Sunday, August 31, 2008 0 comments

Miscellaneous Articles for the Last Week of August

Here are some miscellaneous articles you may find interesting. As usual, click on "read more" if you are interested in hearing my opinions...




Four Bearish (Cautious?) Investors

MarketWatch has a brief story on Jeremy Grantham, Bob Rodriguez, John Hussman and Steve Leuthold. All these four can be called bears, with Grantham being a superbear. I personally do not consider any of these investors anywhere near superinvestors like Martin Whitman, Bill Miller, Edward Lampert, and the like. Nevertheless they are successful investors who are far better than the general investing population (or me :) ). I'm not too familiar with these four investors but I don't think any of them, except possibly Rodriguez, are value investors (the definition of value investing varies with some considering all successful investors as value investors but I use a specific definition that counts only those who are primarily bottoms-up fundamental investors.) However, Granthan and Hussman are definitely contrarian investors (not sure about the other two.)

Jeremy Grantham has turned even more bearish than his usual self:

One of his biggest fears, he added in an interview, is that "the whole global economy will be weaker than the market expects for quite a considerable time." How long? "I would guess at least two years of sustained disappointment."

Notably, just a few weeks ago Grantham turned negative on his "beloved" emerging markets, which had been a spot-on bullish call. "If the global economy is going to disappoint, the cost of holding them just seemed too high," he said.


A lot of people who were bearish on the US markets tended to be bullish on emerging markets and/or commodities. Grantham seems to be pulling out of EM (emerging markets) and I'm sure everyone is aware that those markets are getting clobbered. It's especially painful for American investors who are seeing the US$ appreciate on top of the EM share prices declining (of course, those markets are up a lot over the last few years so those who got in early likely made a lot of money.)

Grantham is particularly uneasy about China, a leading engine of world growth that seems to be sputtering. "I worry on behalf of the global economy at the consequences of China stumbling," he said. Without China's robust demand, he added, "the whole level of global imports and exports would start to drop."


As The Globe & Mail article I listed above alludes to, China is slowing down right now. I have been bearish on China for a few years for the reasons that are becoming evident right now. The problem is that China is running a totalitarian government on top of a so-called free market. It's not clear how the government will handle any economic slowdowns, which are natural events in capitalism. I just hope that the Chinese government doesn't do something stupid.

As for John Hussman, he has remained bearish for a while now...

Investors' consensus is mistaken, Hussman contends. He said the U.S. is mired in recession, and once investors realize that earnings expectations are overblown, stocks will take another major hit.

"The potential downside could be abrupt, leaving little opportunity to make defensive changes after the fact," Hussman wrote.


I share Hussman's--and Marc Faber's--opinion that US corporate profits are going get downgraded. This risk is likely high for technology, materials, and energy sectors. Interestingly, Hussman seems to think technology will do well but I'm not so sure. The market will reward growth (as Bill Miller likes to say) but I'm not so sure about companies like Amazon--which I actually like--trading at lofty earnings multiples.

That said, Hussman doesn't expect much from stocks. He predicted that U.S. market returns will average 4%-6% annualized over the next decade, primarily due to weaker corporate earnings.


This is very bearish. I think if this comes to pass, many investors will die of heart attacks. This is just a guessing game but I personally think the broad markets will probably average 7% to 8% over the next decade. I find it hard to believe that you will end up with 4% to 6% returns with valuations being what they are right now. Since the current valuation multiples are not very high in the US, even if you chop down earnings, things don't look that bad.

Frontier Market: North Korea

Thanks to Commodity, a gurufocus.com message board poster, for originally pointing out this interview with Jim Rogers.

Jim Rogers, one of the ultimate world investors, shows his contrarian stripes when he recommends all the distant countries that scare most people--investors or not.

Jim thinks North Korea and South Korea will unify. North Korea has all the minerals, the cheap labor, and shares a border with China. South Korea has all the intellectual capital, the technology, and the expertise. Jim says it's the perfect match.


I have had the same feeling for a while now. It makes sense for North and South Korea to unify. Once the North Korean government collapses--it seems to be on its last legs--it is almost inevitable. It is very similar to East and West Germany. The people are the same ethnic group, speak the same language, and the borders are largely artificial. As Rogers points out, a unification will provide a huge economic boost in the long run. But similar to the difficulty Germany faced in the late 90's, it will be painful in the short-run. I think the unification can happen as quickly as within the next 10 years. North Korea is already running out of "allies" as Russia and China dump their state-controlled economic systems (both still need to do a lot in terms of political freedoms though.) As China's economy becomes stronger, while Russia also becomes prosperous, then North Korea will likely be forced into dumping whatever system it is following. USA will also be forced to remove it from its Axis of Evil list.

Investing in North Korea is totally out of the question for most investors (it might be illegal for Americans too--not sure (depends if there are penalties for dealing with Axis of Evil countries.)) However, for non-Americans or for the future, it's worth thinking about it.

I asked him if we could get money into North Korea. "You can always get money in," he said. "That's never a problem. It's getting money out you need to worry about."

I suggested buying a retail mall or a shopping plaza just across the border in South Korea. South Korean retail space could appreciate when the North Koreans come flooding across to buy their first iPods and laptops.

Jim said he hasn't figured out how he'll play it yet. "But real estate is very cheap up there [in northern South Korea]. Everyone's worried there's going to be a war. That's probably a good place to start."


This is totally out of the question for small investors like me but it's worth keeping in the back of the mind. Ideal situation, like with China, is to invest indirectly in companies that do trade or benefit from a unification.

Rogers also is thinking of Cambodia, Taiwan, and Malaysia's southern state, Johor. As usual, these are just ideas and they involve super-high-risk. Rogers, along with Marc Faber, were bullish on Vietnam a few years ago and anyone that invested a bit late would have suffered massive losses.


Frontier Market: Russian Farmland

(source: James Hill for The New York Times)


I ran across this New York Times story on Russian farmland and how capitalism has surplanted the collectivist farms of the yesteryear. A lot of Americans and others seem to be distrustful of Russia but I'm not as concerned. Contrary to the views espoused by the Western press, this isn't the Soviet Union. It's still early and the Russian government still meddles with business so one can never be sure what is going to happen. But that's the case in almost any developing country.

The farmland idea isn't anything new. Commodity bulls have been bullish on soft commodities--agricultural goods--lately and investors like Marc Faber have been recommending farmland in Argentina as investment. What I find interesting about the Russian story is the fact that I never knew that it had so much dormant fertile land--some 35 million hectares. I always used to think of Russia as a cold barren tundra but goes to show how little I know :)

This is another idea that is hard for small investors to capitalize on. I suppose one can start hunting through London Stock Exchange, where a lot of Russian companies are listed, to see if they can find Russian companies engaged in agriculture. There is huge risk involved here since the Russian government has a habit of attacking private investors. I'm not justifying it at all but there is a method to this madness. The Russian government, as well as the public, believes that their resources were looted by investors in the early 90's, often with the aid of powerful organized criminals. Vladimir Putin drew a line in the sand warning resource companies that they belong to Russia but technolgoy, service, and other industries have largely been left on their own. It's not clear to me how the Russian government will treat agriculture. Agriculture can be used as a government force--it might even be more valuable than oil to some highly populated Asian countries in the future--so it's not clear how safe private ownership of Russian farms will be in the future.

