutsche Bank.  After the offering EMC will own 26.5 million shares of Class A common stock but will own all 300 million shares of the Class B common stock, representing approximately 87% of the outstanding shares.  The rights of A & B shares are identical, except when it comes to who gets the final say: Class B shares have 10 votes, or then-times the 1 vote per share of class A common stock.

As a sign of the times, you can actually watch the entire IPO roadshow here, on the web.  The stock will begin trading as VMW, and will likely issue the week of August 13th.

There has been plenty of blog coverage of the IPO.  Here is a Google Blog Search link to the most recent articles.

EMC has already run up by over $10 Billion in market capitalization since the IPO was announced.  Not surprisingly, that is roughly in the range of the expected value of VMware.  With $289 Million in revenue in Q2 2007, VMware is on fire, growing at near triple-digit rates year-over-year.

Even if you have no interest in investing, it’s likely worth watching the roadshow if you are interested in the virtualization space.  VMware is a smart aggressive company, and they keep moving the bar higher.

Hard to believe that EMC acquired them for just $623 Million in 2004.  Now that was a good buy.

I recently rolled over my 401k from eBay into an IRA. As a result, I now have the ability to better balance out my retirement portfolio across different asset classes.

In a previous post here, I discussed the launch of the first international REIT index ETF, the SPDR DJ Wilshire International Real Estate ETF (RWX).

Of course, in the months since then, a new fund has launched, provided by WisdomTree, the WisdomTree International Real Estate Fund (DRW).

The question is, which to choose?

Let’s assume first, for the purpose of this article, that we’re not going to debate whether or not now is the time to invest in real estate, international real estate, or whether ETFs are the right vehicle. Another time, another post. For tonight, the question is between these two funds.

Normally, picking ETF funds that track the same index is trivial – go with the one with lower expenses, unless the fund has a history of failing to track the index accurately.

However, when ETFs follow different indeces to track the same asset class, it gets a bit more complicated. In this case, there is a fairly radical difference in the two indeces that form the basis of these two funds.

I found this excellent table outlining the historical performance of the two on this Seeking Alpha post:

The first place anyone starts when comparing ETFs is performance, and here, it’s a mixed bag. For the 10 years ending March 31, 2007, the performance differential for the underlying indexes looks like this.

It’s worth noting that these returns are backtested, and do not reflect fees for the ETFs. But because the two ETFs have similar fees – 0.60% for RWX and 0.58% for DRW – the real-time returns should have been similar.

Mixed… DRW has lagged in the past 5 years, but is significantly higher over 10 years. Of course, this is backtested theory – neither fund existed that long.

In terms of the philosophy of the two funds, the question really outlines how truly you hold to indexing ideals versus value-philosophy in your investing. The SPDR is market-cap weighted, like the S&P 500 or the Wilshire 5000. The biggest percentage of the fund goes to the stock with the highest market cap. The WisdomTree fund is dividend-weighted. The biggest percentage of the fund goes to the stock with the highest dividend.

Personally, I’m normally biased towards simple, market-weighted indeces for the US market. However, deep down, I’m a value investor at heart, and the concept of dividend weighting, particularly in foreign markets where security enforcement may vary, is fairly appealing to me, especially in a dividend-focused asset class like real estate.

As another nod to DRW, the WisdomTree fund has both REITs (Real Estate Investment Trust) and REOCs (Real Estate Operating Companies) in it. Not all countries have the REIT structure, which originated in the US. As a result, DRW also has far more stocks (224) in it than RWX (154).

I found a lot of good articles comparing these two:

• Seeking Alpha: And Then There Were Two: WisdomTree Launches International REIT ETF
• Wisdom Tree: DRW Fund Details
• TheStreet.com: Play Foreign Real Estate With ETFs
• Motley Fool: International Land-Rush ETFs

In the end, I was very close to just splitting my cash between the two funds. That might actually be the right answer if you have sufficient assets. However, I decided that since the real estate market has been anything but value oriented for the past five years, my bias is towards the WisdomTree approach for this asset class.

