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Monday, February 3, 2014

Sothebys special dividend and the possible consequences.

With their special dividend announced last week Sothebys reduced their
chance to transform from a service provider hemmed in by fixed
commissions and high overhead into becoming a vast storehouse of
capital comprised of art, real estate and cash.

To use the example of a bank - Sothebys now is more like a commercial
bank that provides loans and has reduced their chances to become more
like an investment bank with significant ownership of the companies
that they advise and service.

They have reduced their chances to participate in the returns
available holding art over the long term by giving up their strong
cash position.

Basically Sothebys (BID) is a company that sells art to the very rich
(200 people make up 80% of their gross sales) taking a commission for
their sales.  This reason that the very rich trust them is because
their commissions are transparent and they are perceived to be the low
cost producer.

On top of this the very rich expect their suppliers of art to make
grand gestures, have numerous offices in magnificent venues, take out
expensive advertisements, produce coffee table quality catalogs,
donate their employee's time to charity auctions, support in depth
research and provide sumptuous dinner parties to their clients on a
regular basis. This scorched earth policy of low margins and high
expenses has put many of their competition out of business but at
punishing cost and great risk.

To a significant extent they have succeeded but the model of slim mark
ups and overwhelming overhead is difficult, maybe impossible for
sustained growth and success.  They are just as much a service
organization supporting scholarship as a profit making corporation. It
is a daily dilemma that challenges management with days spent doing
research and nights entertaining their needy clients.

And now a virus has come into their system that will be close to
impossible to cure.  This is the action of contemporary art promoters
using auction houses to bid up the art they own in large quantities to
create the impression of value.  This market will crash when the
collectors realize that they have been manipulated.  It will come out
that the supply is limited only by what collectors are willing to buy
and that few sophisticated museum directors and their curators will
have anything to do with it.  Fifty years from now the only thing of
value from this scam will be the promotional literature used to create

The promoters have brilliantly figured out that new, unsophisticated
art collectors coming into the art market primarily rely on auction
records to make decisions on value.  So they simply bid against each
other at auction to create the illusion of value for their mass
produced works of art.  Sothebys benefits taking the commission for
one work of art that is bid up but the promoters then see huge profits
on the 100 examples of the same work of art that they have in their
inventory.  Foolish, testosterone laced, hedge fund cowboys looking
solely at auction records are deservedly then  hoisted by their own

Sothebys certainly does know know that outside manipulators are
running up their own artwork at their auctions but they have become
dependent on the commissions that these outsize sales generate.  So
dependent that they must be terribly reluctant to delve deeper into
this practice.  Their profitability would disappear and they would be
reduced to going back to selling rare books and maps to cheap,
covetous people like me.

For Sothebys to survive much less succeed they have to have a large
cushion of cash for the downturns and art market busts that regularly
occur.   A look at their chart confirms violent downswings in their
stock price over the years.  Large drops have occurred in 1999 to 2000
going from $47 to $14.68 and again from 2008 to 2009 going from $61.40
to $6.05, and finally in  2011 to 2012 going from $52.95 to $27.53.

Bill Ruprecht and his team had done brilliantly preparing for the next
crash by building up an appropriate cash cushion.   This was lost last
week when they appeared to give into the wishes of some share holders
who firmly suggested that they free up their cash cushion.

Also the cash that will be paid out will make it harder for Sothebys
to take advantage of excellent opportunities like the Matisse Estate
that they purchased in November 1990 for 143m where they subsequently
made well over a 300% gross margin return on their investment.

The simple fact is that an art dealer and auction house MUST be able
to deal from a position of strength.  The very rich have a well
developed nose for fear and flee from those whose glands excrete even
the smallest quantities.  The Sothebys executive team have placed
themselves back into the position of supplicants with this payout and
the promise of payouts in the years to come.  They have forced
themselves back into the role of an under capitalized market maker at
the mercy of their consignors and buyers who expect expensive service.

This has happened just at the point when they could have achieved the
vast profits that accrue to those who take long positions and wait for
the 400% percent returns that can and do occur every ten years for the
very best works of art.  They will now continue to be a wonderful
organization sustaining confidence in the art market but that provides
overwhelming amount of the profits to their clients.  So they will
continue to be loved by all (except Christies) but at punishing and
dangerous expense.

They are now vulnerable to a severe art market correction or one US
Attorney who starts an investigation into the manipulation of
American, German, English and Chinese Contemporary Art Market prices
by outsiders that Sothebys may have failed to detect, police, report
and reject.

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