Thursday, April 26, 2007

The Difference Between Traditional and Thematic Analysis

The problems in the sub prime mortgage area provide a perfect example to illustrate the difference between traditional investment strategy analysis (practiced everywhere) and thematic analysis (practiced here).

Traditional analysis takes what in effect is a vertical approach, a silo view, if you will, and bases its investment decisions on the traditional components of equity analysis – cash flows (or earnings), growth, and risk. Traditional analysis looks for the impacts that can be felt within an economic sector or industry and seeks to identify its top and bottom line effects to the investment in question.

Thematic analysis, on the other hand, takes a horizontal approach and looks for the trends and themes that cut across the industry and economic verticals. Thematic analysis looks for the mega trends and themes that can alter the direction of whole economies, sectors, industries, and companies.

Let’s use the sub prime mortgage problems as an example of the difference between the two analytical approaches.

Sub Prime Contagion

From a traditional analysis perspective, the main concern re sub prime is contagion*. Will the weakness in the housing market caused by the sub prime problems extend beyond the housing market and affect other parts of the US economy? Moreover, will this contagion extend beyond the US borders by depressing US consumer spending that then results in reduced global growth from the world’s leading source of demand thereby producing a global contagion**? Thus far, this fear seems to be unfounded.

Relief has swept over many investors as the sub prime problems have shown little effect beyond the immediacy of the housing market. Earnings and economic reports provide the proof that so far corporate profits and consumer spending have not been meaningfully impacted by sub prime’s problems. In other words, no contagion.

Now, let’s view this thematically.

Sub Prime as a Thematic Metaphor

From a thematic perspective, the sub prime problems appear to be symptomatic of a larger issue – liquidity.

Liquidity is a thematic driver that cuts across all verticals, both economically and financially. Liquidity is the cross beam that provides the floor below the market that everyone points to as a reason why stocks will not decline. It is also the root cause for the sub prime problems for, were it not for excess amounts of capital, loans that should not have been made would not have been made. Or, would have been made with less gusto.

If we were to stop with liquidity, the story would be obvious and over and of limited value. It would be said that bad real estate related decisions were made, liquidity was the culprit, but that’s all been fixed. The end.

But that’s not the end as there is another mega theme that plays a role in the sub prime story - Financial Innovation.

Financial Innovation as Theme

Financial innovation is the manufacturing process of money. It is the innovative blend of structure and talent to create new financial machines and systems that capitalize on opportunities through financial engineering. Instruments and process systems are created that leverage talent and capital to satisfy the needs of globalization (a theme in its own right).

Thanks to the ingenuity of asset managers and their financial services' compatriots, financial innovation has produced two such structures – the unregulated money machines of hedge funds and private equity.

Playing their increasingly activist roles, hedgies and PE have helped provide some of the fuel to the sub prime fire. Investments in companies that leant the sub prime money made capital more available than otherwise would be the case. But, there is a back end to this part of the story. And H&R Block provides a very good example.

The H&R Block Sub Prime Example

H&R Block’s announcement last week that it will sell its sub prime unit Option One Mortgage Corp to the private equity firm Cerberus Capital Management reveals both the activist role that liquidity and financial innovation plays in the form of a private equity firm cleaning up a piece of the sub prime mess and, importantly, the willingness, even eagerness, of corporate management to unbundled itself of its mistakes***.

Investment Strategy Implications

Traditional analysis looks for interconnections between economic and industry silos. It seeks to identify the valuation drivers within its defined space and any outside forces that might impact that space. In the case of negative impacts, contagion is its prime fear. Think contagion as virus.

A thematic perspective, however, looks for the conditions that enable a contagion virus to breed. It looks for the mega trends that have the wherewithal to impact the valuation drivers in multiple silos.

In the case of the sub prime problems, the contagion fears have been alleviated for now. And this has added strength to the current bull rally, especially in conjunction with the large cap 1Q07 results. Understanding its thematic nature is a value-add to any investor’s analytical approach.

*Contagion is not considered a theme as it is an effect and not a causative agent.

**Decoupling, global growth ex US, is A related theme. See my weekly report of April 23, 2007 (subscription required) and the IMF World Economic Outlook report.

***The nexus between corporate management, activist investors, and unregulated money is at the core of McVey’s “Misalignment Triangle”. See blog posting of March 30, 2007.

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