If you are interested in these funds, I suggest you read all the above material yourself. Post here if you reach a different conclusion – I’m interested to know why.

P.S. In case you are curious, I went with a straight, market-weighted index (Vanguard REIT Index ETF, VNQ) for the US REIT portion of the portfolio.

First, I wrote in a post about the Nintendo Wii a while back that I thought the new Wii Remote was a gimmick. Well, while I still think it’s a bit of a gimmick, it’s a well executed one. The thing works. It’s very easy to pick up and play, and there is something very engaging about interacting with video games this way.

In fact, my two year old son, Jacob, thinks it is absolutely hysterical to watch people play with the Wii. I think he loves seeing people jump around, and then have it be mirrored on screen. I don’t know, but when my brother Daniel was playing Wii Tennis, we could not get him to stop laughing.

It’s great. More importantly, it is well designed. The wireless detection and motion measurement is good enough to work and not be frustrating.  My faded, scarred memories of the Nintendo Power Glove have now been put to rest.  This is what motion detection should be in a gaming environment, with very little setup.  I’ve have found some sports more “realistic” than others. Tennis and Baseball seem to map well (there is something very rewarding about hitting a home run with the Wii Remote). Bowling is OK, but has some kinks. Golf and Boxing are really not designed to reward people with realistic motion.

From a product design standpoint, the way the remote fits in the hand, the placement of the buttons seems excellent. The affordances of the Wii remote seem to match the intended motions well.

Now, since I’m a nitpicker, here are my design suggestions for Nintendo:

• Learn by example. It’s clear that the Wii remote is measuring some types of movements and not others when you play certain games. It would be nice to have a standardized “visual feedback screen”, where you could make sample motions, and the Wii would “diagnose” what it actually detected.  When is it looking for lateral motion, up/down, twisting.  It would be a big help to avoid frustration if you actually knew what the game was looking for. It took me 5 frustrating minutes to figure out the motions that the boxing game really cared about. Another idea here would be a “demo” mode where the Wii showed you how it expected you to work the remote for that game.
• Ship with Two Controllers. It’s a bit lame to get the machine, and then realize that most of the games are more fun with two people. You can’t find extra controllers anywhere – Nintendo should have launched the 1.0 package with two controllers. It would have highlighted the social aspect of the Wii.
• Expand to the Feet. It seems like there should be something, like the Nike+iPod insert, that you could add to your feet for these games. Since it’s only looking at the motion of the hand controllers, games that need foot motion are left out, or end up somewhat awkwardly implemented (like Boxing). This interface could really scale to having multiple on-body measures – maybe eventually motion points in multiple places (like arms, legs, torso).
• Wii Elbow? Wii Shoulder? After playing for an hour, I hate to say it, but you can really feel it. It’s not tiring, per se, but I could feel a little bit of tennis elbow coming on, and my rotator cuff was feeling a little strained. Maybe there needs to be a stretching routine for the Wii? I know this sounds goofy, but I’m expecting to see more engineers walking around rubbing their elbows & shoulders as 2007 goes on.

It’s not surprising to me that the Wii is selling as well as it is. What is suprising is that the Wii is almost outselling the Xb0x 360, even though the Xbox is a high definition box with more games and with ample supply. I agree with this article – I’m going to be checking out Nintendo stock a little more closely.

I’m going to play a bit more now. My “Wii Age”, according to Wii Sports, started at 50 when I first played, and is now down to 33. I’m going to have to work hard to get down into the 20s.

In the meantime, watch out for Wii damage (my most popular post on the topic), and tighten your straps.

If you want an example, here’s one:

How Google Hits $1000 a Share (2006)

[Cisco's] Market Cap Climbing to $1 Trillion (2000)

At least I’m not the only one who thinks so.