The concern is that private investors do all the hard work and risk their capital, while the government comes and seizes the operations after it becomes a success. I hope Russia doesn't revert to that but it's a risk in most developing countries. Nevertheless, the investment story looks attractive, with huge untapped agricultural lands and/or existing farms with low yields with potential for vast improvements.

As in other cases, one way to capitalize indirectly is to invest in American/Canadian/whatever businesses that benefit from the Russian agricultural boom. The NYT story mentions an instance where John Deere--an American agricultural equipment producer--tractors being used. An industrial concern like that is a safer bet, although it is a bit too diversified and isn't strictly a bet on the Russian farmland.

China's Slowdown

Well, finally it is happening: china is slowing down...

(source: Warning signs from the centre of the boom, By MARCUS GEE and BRIAN MILNER AND GEOFFREY YORK. The Globe and Mail. August 29, 2008 )

After fretting for the past five years or so about how to keep the economy from overheating, Beijing is now faced with the novel problem of how to keep it from cooling. “If you're sitting in Beijing, you're saying, ‘We've already lost two percentage points of economic growth. How much more are we going to lose?'” said Nicholas Lardy, a senior fellow at the Peterson Institute of International Economics in Washington.

“That's a big turning point for the Chinese economy. That means questions of profitability, questions of unemployment, questions of social stability.”


It's kind of interesting how things work. The Chinese government was trying to cool the economy to no avail over the last couple of years but now is contemplating how to prevent a cooling.

The Chinese government is facing a problem unlike anything it has in the past. The last big problem faced by the Chinese government was the 1997 Asian Financial Crisis. The country has changed so much that the current slowdown is far more complex. The difficulty for the government is that the current slowdown is "normal" in my eyes. So the government is battling something intrinsic to capitalism and any free market. Things go up. And things go down. The problem in China, though, is that increasing unemployment--growth rate below 8% would do it--can lead to the overthrow of the government. In a democracy, such a scenario results in the current government being replaced with a new one. But given that China is a one-party state, throwing away the current party is equivalent to a potential collapse of the system.

Barring a horrible scenario (hope it doesn't occur,) I think you will see the Chinese government start to democratize their government after this slowdown. All this talk about China always having been ruled by one party is complete nonsense. Either a political system is superior or it isn't. Democratic governments aren't superior because I say so; instead, they are superior because there is nothing else better. The Chinese government will start to dismantle their authoratarian structures in order to save themselves.


Inside Look at a Film Distrbution Company

A fun read for those interested in the entertinament industry or film distribution in particular...an inside look at Entertainment One, an up-and-coming Canadian content distribution company...

(source: Almost Famous by JOANNA PACHNER. Report on Business magazine. August 29, 2008 )

''Alliance reversed the Globe ban,"Patrice Theroux announces slyly after sneaking a peek at his e-mail. We've just settled into cushy leather in his huge, panoramic office in a midtown Toronto high-rise, which happens to be right across the street from Alliance Films. A month earlier, that giant of Canadian film distribution had barred The Globe and Mail's film critic Rick Groen from its movie previews after he bestowed a merciless goose egg on Sex and the City, one of Alliance's biggest releases. But the distributor backed down--these are rough times in the film business, and Alliance's smaller releases need all the ink they can get. "I wondered how long it'd take them to do that," says Theroux, nodding across the street.

It must be strange to come to work every day and look out at the headquarters of the company you were instrumental in building, which is run by a man who's been called your surrogate father, and which you now intend to topple from the pinnacle of Canada's entertainment industry. But after 18 years at Alliance--eight of them as president of its movie distribution unit--Theroux was unceremoniously canned in July, 2006, for trying to orchestrate a management buyout.

It was the best thing that could have happened to him. As soon as his non-compete agreement expired last summer, he came here, to Entertainment One, Canada's largest wholesale distributor of CDs, DVDs and video games. Last year, it grossed $577 million, largely by delivering its wares to retailers' racks. Theroux is now head of the company's new Filmed Entertainment division, and E1 has spent more than $200 million on eight film and TV acquisitions (see "Big deals," page 61), catapulting it into the position of No. 2 distributor and largest television producer in Canada. That's in just over a year.



John McCain's Interesting VP Selection

John McCain is potentially gambling big time by going with an unknown VP. Sarah Palin will appeal to the core Republican base of social conservatives and the Christian Right (she is against abortion, generally against the environment, and so on.) McCain seems to be betting his campaign on attracting the so-called female vote, and likely pushing for energy independence through Arctic drilling (Palin is pro-Arctic drilling.) What this does, however, is distance his position from the George Bush administration. Anyway, a bold pick for sure.

(Just for disclosure purposes, I'm not American and don't really care much about their party politics. I also don't vote for social conservatives so the modern-day Republican Party is not my thing. However, American politics impacts the rest of the world (although less than most imagine) and I find this pick interesting. It looks like Canada will be having an election soon too.)


EU & Russia

(source: Peter Shrank for The Economist)


I love the above cartoon by Peter Shrank for The Economist (story here). It succintly captures why the EU, represented with the little stars behaving independently, won't do anything to the the bear (Russia.) We are, of course, talking about the EU reaction to the Russia-Georgia war (EU is supposed to be holding a meeting on September 1st.) The fact of the matter is that there is strong economic trade between Russia and the EU. Some countries benefit greatly from this relationship while others not so much. I personally think it's ridiculous that some high level EU officials have even suggested sanctions. It's one thing for the hawks distant from any potential damage in America or Canada to call for some harsh response, but it's totally ludicrous for EU officals to suggest sanctions while potentially driving their economies into the ground with the resulting trade war. This sounds just as crazy as the trade war against China suggested by some in America.

I have expressed my views in the past and nothing has changed my mind, even with all the one-sided reporting in the West. I still feel that it's hard to fault Russia when Georgia is the one that started the big attack on South Ossetia, killing not only civilians but also the so-called Russian "peacekeepers." It's ridiculous for the EU or USA or Canada to say that Russia shouldn't have done anything. If Canadian soliders died due to foreign shelling I think we all know what Canada would do. Technically, Abkhazia and South Ossetia belong to Georgia but they have operated independently for more than a decade and have little ethnic or linguistic attachment to Georgia.

Obviously it seems to have escaped some politicians in EU that Europe needs Russia more than Russia needs Europe. Practically the only thing Russia needs Europe is for discretionary consumer goods and capital (capital is less of a need these days.) Conversely, Europe needs Russia for resources such as natural gas, oil, and steel. Sure, it can import them from elsewhere but it would be far more expensive (hence destroying their economies in the process.) Russia would lose little in the long run (although short term would be painful) by exporting their resources to China, India, and south-east Asia. Already, Sashkavalli's dumb war is leading to Azerbajan thinking of re-routing oil through Russia, by-passing Georgia. There is also some attempt to re-route the oil through Iran, in order to avoid Russian dependence. If America was actually supporting Saskhavalli's attack--hard to see how that wouldn't be the case with 100+ American soldiers in Georgia at that time--this could turn into another huge blowback for America. Not only do you end up with American ally Georgia--the third biggest supporter of the Iraqi war--being run over by Russia, you also end up with more oil being shipped to Iran.

This whole Shaskavalli Strategy is turning into a mess for Georgia and innocent citizens are the ones that are going to be hurt. If Georgia loses the oil routes, it will permanently hurt its economy. America, EU, World Bank, and other governments may provide loans but private investors will be reluctant to invest in Georgia.

