Cyrillic Partners

Would-be air travelers pick on price. The difference between a Delta flight and a US Airways or United flight is probably un-noticeable to someone who isn’t a frequent flier. That’s why websites such as Priceline, CheapTickets and Expedia proliferate and prosper.

But airlines are increasingly upping the fees on things that used to be amenities. We wrote last week on United’s move to charge people $15 to check a bag. Now comes news that US Airways will start charging $2 for a soda or bottled water on flights. Alcoholic drinks will go up to $7 a piece. There was a time when movies and headphones were free too. What’s next? You’ll have to pay $1.50 for a seatbelt? $3 for use of the overhead compartments?

Yes, the price of gasoline has gone up. No doubt the airlines suffer for this. Still, is it fair to hide a slew of fees under the price of a ticket? Can a reasonable person be expected to keep track of which airline charges for checked bags and calculate the appropriate step up in price attendant to the ticket?

I don’t like companies that play games like this. Life is hard enough without having to keep track of hidden fees and changing rules. Better to focus on costs than look for ways to gouge the unsuspecting. I can only imagine the unhappiness my parents would have flying with an airline that tried to charge for a glass of water on a flight. They’d never fly with that airline again. With good reason.

It makes Delta the more attractive for focusing on its expenses. Though I would not put it past the company to follow its peers down this perilous path.

Corporate acquisitions seldom help the buying company. Promises of synergistic growth typically fall way, way short, studies show. However, if cost saving is the goal of a corporate acquisition, then the buyer’s stock goes up.

That’s why Delta’s move to cut 4,000 jobs is a positive sign for the impending deal with Northwestern. When cost cutting is on the brain, shares go up.

The thinking goes like this: China’s middle class is growing and the Chinese people have more disposable income to make vice-related purchases. An abnormally high relative saving rate may be an indication of repressed demand for goods and services related to leisure consumption. The U.S.-China currency exchange is stable compared to the way the dollar is tanking against the Euro. And so called “vice” investments tend to be robust in good times and even better during a recession. So why not invest in Chinese brewers, vintners and distillers?

Here’s a few picks:

Tsingtao Brewery Company Limited: Sells Tsingtao, Hans, Laoshan and Shanshui beers. Sold 5.05 million kiloliters of beer in 2007 both in China and abroad. The company is 27% owned by Anheuser-Busch and has 12.8% of the domestic beer market.

Recent News: Profits fell 19% due to increases in the corporate tax and disappointed analysts.

The problem: global barley prices are up 13 percent.

More to come.

Michael Lewis, an awesomely interesting writer, offered readers of March’s Portfolio Magazine an overly bearish appraisal of the Black-Scholes options pricing model.

This may not, of course, be Lewis’ fault. Portfolio is published by Conde Nast, notorious for yellowing-up its journalism to maximize the shock/sex/scandal factor. How Conde Nast sexed up Wired Magazine to the point of near-unreadability is a sore spot with many readers to this day who say the magazine was “Conde Nastified.”

The story, titled “Inside Wall Street’s Black Hole,” (natch) posits this: The credit crunch ousted bank executives and average Joe Homeowner alike because everybody was mis-pricing their downside protections. Wall Street broker/dealers used Black-Scholes, which provides a framework for pricing options, to justify extending credit to would-be homeowners. But the famous formula doesn’t take into account the possibility of cataclysmic downturns. When the downturn happened, the predictive model didn’t hold up. Therefore, Black-Scholes screwed everybody.

Lewis then goes on to “prove” the point by including quotes from one interview and by paraphrasing much of Nassim Nicholas Taleb’s work (for this feat of journalism he gets paid an ungodly amount per word).

The thesis belies a surprising amount of naivitae. It’s like getting lost on the island of la Grande Jatte and blaming Georges-Pierre Seurat for not giving you an accurate map.

Lewis would do well to remember that a financial theory is just that. It is not a universal law. Newton’s theories of motion start to fall apart when you approach the speed of light, so should anyone be surprised when Black-Scholes starts to break down as the economy fluctuates wildly?

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When the Portfolio cover-line promised me “The Formula that Wrecked Wall Street,” a very different formula immediately jumped to mind: 2 and 20.

That’s the compensation formula used by most hedge funds. It works like this: A hedge fund raises $100 million from private investors, university endowments, large banks and the like. The managers get 2% of that a year, regardless of performance. If they make a profit on their investing operations, say the portfolio gains 10% to $110 million, they get 20% of the profit, or $2 million.

It’s not a bad deal if you can get it: The hedge fund manager walks away with $4 million in income for getting about the market rate of return.

But what’s really deleterious to Wall Street, and general macroeconomic stability, is what happens in year two.

Let’s say the hedge fund manager has a bad year and the portfolio loses 10% of its value (It’s now worth $99 million). The manager still gets $2 million for his “management fee,” but doesn’t take home any bonus pay.

It doesn’t sound like that would have a negative effect, but it does. That compensation structure creates the incentive for the hedge fund manager to take wild risks, literally gamble it all for a shot at a bigger management fee because there’s no downside to poor performance.

If the manager loses all the fund’s money after five years, he or she still walks away with $10 million in fees. And since there’s so little visibility into the performance of hedge funds, there’s little accountability. An unscrupulous hedge fund manager might easily be able to raise another fund. (Which is why public disclosure is important and why journalists serve a role in the new economy.)

So why not risk it all? Go for the one in a hundred chance you’ll get a 100x payoff. It’ll always be preferable to the one in two chance of a x/2 gain.

That’s a formula that’s wrecking Wall Street and probably scares the heck out of Ben Bernanke.

Less than a week after VW announced it would open a production plant outside of Moscow (see story), GM has decided to join the Russian automarket, offering a bid to buy a slice of AutoVaz.

AutoVaz’s parent company, state arms exporter Rosoboronexport, was looking to offload a piece of the car maker just as GM was looking to expand into new markets. The U.S. automaker has seen its margins decline as people move away from highly-profitable SUVs and toward less-profitable cars.

GM sees Russia as an opportunity for growth. The two companies had a joint venture to produce the Chevrolet Niva sport-utility vehicle and the Chevrolet Viva sedan.

[Reuters has the story]