Employee Stock Purchase Plan (ESPP) Is A Fantastic Deal

Most people think of their ESPP plan as a nice little perk. But after running the numbers, it seems like it’s a much better return that people give it credit for. It’s definitely a much higher return, on average, than the 15% number that people tend to gravitate to.

Let’s walk through the highlights of why by walking through the original post. First, he defines the basics of what an ESPP plan is:

An ESPP typically works this way:

1. You contribute to the ESPP from 1% to 10% of your salary. The contribution is taken out from your paycheck. This is calculated on pre-tax salary but taken after tax (unlike 401k, no tax deduction on ESPP contributions).

2. At the end of a “purchase period,” usually every 6 months, the employer will purchase company stock for you using your contributions during the purchase period. You get a 15% discount on the purchase price. The employer takes the price of the company stock at the beginning of the purchase period and the price at the end of the purchase period, whichever is lower, and THEN gives you a 15% discount from that price.

3. You can sell the purchased stock right away or hold on to them longer for preferential tax treatment.

Your plan may work a little differently. Check with your employer for details.

OK, so that covers the basics. I have seen minor variations on the above, but nothing that eliminates the math that he is about to walk through:

The 15% discount is a big deal. It turns out to be a 90% annualized return or higher.

How so? Suppose the stock was $22 at the beginning of the purchase period and it went down to $20 at the end of the period 6 months later. Here’s what happens:

1. Because the stock went down, your purchase price will be 15% discount to the price at the end of the purchase period, which is $20 * 85% = $17/share.

2. Suppose you contributed $255 per paycheck twice a month. Over a 6-month period you contributed $255 * 12 = $3,060.

3. You will receive $3,060 / $17 = 180 shares. You sell 180 shares at $20/share and receive $20 * 180 = $3,600, earning a profit of $3,600 – $3,060 = $540.

Percentage-wise your return is $540 / $3,060 = 17.65%. But, because your $3,060 was contributed over a 6-month period, the first contribution was tied up for 6 months, and the last contribution was tied up for only a few days. On average your money is only tied up for 3 months. So, earning 17.65% risk free for tying up your money for 3 months is equivalent to earning (1 + 17.65%) ^ 4 – 1 = 91.6% a year.

90%+ a year return is fantastic, isn’t it? That’s when the employer’s stock went down. Had the stock gone up from $20 at the beginning of the purchase period to $22 at the end, your return will be even higher at 180%!

I think the reason people focus on the 15% is a classic example of why people, even very educated people, are not very good intuitively at dealing with money. 15% feels like the value of the ESPP program, because that is the “cash on cash return”, as we used to describe it in venture capital.

Let’s take the example of a hypothetical engineer, Joe, who makes $85,000 a year working for Big Tech, Inc. Joe is a saver, and as a result he puts 10% of his salary into his ESPP plan. Over the course of the period, the stock goes nowhere. Big Tech shares are always worth $50.

At the end of six months, Joe has contributed $4250 to his ESPP plan. They take the lower of the two stock prices, which are both $50, and set the price at 15% lower, $42.50 per share. (You can tell that I used to be a teacher… my numbers are suspiciously turning out to divide out evenly…)

$4250 buys 100 shares at $42.50 each. Since you got a 15% discount, people think that you got a 15% return.

Wrong. A 15% discount actually means you got a 17.65% return. (Read that line again). You have stock worth $5000. But you only paid $4250 for it, for a gain of $750. $750/$4250 = 17.65%.

This isn’t some sort of numbers trick – it’s actually just the difference between looking at what discount you got off full price (15%) versus the return on your money that you received (17.65%). Percentages going down are always more than percentages going back up. For example, if you got a 50% discount on a $1000 TV means you only have to pay $500. But if they raise the price from $500 to $1000, that’s a 100% increase.

So that’s the first gotcha. And 17.65% is nothing to sneeze at. That’s better than the historical average return of every easily accessible asset class I know of (I am excluding Private Equity & Venture Capital, since most people do not have access to them.)