Having said all that, I hope Russia does the moral thing and withdraws back to Abkhazia and South Ossetia. The checkpoints that cut off the key east-west route, and the occupation of the port city far away from Abkhazia is totally uncalled for. This is nothing more than insulting a deated foe on its back. It would gain a lot of goodwill, not from those that distrust it but from those who are more neutral, if it withdrew back to the original positions. I also hope that Russia keeps control of the paramilitaries that seem to be loose and can potentially cause serious crimes (war crimes, ethnic cleansing, mass rapes, etc,) such as the vicious Chechen militias, the so-called Russian Cossacks, and the Ossetian paramilitaries. Unprofessional, lawless, heavily armed individuals running around is the last thing the world needs--in Georgia or elsewhere :(

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Friday, August 29, 2008 0 comments

Politicians Trying to be Bad Economists

Economics is called the dismal science so no one really knows much of the "truth" or what is really happening out there. However, there are some government policies that are just reckless and don't accomplish anything meaningful. I guess it's that time of the season :(

First, we have the Japanese government trying to combat the rising energy and commodity prices by spending money on several things including an attempt to lower tolls on roads. This is going to totally backfire. It will actually increase, or at least maintain, oil demand.

Japan unveiled a 2-trillion yen, or $18-billion (U.S.), stimulus package Friday, including assistance to small businesses and other pump-priming measures to shore up its flagging economy hit by soaring energy and material prices.

The new measures include discounts on expressway tolls, assistance to farms and help for part-time workers to find better jobs, according to the Cabinet Office. Funds were also earmarked for better medical care, ecological technology, housing loans and education.


Japan has been dropping money from helicopters on practically every single economic problem in the last 20 years. There's a reason that Japan's debt to GDP is 195%!!! If Japan doesn't start cutting its debt, it will end up as one of the poorest countries in the world in 50 to 100 years. Its population is shrinking so the debt burden will get bigger and bigger by the year.


Coming on the heels of the Pakistani stock exchange outlawing price declines below a limit, it looks like some politicians in Russia are thinking of getting the government to buy shares in the slumping Russian market.

The government is considering investing in the Russian stock market to break a weeks-long fall of local shares, a senior Russian lawmaker said yesterday.

"I think the time has come for the state to step in discreetly and invest," said Pavel Medvedev, a member of the State Duma's financial markets committee. "The idea is being discussed - in the Duma and, more importantly, in the government." He would not specify the proposed amount of investment...

Market-watchers say they have heard rumours about a government plan to buy stocks worth $1-billion (U.S.) to $20-billion.


I don't think these politicians know what they are doing or what the market represents. The Russian market has been declining primarily due to slumping commodity prices. There were some reports that investors are fleeing Russia but that seems to be based on a misleading report that seems to have mixed up currency reserves with investment flows (central bank actions impact currency reserves and it's not the same thing as private investment flow.) Buying up shares is not going to do anything in the long run. All it will do is to transfer government wealth to a select few. The wide range that is quoted makes me think this is wishful thinking on some people's part (recall that there have been several rumours over the last 3 or 4 months that the Chinese government would buy shares in their local market as well.)

Free market proponents won't agree with it but governments do intervene in the stock markets when they see it fit. In fact, there is some rumour (totally unfounded) that the US government may buy shares in Fannie Mae and Freddie Mac (this is in contrast to the general consensus that the government will only invest in preferreds or higher). Government intervention can work but it is very costly and unpredictable. Perhaps the most successful outcome was when the Hong Kong government started buying shares en masse in 1998. The HK government pursued the policy in order to thwart what it considered as speculative attacks on its currency and share prices. Amazingly, it actually worked in the end and the government actually made money for the citizens (after selling the shares it owned at higher prices.) But none of the situations I have come across (or mention here) are similar to the Hong Kong situation.

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Thursday, August 28, 2008 0 comments

MBIA Reinsures FGIC; Another Poor Quarter at Sears; US GDP Revised Higher; Fannie Mae Cleans House; Market Manipulation in Pakistan

Some articles that some of you may find interesting...


  • MBIA agrees to reinsure $187 billion of FGIC muni bonds: In a deal cut by Eric Dinallo, FGIC unloading its valuable (and likely safe) muni bonds to MBIA. This should reduce the capital requirements for FGIC while permanently giving up future profits. It also shows that Dinallo cares a great deal about muni bonds (now the muni bonds will have MBIA's A rating whereas FGIC was BB (junk). I suspect that equityholders in FGIC--PMI, GE, Blackstone, Cypress and CVIC--will end up with very little in the end, if anything.
  • Sears misses estimates but expects stronger second half: Sears keeps posting weakening profits... not too surprising given that retail isn't doing well, and a big chunk of Sears sales are in housing appliances.
  • Believe it or not, US GDP is revised higher to 3.3%: I have alluded several times to the possibility that the US economy may not do that badly. A 3%+ growth is amazing for the US (it's very close to non-inflationary potential.) Exports are on fire. Some people are saying this is the peak but people also said the growth in 3Q07 was the peak. Having said that, I still think the equity markets will be under pressure. There is far less correlation between stocks and the economy than many imagine (eg. 2000-2002.)
  • Fannie Mae fires its CFO, CBO (chief business officer, whatever that means), and CRO (chief risk officer): Perhaps a bit too late for Fannie shareholders but anyone presiding over the mess--exagerrated by the press and short sellers in my opinion--needs to be held accountable. It does beg the question, though, how the CEO manages to stick around. The GSEs can grow their way out of the mess if given time (for instance, they are posting record profits due to increasing spreads right now.) But over-reliance on fair value accounting and government pressure (to keep lending, instead of deleveraging) puts them in a tough situation. If I'm not mistaken, Fannie (or maybe it was Freddie or Ginnie) had either negative book value or close to negative book value during the real estate bust in the early 90's. The difference now is that fair value accounting has changed the game; people rely way too much on mark-to-market losses. Having said all that, I'll be the first one to admit that things have to change from a long-term point of view. The GSEs are way too big and I suggest breaking them up in the future--but not now.
  • Karachi Stock Exchange sets price floor for stocks: Yes, someone "smart" in Pakistan has figured out that if you ban stocks from trading below a particular price, they can never decline. There have been riots over falling stock prices in Pakistan so I guess this would fall under the "brilliant" political solution to solve an unsolvable problem. Obviously the exchange, as well as the investors, haven't figured out what a free market is, or what a stock exchange represents. I guess stocks are only supposed to go up...

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Wednesday, August 27, 2008 2 comments

Japanese Real Estate Developer Declares Bankruptcy

If you though that only American, British, Spanish, and Irish homebuilders were having bankruptcy problems, well, add Japan to the mix.

Shares of Japan's Sohken Homes Co. were suspended from trading Wednesday after the home builder filed for court-led rehabilitation with the Tokyo District Court, becoming the latest Japanese developer to enter into bankruptcy protection...

The move comes in the wake of Urban Corp.'s filing for court protection earlier this month.

July saw similar moves by condominium developer Zephyr Co., with debts of around 95 billion yen, and construction firm Suruga Corp. with debts of 62 billion yen.


I'm not sure if this is the start of a trend or if it is just a few weak homebuilders falling by the wayside. I have been mildly bullish on Japanese real estate but it looks like it is starting to face some issues. The bullish case (from a contrarian point of view) for real estate in Japan lies with its massive decade+ bear market. The bearish case lies primarily with the poor demographics (declining population.) At some point Japanese real estate will be a good investment. One strategy is to follow Martin Whitman and invest in top-rated class-A buildings, which are cheaper than in many other parts of the world.


(Astute readers of this blog may recognize Suruga in that quoted news story. It was a company I was following for almost an year, only to discover that it was entangled with the organized criminals in Japan. The lesson for all newbies is to pay attention to why Buffett and Munger never invested in gambling companies. I think it was Munger who said that the gambling industry is dirty. I think it is prudent to apply the same thinking if you are looking at small-caps. A lot of people trip over themselves for the small-cap Chinese companies (many of them incorporated in Cayman Islands and listed in Hong Kong or NASDAQ) but I wonder how many of them are fronts for the Triad.)

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Monday, August 25, 2008 1 comments

Contrarian Industries

One way to look for contrarian ideas is to look at the worst performing industries (needless to say this is the opposite of what growth or momentum investors would do.) Shown below are the worst industries in the last 5 years, according to Dow Jones and Morningstar categorizations. (as usual click on the image for a larger, more legible, table.)






The lists are quite similar. The best performing industries are those in the commodity complex. The worst are anything that got infected with the subprime virus: homebuilders, banks, furniture makers, and so on.

I would avoid areas like homebuilders and rather look at the medium-term underperformers like paper, media, automobile parts suppliers, insurance, and so on. One of the reasons is because industries that did really well in the past rarely lead in the future. Given that we just had an unprecedented real estate bubble, it is not clear when homebuilders, banks (with lots of real estate assets), and so forth, will recover. It is quite possible for them to underperform even if a bull market started today. In contrast, industries such as media, insurance, and even the struggling auto industry are totally out of favour and have been underperforming even without the real estate problems.

The risk with the latter underperformers, though, is that some of them are seriously in trouble (eg. American auto manufacturers) while others are in industries in secular decline (eg. paper, newspapers.) Many businesses in these industries are most likely value traps so one needs to avoid them at all costs.

Having said all that, valuation is what matters and it is quite possible that, say, a homebuilder is a better investment if the numbers are good. I should also note that industry performance in other countries may differ. For example, newspapers in Asia are growth industries whereas they are an almost-bankrupt industry in America and Canada (they are also doing ok in Europe.) Some regions like Europe are hitting low valuations so it may be worth looking there in various industries rather than paying a risk game trying to avoid value trips in America.

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China's Olympics: Coming Out Party Was Successful!

(source: Beijing 2008 Closing Ceremony. Steve Russell for The Toronto Star. August 25, 2008)


As Always, the Olympics are either a colossal waste of money, or a worthwhile pursuit. I'm not really into sports but I do consider the Olympics to be something special and watch some of it on TV. It's one of the few events where the whole world participates regardless of political or economic stance.

China's Olympics, held in Beijing, was very successful in my eyes. The opening and closing ceremonies were entertaining; the events were hosted without many problems; infrastructure and facilities were supposedly excellent; many Olympic and world records were broken; exciting races; and everyone got to know China a little bit more. I've been "following" China for a while now so there is little new to me but I'm sure the general population, whose knowledge is often shaped by stereotypes and politically-driven views, learned something.


Symbolic Event

To some this is just another Olympics but it's a rare event for the China. This is their coming out party. This is the event that puts them on the world stage. For wealthy, developed countries Olympics isn't a big deal. One of your cities is bound to get an opportunity to host it sooner or later. For developing countries, that's not the case. You may only get the opportunity once in a hundread years. This could very well be the case in China, which may not host it for the next 100 years. So the Beijing Olympics is very symbolic and when they say they have been waiting for a hundread years, it's true.

China spent $43 billion on this Olympics compared to $12.8 billion by Athens in 2004. The 2012 Olympics in London is already facing budget concerns and won't be spending anything like Beijing did. As staggering as that amount may seem, most of it is on long-term infrastructure that is much-needed for a country like China. China is projected to spend $400 billion on their infrastructure this year so this is just 10% of it.

The Olympics will also improve the awareness of Beijing. It's hard to quantify but impression among tourists, businesspeople, and politicians are likely to improve. A well-known city like London probably doesn't derive much benefit from hosting the Olympics but Beijing isn't in the same situation.

The Future

China's performance in the Olympics was excellent. It ended up with the most gold medals, and only trailed USA for the total number of medals. I guess it's a sign of the times that China with its large population is finally catching up to the elite athletic countries.

With the Olympics over, China still has a lot of problems ahead. Some human rights activists were dissapointed that nothing seems to have been done on that front. They were hoping that the Olympics would increase freedoms but that didn't really happen. I personally think it is unreasonable to expect the Olympics to have a major impact on freedoms. When an American TV personality asked the IOC head, Jacques Rogue, about this, he basically pointed out the reality of the situation. The IOC can simply lodge a complaint but the countries do whatever they want. He pointed out the example of USA preventing Cuban athletes from entering USA, and when the IOC lodged a complaint, USA just ignored them. All the IOC can do is to lodge a complaint and the government does whatever it wants.

China purposely capped economic activity around Beijing during the Olympics. This ranged from temporarily placing bans on polluting industries, to cutting down on car traffic. They also seem to have imposed some strict visa procedures, which ended up backfiring with less-than-expected tourists. The economy should bounce back up now that the Olympics are over. However the future of the issues facing Beijing--and China in general--such as pollution, weakening economic growth, curbs on freedoms, and so forth, need to dealt with.

My Olympic Entertainment

As for me, I'm not really into sports but did check out some events here and there. As usual, track & field was entertaining. There is always a concern with drugs in track & field but the winners were nearly all clean this year. Notwithstanding the showboating which led to just barely setting a 100m world record, Usain Bolt is the real thing. I saw the table tennis final between two Chinese and it was exciting. I also checked out taekwondo, which is fun but can be slow. Anyone that stayed up to watch the men's basketball final between USA and Spain had a blast. I thought the Americans were going to crush the Spaniards but that was not to be and resulted in a very exciting game.

I am glad to see the power of the Internet finally being unleashed. The television broadcaster in Canada (CBC) and USA (NBC) provided free live internet feeds. Once upon a time, you simply watched what was broadcast on TV. Not anymore. It was cool to watch some events that don't get much attention from the Canadian broadcaster (kind of makes sense if Canadians aren't competing in it.) I hope the internet feeds continue and are improved upon for the future (CTV gets the future Olympic rights in Canada and I hope they don't mess it up.) One downside to the feeds was the fact that they were low resolution so they were small video boxes on my computer monitor (I'm not sure how good the American website feeds were.) I guess it's a bit too much to expect high-definition (HD) feeds right now but it would be nice to get them in the future.

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How Close is USA to Japan of the 1990's?

What are the chances of America ending up similar to the Japan of the 1990's? That's the question being answered in this article from The Economist. It's a brief article but I urge everyone to check it out since it covers most of the issues. There is a very real risk of America ending up similar to Japan but things are never the same between countries, let alone across differing time periods.

The big problem faced by America is the real estate bust that is unfolding:

(source: The Economist)




As can be seen in the chart above, the central bank response has been somewhat similar (at least when it comes to interest rates.) There are a number of advantages that America has and one of them is them is the following:

...It was from here on that Japan made its biggest policy mistakes. In 1997 the government raised its consumption tax to try to slim its budget deficit. And with interest rates close to zero, the BoJ insisted that there was nothing more it could do. Only much later did it start to print lots of money.