The second gotcha is the fact that Joe didn’t just give them $4250 one day, wait six months, and then got $5000 back. He actually paid it in gradually, paycheck by paycheck. So, he didn’t get a 17.65% annual return.

Now, this is the place where I’ll get technical and explain that Joe didn’t get 17.65% return over 3 months either… that math is faulty. To calculate this correctly, you need to do a cash flow analysis where you evaluate the internal rate of return taking into account each paycheck that Joe made.

In fact, using the numbers provided in my example, I get an annualized return of 98.4% for Joe – and that’s for a stock that didn’t go up!

Salary: $85,000.00
ESPP: 10%
Paychecks/Year: 26

1/14/06 $(326.92)
1/28/06 $(326.92)
2/11/06 $(326.92)
2/25/06 $(326.92)
3/11/06 $(326.92)
3/25/06 $(326.92)
4/8/06 $(326.92)
4/22/06 $(326.92)
5/6/06 $(326.92)
5/20/06 $(326.92)
6/3/06 $(326.92)
6/17/06 $(326.92)
7/1/06 $(326.92)
7/1/06 $5,000.00

IRR 98.4%

So, I think the lesson here is pretty clear. The biggest problem with ESPP programs is that you can only contribute up to 10% of your salary to them, typically. Otherwise, it would make sense to take out almost any type of loan in order to participate. You’d easily be able to pay it back with interest.

However, be forewarned. All of this analysis assumes that you will sell your stock the day you get it. It also is a “pre-tax” return, since you own income taxes on the $750 gain the day your ESPP shares are purchased.

Disclaimer: I am not a financial professional, and every personal situation is different. This blog is personal opinion, not financial advice. You should thoroughly investigate and analyze any financial decision yourself before investing any money in any investment program.

Update (11/10/2007):  There has been some commentary that questions the IRR calculation for this example.  I’ve uploaded the Excel spreadsheet for this example.  It shows that for this series of cash flows (13 negative, 1 positive) that the IRR is 98.4%.  For this spreadsheet, I use the XIRR function, which is part of the Excel Analysis Toolpack Add-on, which handles IRR calculations for non-periodic cash flows.

From Excel Help:

XIRR returns the internal rate of return for a schedule of cash flows that is not necessarily periodic. To calculate the internal rate of return for a series of periodic cash flows, use the IRR function.

I followed him to TheStreet.com, and even ponied up $99 a year for a while for the privilege of reading his articles.

Now, he is at CBS Marketwatch, and even better, he has a blog!

You want to read Herb regularly if you are a fundamentals-based investor, and you like to read pieces about hot companies where some of the numbers may be in question.  Herb is very good about admitting mistakes, but I have to say, he’s normally very ahead of the curve with company problems.  As a result, there are quite a few CEOs out there who hate him.

Here are a couple of posts from his blog today that explain why Patrick Byrne, CEO of Overstock.com, hates Herb:

Overstock: It’s a conspiracy, I tell ya – a conspiracy!

More Overstock: Why Investors got Byrned. 

You might not realize it from these pieces, but Herb was writing about rising inventory levels and low turnover long before the public-facing numbers turned.

He’s fairly high on my RSS feed list.  I think if you invest in individual stocks, he should be on yours as well.

I was first introduced to Timber as an asset class at Harvard Business School, in one of my classes on Venture Capital & Private Equity. Dave Swensen, who managed the Yale endowment for over 20 years, discussed the strategy that led Yale to incredible outperformance in the 1980s and 1990s. He took the endowment from $1.3 Billion to $14 Billion, using a strategy very different than his colleagues.

It would be a whole different post to sing the praises of Mr. Swensen, and his philosophy on investing has now become public knowledge since he released a book on the subject. In his discussion with the class, I remember his specific comments on assets that had extremely attractive risk/reward ratios. Private Equity is one, to be sure, but he also allocated over 20% of his funds to “real assets”, which included Timber.