America’s inflation rate of above 5% is an advantage. Not only are real interest rates negative, but inflation is also helping to bring the housing market back to fair value with a smaller fall in prices than otherwise.


Japan should have started printing money when the rates were almost zero. That is one of the biggest mistakes. America, in contrast, has positive inflation so there is little need to print money. In fact, I commend the Bernanke FedRes for not printing money and letting natural inflation do its work.


In any case, I think it is unlikely for USA to end up in a situation similar to Japan for the following three reasons:

First of all, the real estate losses are spread out across the world. In fact, some European banks are taking much bigger losses than American banks. This shouldn't be a surprise because Europeans were big buyers for CDOs and CDO-squareds (arguably some of the most complicated real estate securities ever created.) So the cost of the real estate bust is being spread out across the world. I think if all the losses were taken by Americans (as Japan had to; or America had to with their S&L crisis in the early 90's) then USA would be in far worse shape. The real estate bust is still unfelt by many in America--particularly those not living in the bubble areas of California, Nevada, and Florida, among others. Although it may be revised down in the future, let's not forget that GDP growth is still positive. I mean, it's even stronger than Canada right now!

Secondly, USA does not have a stock market bubble anywhere near what Japan had. The P/E ratio on Japanese stocks were something like 40+ back in 1990 whereas S&P 500 P/E is under 20. Even if you adjust the P/E upwards to account for the low P/Es of cyclicals, it will be nowhere near the Japanese valuations. My understanding is that other measures such as price to book and dividend yield show similar results.

Lastly, although very few seem to tie this into the Japanese real estate bust, Japan had/has horrible demographics compared to USA. By this, I am referring to the low population growth in Japan versus USA. The economy, and real estate in particular, will likely perform much better if the population is growing rather than shrinking.


So, overall, I do not think USA will face anything remotely similar to what Japan faced in the 1990's. However, do note that, as pointed out in the article, America has some negatives that Japan never had (such as low savings rate) but I do not believe these to be as material as the three I focused on.

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Saturday, August 23, 2008 0 comments

The Problem with Government Funding Alternative Energy

I'm not as "right wing" or as fiscally conservative when it comes to the economy and government policy. However, unlike most liberals, whom I identify with, I am of the strong opinion that too much government intervention results in undesirable side effects. The unfortunate thing about most left-leaning individuals or liberals is that they seem to ignore the fact that government intervention can produce bad results even if the intention is good. Perhaps the most relevant and powerful example of this is the current energy situation and funding of alternative energy by the US government.


Ethanol

Although it's old news now, a good example is how the US government under the leadership of George Bush decided to stem the over-reliance on oil--which incidentally isn't a bad thing except for environmental concerns--by forcing fuel to be diluted with ethanol. Even if you ignore the conspiracy theory that this is actually a move to placate oil interests by increasing reliance on oil (pushing ethanol essentially means you keep oil,) this starategy has been a total disaster. On top of having little impact on lowering oil usage, it has had little environmental impact (ethanol from corn is quite dubious; but sugar cane ethanol is more attractive.) It also seems to have contributed to some of the increase in food prices (corn is a key feedstock for livestock, at least in North America.)

The ethanol strategy led to a bubble, albeit small, which seems to have burst. A quick glance at the chart of Pacific Ethanol (PEIX), a leading ethanol player, illustrates the current state of affairs. Even some of the big proponents who influenced and drew up the ethanol strategy seem to be distancing themselves from it. You know the strategy totally backfired when the cheerleaders seem to have dissapeared.

Fortunately, other governments in the world, although just as dumb as the US government, never jumped on the ethanol bandwagon (only exception is Brazil which has been using sugar cane ethanol for more than a decade.)

Automobiles

A more relevant example is one that is unfolding before our eyes. The big three American automobile manfuacturers (GM, Ford, and Chrysler) are struggling. That may come as a shock to some but it's true ;) Their future seems to lie on providing more fuel-efficient vehicles. The inefficient vehicles--trucks, SUVs, sports cars--are not going to dissapear; but I do think that their growth rates will be negative while the fuel-efficient cars gain more popularity. People who need trucks will buy one; people who love sports cars will buy one; people who like SUVs will still use one; and so on. But the general population who has no affinity towards one car platform will likely seek more fuel-efficient and often cheaper cars.

Notwitstanding the profitable foreign divisions of the Big Three, these companies are betting their future on building cars off more fuel-efficient platforms. So, they are now seeking up to $50 billion in government loans. I'm not an American taxpayer (I'm Canadian) but it's ridiculous to give $50 billion to 3 companies to help them re-tool their factories, develop alternative vehicles, and so forth. Given that the market is unwilling to give $50 billion to these companies (their bonds are rated junk) it may be safe to assume that these "loans" are never going to be paid back (so it's free money.)

Unlike the ethanol strategy which was largely a Republican party solution, this one is primarily driven by the Democrats (not surprsing given that largely Democrat-run Michigan is the one that is suffering and the auto manufacturers are heavily unionized.) I am quite confident that this strategy is going to backfire and end up with undesirable side-effects (like the ethanol one.)


My Opinion

So you can see how letting the government "pick" how to funnel money--a lot I might add--often isn't the best tactic. On top of these grand plans being driven by ulterior motives, the government is unlikely to do a better job than the market.

Having said that, I'm like a typical left-leaning person in that I think government dropping money from helicopters can be good in some cases. Ignoring so-called national interest projects, if government were to fund something, I think it is better off funding primary research than to hand out money to select industries or businesses. It is much better for them to provide funding to universities, research institutions, or even fund early-stage projects. Some think that this is often a waste of money (most of the funding ends up useless) but any breakthrough at the primary research stage has massive spin-off benefits. For example, it is doubtful that America would have such a strangle-hold on the Internet if the government did not fund those university projects (on top of DARPA's funding of ARPANET, it should be noted that practically all the protocols, network structure, naming conventions, and so forth, were developed by universities and various government-funded institutions.)

In contrast, funding select businesses or late-stage commercial projects simply results in handing money to some select owners and/or propping up failing industries. Government funding the Big Three is just as dumb as if the government had funded the monoline bond insurers. All these companies should sink or swim based on their own merits. (If I'm not mistaken, the Japanese government partially funded Toyota's hybrid development about a decade ago but I consider that closer to primary research.)

When it comes to alternative energy, the government should not fund anything (except possibly primary research.) The government simply can't predict which technologies, processes, or industries, will succeed in the future.

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Thursday, August 21, 2008 0 comments

Sam Zell... Jim Rogers... Marc Faber

Relying on predictions about the future can be harmful to your financial health so you shouldn't read this :) But for those, like me, that like to listen to some speculations about the future, here are some thoughts from Sam Zell, Jim Rogers and Marc Faber. Needless to say, all three contradict each other and hedge their bets by implying that these are just possibilities.



Sam Zell

Sam Zell, who is having a rough time with his Tribune ownership, sees a potential bottom in real estate early next year. He thinks real estate is priced fairly right now and thinks debt is more attractive than equity for the distress situations.

Billionaire Sam Zell said the housing market could start recovering as early as next year and he's focusing on investing in debt rather than equity.

``We believe that the opportunities, particularly in difficult situations, are in the debt,'' said Zell, who made his fortune building the largest publicly traded office and apartment companies in the U.S. ``We have been focused on, not only in real estate but in corporate, identifying debt situations where it is trading at a discount.''

...

Zell says he's not buying property at the moment.

``I think the real estate market as a whole is fairly priced,'' Zell said. ``I think from a yield point of view, it might be attractive. But I am a capital investor and an entrepreneur, and I need to be able to invest in situations that by virtue of changing them, I can dramatically change value.''


The best American real estate investor is not Donald Trump; it has always been Sam Zell. Now, whether that means he is going to be right or not remains to be seen. Since all these comments are vague, it's hard to know if he is talking about residential real estate or something else.


Jim Rogers

Jim Rogers reiterates his past stance and says that the current commodity correction is temporary. He expects commodities to recover and remains long-term bullish:

``I don't see that it's the end of the bull market,'' the chairman of Rogers Holdings, said in an interview in Bangkok before speaking at an investor conference later today. ``Until either a lot of supply comes on stream or the economy collapses, the bull market will continue,'' he said.

Soybeans, copper, platinum and crude oil have dropped from all-time highs after a rally in the dollar curbed demand for raw materials as a hedge against inflation and concerns increased that economic growth will slow. Sixteen of the 19 commodities in the Reuters/Jefferies CRB Index fell this month, after the index plunged 10 percent in July, the biggest such drop in 28 years.

``I am contemplating whether it's time to get involved in base metals again,'' Rogers, 65, said today. ``I haven't bought any for awhile.''



Marc Faber

In the same Bloomberg article, Marc Faber says that he doesn't know if the commodity correction is temporary or not:

Marc Faber, 62, who told investors to bail out of U.S. stocks before 1987's so-called Black Monday crash said Aug. 15 that commodities may have peaked. ``Whether that is a final peak or an intermediate peak followed by higher prices, we don't know yet. It could go lower,'' he said.


The most striking thing to me is the fact that Faber raises the possibility of this being a final peak. Although he is not turning bearish (yet), I haven't heard him mention any words like "final peak" in the past.

Marc Faber is starting to become superbearish (his stance is starting to resemble some things he said in early 2007--but he was wrong back then). Randall Forsyth of Barron's summarizes Faber's views in his piece about global liquidity:

A declining U.S. current account deficit could lead to a tightening of global liquidity as foreign central banks accumulate less dollar reserves, which are recycled into the global capital markets. The U.S. current account gap has shrunk from a peak over 6% of gross domestic product to under 5% as weakening consumer demand has cut imports while exports remain relatively robust as growth continues in emerging economies and the dollar is cheap.

As the growth of foreign monetary dollar reserves slows, the dollar is boosted and gold and commodities are hurt, Faber points out. Further, he writes:

"I have a friend who is an outstanding economist who thinks that the Asian current account surpluses will shrink in 2009 by about 50% from their peak in 2007. In this scenario, globally liquidity would become extremely tight and would have a devastating impact on asset markets including real estate, commodities, non-AAA bonds and equities. Such a decline in the Asian current account surpluses would cut the U.S. current account deficit by half and lead to a very strong U.S. dollar."


I have been casually following Jim Rogers and Marc Faber for about 4 years now, and it is rare for them to take divergent positions. Similar to Jim Rogers, Marc Faber has, in the past, said that the commodities complex may enter a short-term correction but he was still long-term bullish. However, this is the first time I have seen him mention the possibility of this being a final peak.

As usual, Rogers looks at the situation from a macro supply & demand point of view. He doesn't think supply is coming onstream so the bullish case is intact. Marc Faber, in contrast, tends to rely a bit more on technical analysis, investor psychology and reversion to the mean.

Faber is basically saying that if liquidity contracts, US$ will rally and crush everything. This is a view I have discussed in the past. To sum up, practically every asset--gold, commodities, US stocks, emerging market bonds, emerging market stocks, junk bonds, real estate, art, collectibles--had appreciated from early 2000 to the recent past. The only assets which did not do well were US$ and US Treasuries (Treasuries have rallied recently so they are not an underperformer either.) So if there is one asset that is totally out of favour that no one expects to do well, that is the US$. It is quite possible for all the assets to correct while the US$ rallies. No one expects the US$ to rally because the consensus is that the US current account deficit will keep expanding. But lo and behold, we are starting to see the current account deficit improving--something few expected as recently as 6 months ago--and some are shocked that the US$ is stabilizing--and even gained against a 'commodity super-currency' like the Canadian dollar in the last month! Essentially, a reversal of the cheap liquidity of the last 5 years. If making money over the last few years was easy then losing money over the next few years is going to be easy.

Having said all that, this is all just speculation right now and it's not clear if the US$ will sustain its strength. Also, it's not as if Marc Faber (or anyone else) aren't wrong at times. Like I said, betting on macro can be harmful ;)

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Wednesday, August 20, 2008 2 comments

Anticommons and the Stifling of Innovation

In the second decade of the twentieth century, it was almost impossible to build an airplane in the United States. That was the result of a chaotic legal battle among the dozens of companies—including one owned by Orville Wright—that held patents on the various components that made a plane go. No one could manufacture aircraft without fear of being hauled into court.


Are we hitting the point where excessive intellectual property legislation is starting to hamper innovation? This is something I am starting to wonder. Writing for The New Yorker James Surowiecki describes the problem of the "anticommons":

The situation that grounded the U.S. aircraft industry is an example of what the Columbia law professor Michael Heller, in his new book, “The Gridlock Economy,” calls the “anticommons.” We hear a lot about the “tragedy of the commons”: if a valuable asset (a grazing field, say) is held in common, each individual will try to exploit as much of it as possible. Villagers will send all their cows out to graze at the same time, and soon the field will be useless. When there’s no ownership, the pursuit of individual self-interest can make everyone worse off. But Heller shows that having too much ownership creates its own problems. If too many people own individual parts of a valuable asset, it’s easy to end up with gridlock, since any one person can simply veto the use of the asset.


Nothing to do with investing per se but an insightful read. Situations like these is what makes me skeptical of economic socialism (tragedy of commons) as well as extreme free-markets/libertarianism (tragedy of "anticommons").

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Tuesday, August 19, 2008 8 comments

Portfolio Management is a Tough Business

I know we all make fun of hedge fund managers, most of whom are overpaid, but running a portfolio is not easy. If investing was considered as a business--Benjamin Graham said it should be considered a business--then it is one of the toughest businesses out there. Andrew Ross Sorkin of The New York Times profiles Ronald Insana, a CNBC personality who left to run a hedge fun a couple of years ago.

As an investor, Mr. Insana didn’t exactly have the wind at his back. During the 14 months his fund of funds was up and running, the Standard & Poor’s 500-stock index fell more than 15 percent. While some hedge funds managed to eke out gains, many did not. Ultimately, Mr. Insana’s fund lost 5 percent.

In the mutual fund business, beating the S.& P. would be more than enough to survive, and even prosper. Mr. Insana would have been a hero. But the hedge fund business is far more cut-throat. For a small fund like Mr. Insana’s, it is imperative to make money regardless of whether the S.& P. is up or down — and because he didn’t, the 20 percent portion of his fee structure was worth nothing.


I think if someone wanted to run a "business," they are probably better off trying their hand at inventing a new device, developing some service, running a retail operation, or some such thing. Investing is far tougher (just look at my record *bangs head against wall*) and possibly less productive to society. It is perhaps better to attempt investing 'on the side' while having a full time job, or studying in school, or whatever. Although it would limit your ability (won't have all day to read the paper, analyze companies, etc,) it may be easier to handle and will afford you the opportunity to recover from mistakes.