Timber is fascinating as an asset class. Here is a summary, cribbed from a recent post on Seeking Alpha:

• Excellent Returns. Annual returns of 14.5% since 1972. Better returns than any common asset class (stocks, bonds, real estate, commodities)
• Less Volatility than Stocks. What? More reward with less risk? It shouldn’t be true, but it here at least empirically.
• Timber is counter-cyclical with Stocks. Especially nice to have an asset that zigs when the stock market zags.
• Money grows on Trees. Fundamentally, you have to like the fact that 6% growth every year comes from the fact that trees just grow bigger with natural sun & water. The value of trees is also non-linear, in that growers can just “not cut” in weak years for timber prices, and make even more in subsequent years.

Here’s a nice post from Seeking Alpha in July on why Timber should outperform in an inflationary market. It even features my personal favorite REIT stock in the sector, Plum Creek Lumber (PCL), which I’ve owned since 2002.

You have to love the web. I found this fantastic blog post from 2005 on Timber. Couldn’t have said it better myself.

Until recently, it was very hard to invest in timber without a portfolio allocation in the millions of dollars. However, now, there are several ways to add timber to your portfolio. My favorite are the REIT stocks, like PCL & RYN, which allow you to own companies who have a primary business in owning & maintaining timber land. Given the regulations around managing timber land, and the tax-advantages of the REIT structure, it’s hard to get better direct exposure.

It’s interesting, but as the trend continues towards development & environmental protection, these firms should have an even more compelling advantage as the supply of quality timber dwindles, and the regulatory environment grows more arduous. Even the sleepy paper companies are starting to look more valuable for the timber land that they own, rather than the product they produce.

It’s so interesting that money, in some cases, really can grow on trees.

Update (6/13/2007): A commenter forwarded me to a webpage that had a link to one of my favorite articles on timber as an ivnestment, from a 2001 issue of Smart Money magazine.  Check it out here.

One example of this is the continued fascination that people have with the Dow Industrials index. This group of 30 stocks has changed over the years, but dates back over 100 years (1896), ever since Dow & the Wall Street Journal attempted to capture a measure of the “Industrial Strength” of the US Economy.

The problem is, the equation they used to calculate it is nonsensical. Literally.

The Dow Jones Industrial Average is a “price-weighted” index. This means that a $1 move in a $25 stock is worth more than a $1 move in a $10 stock.

This, of course, makes absolutely, positively no sense.

Now, a “market-capitalization-weighted” index, like the S&P 500, makes sense. An “even-weighted” index makes sense. Even some of the cool new “fundamental-weighted” indexes, based on figures like the revenues or cash flows of companies makes sense.

But a price weighted index makes no sense. If a stock in the Dow Jones splits 2:1, it’s future impact on the average will be lower than if it never split at all.

This, compounded with the incredible unpredictable and poor timing that the index owners have used to add & remove stocks from the index has led to extremely unpredictable performance.

There is a really great piece in Business Week that illustrates how ridiculous this index is.

As you may have heard, Berkshire Hathaway, Warren Buffet’s company, hit its own milestone lately by trading at $100,000 per share. Yes, that’s right. The reason it is so high is that they have never split their stock, and it has compounded at extremely high rates since the 1960s.

Can you imagine what the Dow would be like if it had included Berkshire Hathaway as one of its stocks (which would be easy to justify)?

The answer is: if they had added it in 2000, the index would now be at 22000!

Buffett’s Baby: Too Big for the Dow

Despite this, every newspaper and television show seems to highlight this milestone for this nonsensical financial metric. And it really does influence investor behavior. I have family members who have told me they are reluctant to buy stocks right now because “the Dow is so high”.

For the 20 or so readers of this blog, hopefully now you know the truth. Spread the word. The DIA is meaningless.