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Monday, August 18, 2008 2 comments

The Risk With Fannie and Freddie

AccruedInterest quotes a Merril Lynch analyst in explaining why Fannie and Freddie shareholders have far greater risk than perceived:

The ultimate problem here is best described by Merrill Lynch's Ken Bruce. You can dive into Freddie Mac or Fannie Mae's balance sheet and make a good case that they don't need new capital, at least under current forecasts for housing. You'd therefore conclude that if they were a truly private company, they'd best serve shareholders by trying to stick it out. But they aren't a truly private company. As the perception of their capital strength wanes, policy makers are going to conclude that we are better off nationalizing the GSEs. The case will be made that the collective needs lower mortgage rates, and only a strong, liquid and publicly minded GSE can help bring that about.


This is an example of where being too entangled with government coming back to hurt you. You get the benefit during good times but when things get rough, your ally, the government, may be the biggest threat to the shareholders.

It's still not clear to me if the government can force the GSEs to undertake capital injections that bankrupt the shareholders. Will this hold up in a court of law? Or are the GSEs some quasi-governmental organization where management is primarily responsible to the government? I guess the management can argue, as in the Bear Stearns case, that the company would have otherwise been bankrupt but it remains to be seen if that reasoning will fly.

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Investing & Econopolitical Risk

UPDATE: I want to clarify others regarding John's decision. Basically, he considered investing in the troubled region but ruled it out in the end (if you read his blog post, that's obvious.) I was simply referring to him because he went through the whole process of identifying the troubled region and then contemplating an investment. He ruled out any investments in the region in th eend but my intention with the post is to examine the risk in such regions and the thought that shold go into them.

One of the most important things for newbies (like us) to understand the political risk inherent in investing. It is one of the first lessons I learned when I started investing a few years ago (more on that later.) Given my rants on the Georgian conflict--I hope it doesn't drive too many of you off (just ignore it if it's not your thing)--it presents a good opportunity to look at the issue.

John from Controlled Greed touches on some thoughts he had about investing in Russia, Georgia, and Ukraine given the Russia-Georgia war in the background. Investing during a war or in war-torn areas likely has massive upside. Recall how John Templeton is famous for investing through the start of World War II. Or how Jim Grant pointed out that Iraqi bonds were one of the best performing bonds 2 years ago (or maybe it was last year--don't recall.) Marc Faber also pointed out many examples in Tommorrow's Gold, his book on historical trends and commodities, including one which showed that foreigners investing in Argentina during the hyperinflation of 2001 did really well (one of the big reasons is because the currency plummets so much that assets in, say, US$-terms is really cheap; Argentina wasn't in a war but many countries in war can face a similar situation) John seems to have given up on the idea after reading this Barron's piece. SeekingAlpha has a brief summary of the situation, along with with bearish and bullish views from some bloggers. I'll critique some of the blogger opinion but let's look at how countries stack up when it comes to econopolitical risk.


Econopolitical Risk

There are many ways to look at, what I call, econopolitical risk. I essentially like to lump economic risk together with political risk (most people just call that political risk.) Almost always, risk in this context is taken to be the opposite of freedom. In other words, the lower the freedom, the higher the risk. This should be plausible to all freedom-loving humans--like me and you (I hope :) .)

There are several "liberal" or left-leaning measures, which tend to emphasize political freedoms (typically produced by humans rights focused think tanks or the UN.) While there are some "right wing" measures that focus on economics (typically produced by economics-oriented think tanks.) American Libertarians do not split behaviour in terms of left and right but differences exist in real life (most libertarians consider one to be a libertarian or authoratarian--can be both left and right). You'll see the left/liberal and right/conservative split when you look at Singapore in the rankings below. A lot of right-leaning measures, that emphasize economics, will rank Singapore high on the list; while left-leaning measures, that focus on human rights or political freedoms, do not place Singapore anywhere near the top. Singapore has done exceptionally well in terms of economics but is governed by a so-called "democratic" dictator. Basically one party has ruled since independence and anytime that happens in a democracy, you really have to assume that either we have found utopia, or that it isn't really a democracy. Most think tanks that rely on economics as opposed to (political) liberties considers Singapore as extremely free--even more free than USA or Canada.

Anyway, since we are investors, for our purposes, let me look at right-leaning measures that focus on economic freedoms. There are two popular ones in North America: Economic Freedom of the World index from Canada's Fraser Institute, and Index of Economic Freedom from the Heritage Foundation.

(The scale in the images below go from the blue side of the colour spectrum (more freedom) to the reddish spectrum (less freedom.) Unrated countries are in gray.)

The following map represents the Economic Freedom of the World index by the Fraser Institute:


(source: Economic Freedom of the World Index 2007 (last data up to 2005). Image from CATO Institute.)

This map is from the Index of Economic Freedom from the Heritage Foundation:


(source: The 2008 Heritage Foundation Index of Economic Freedom. Image from wikipedia.org)

I have also produced some tables showing roughly the top 25 rankings, along with the BRIC countries, and the bottom 5. Note that some countries weren't rated and the list is not consistent between the two studies. As always click on the images to view a larger image.

Economic Freedom of the World



Index of Economic Freedom



Like a typical "liberal" who values political freedoms (speech, press, etc) I personally would not consider Hong Kong or Singapore as the top two investment destinations. Things may look rosy there now but things can fall apart any minute (not that I'm predicting anything.)

Although John was relying on some comment from someone quoted in Barron's, Russia's rankings line up well with his interpretation of the inherent risk. Russia is near the botton third, way below the other BRIC countries (Brazil, India, China.) Safest of the BRICs is probably Brazil. China is totalitarian and who knows what will happen in 5 years; and India, although underpinned by a British legal system, is highly corrupt and unpredictable.

I personally would be wary of Russia. I think it has the potential to do well due to some macro factors: highly skilled population, lower cost than Western Europe, natural resources, and strategically located and very close to China, India, Middle East, and Europe. The downside to Russia from a macro point of view is their declining population (birth rate too low and xenophobic immigration policy), question over stability of government after Putin, and too dependent on commodities. I think it is worth looking at after Putin leaves, and hopefully greater freedom.

As always, investors tend to ignore the econopolitical risk until something bad happens. It wouldn't surprise me if a lot of investors overloaded on BP shares without realizing how flaky their ownership of oil&gas assets in Russia were. I personally think the market has been underpricing the emerging market risk (as you can tell by equity valuations or EM bond spreads over Treasuries) for the last few years. A lot of people are going to be shocked and lose a lot of money. An example is China, which should be discounted a lot more than what investors have done in the last few years. Time will tell.


Petrobras: One of my First Lessons

One of my first lessons in investing was econopolitical risk. One of my very first investments was a Brazilian oil&gas supermajor called Petrobras (PBR). I didn't understand it but I picked it because it seemed to have the lowest valuation. It was trading at a P/E of something like 5 or 6 whereas ExxonMobil, Chevron, PetroCanada, and Suncor were trading at higher P/Es. I thought I was buying an undervalued oil company but I was actually wrong. PBR traded at a low multiple because of political risk. I never realized that PBR was controlled by the Brazilian government and it doesn't act in the interest of shareholders (as American or Canadian oil companies would.) For example, some of the proposed pipelines and refineries seemed designed to placate foreign nations than to satisfy shareholders. My investment thesis was that the P/E multiple would increase and get closer to the American supermajors. But that was completely wrong since the market was discounting the political risk (I didn't know it.) Fortunately, I actually ended up making money because of the oil bull market but it was a bad investment.

So one of the newbie lessons is that if something is cheap, check to see if it is due to econopolitical risk. If it is, then the valuation can stay low forever. So the real homework question is whether the valuation justifies the econopolitical risk.


Is the Market Pricing Russian Risk Properly?

Looking at that SeekingAlpha post referencing the Barron's article, here is my thinking on some issues.

You can see the market discounting mechanism at work by read the Barron's story. They mention that Lukoil is trading at a P/E of 5 versus 7 for ExxonMobil and Chevron. I haven't looked at oil&gas companies in a few years but Lukoil likely has much better growth prospects as well (hence should have a higher P/E if all else were equal.) If you assume all these companies were similar (in terms of production reserves, quality of management, etc) then Lukoil is trading at around 30% discount (5 vs 7).

The decision for the investor is whether the 30% discount rewards you for the econopolitical risk. Without doing any homework on the specific companies, I would say that the discount is not large enough. I would want a 50% discount (which means a P/E of 3.5, compared to 7). Even then, you need to be willing to accept a huge loss if the government charges your company with "environmental violations" or "tax evasion" ;) But if you spread it across many countries, then you will likely do ok. This is how Marc Faber and Jim Rogers manage to make money even though they invest in super-high-risk regions of the world. I personally think this style of investing is more suited for macro or sector rotation investors than value investors. I really can't see Warren Buffett investing in some of these places. Admittedly he invested in China and Korea but it is a small portion of his holdings.

Short Selling Risky Countries

One of the bloggers quoted in the SeekingAlpha article suggests short selling Russia. Well, I'm not into short selling but doing so to a country because it is corrupt, doesn't support freedoms, or is hostile to foreign investors, is likely to not produce much profit. After all, Singapore is basically a "democratic" dictatorship and anyone that shorted in 15 years ago is bankrupt. Perhaps the best example is China over the last 10 years. If you were able to short China 5 years ago, you would have been bankrupt with the margin calls soon afterwards. Similarly, if you went and shorted the Middle Eastern countries 5 years ago because you thought they were terrible, you would be bankrupt now.

The fact of the matter is that countries, and hence companies, can do well under various conditions--including dictatorships, monarchies, and various other totalitarian regimes.

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NATO Expansion is Going to End Up In a Disaster--Except for the Warmongers

(Another totally political post so ignore at will :) )

The whole Georgian situation hopefully puts a lid on American push--primarily from the George Bush administration (but McCain is even more hawkish)--to expand NATO. I still can't figure out if the present war was started due to an incompetent leader (the Georgian leader) or due to plans hatched by others (i.e. leader was a puppet.) The whole strategy seems so juvenile and laughable that it would really be a joke if it weren't for all the deaths involved. Did he really think that his military can somehow take on the 2nd most powerful military in the world? As some in the media have noted, all of this is quite puzzling given that Georgian military commanders didn't even brief the press on the progress of their war (it was all politicians who were speaking to the media all the time.) For what it's worth, Georgia actually seems to have shot down 4 Russian planes--just as improbable as the American stealth fighter that was shot down by Serbia a decade ago.

Imagine if Georgia were part of NATO right now. You would have some incompetent Georgian leader (or possibly a puppet) starting a war and forcing all the NATO members to enter the war (for those not familiar, like most alliances, an attack on one member is equivalent to an attack on all.) The notion of World War III wouldn't just be a conspiracy theory or some view held by some wacko. Hawks who derive their meaning of life from war would love it, but it would be a disaster for everyone else.


As some random posters raise the possibility on the GaveKal forum here, NATO should be disbanded at some point. An alliance designed to primarily combat the USSR has clearly outlived its need. Some Americans and Canadians won't be happy with that scenario but it's inevitable in my eyes. Some European countries are far more tightly integrated with Russia than they are to America or Canada. For instance, something like half of Russia's trade is with Germany (you will note that Germany is less critical of Russia during the Georgian conflict than the US government.) If Europe were to compete with a re-emergent Asia (particularly China) then it needs Russia as an ally. Russia has natural resources, highly educated citizens, and lower cost of labour (than Europe anyway.) Building military alliances contrary to trade and free markets makes no sense. Anyway, this isn't going to happen any time soon but my expectation is for the relevance of NATO to diminsh.

I think Mikheil Saakashvili's tenure is over whether he realizes it or not. Similar to how Henry Paulson remarked to Alan Schwartz, Bear Sterans CEO, that the fate of Bear Stearns was out of his hands, I think Mikheil Saakashvili's fate is outside his hands. It's a shame, really. He seemed to have been on the right track towards building a democratic and liberal state. Who knows what changed? Perhaps power corrupts absolutely, as they say. Or maybe he became a puppet of the George Bush administration (naming the main street to the Georgian aiport after George Bush really raises a lot of questions.) Jeffrey Tayler's article in The Atlantic sums up the end game:

(source: At Putin's Mercy by Jeffrey Tayler. August 2008 Edition of The Atlantic. )

As Russian bombs rained down on Georgia and Saakashvili pleaded for help from the West and for a cease-fire from Moscow, Putin stated bluntly that "Georgia's aspiration to join NATO . . . is driven by its attempt to drag other nations and peoples into its bloody adventures,” and warned that, “the territorial integrity of Georgia has suffered a fatal blow." The Bush administration answered with boilerplate language of protest, failing even to dispatch Secretary of State Condoleezza Rice to the region until six days later for rounds of shuttle diplomacy. Saakashvili complained that “all we got so far are just words, statements, moral support, humanitarian aid.” But neither the United States nor Europe will risk Armageddon for Georgia. For Saakashvili, game over.

The United States has, for all intents and purposes, abandoned Saakashvili, the poster-boy of the color revolutions, and left him at the mercy of Putin, who appears bent on exacting revenge. Moscow and the separatist leaders in both republics have pledged to charge Saakashvili in the Hague for genocide. The lessons that emerge from the Russia-Georgia war are clear: Russia is back, the West fears Russia as much as it needs it, and those who act on other assumptions are in for a rude, perhaps violent, awakening.


Nationalist tendencies did him in. Obviously he should have spent more time brushing up on the concept of realpolitik and how ruthless and clever Vladimir Putin is. He'll survive and maybe even do well if McCain becomes the next president (John "We're all Georgians" McCain is very close to Saakashvili (McCain's foreign policy advisor was formerly a major paid-lobbyist for Georgia.) But I doubt the Georgians will be so kind to him.

As for South Ossetia, well, its capital is totally destroyed (as these photos from the Russian side indicates (note: some photos are graphic)) and I doubt the Ossetians would want anything to do with Georgia in the future. Stalin divided Ossetia into the north and south portions but this is the end of his plan.

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Saturday, August 16, 2008 2 comments

Stocks are Generally Good Inflation Hedges

A lot of newbie investors don't realize how good of an inflation hedge stocks are. In the super long run, they have beat bonds, real estate, and even gold. As long as one doesn't buy at a major peak (such as 1929 or 2000) their stock investment should more than handily beat all other asset classes. Mark Hulbert wrote an article for the New York Times commenting on the misnomer regarding inflation and stocks. In it, he refers to studies that show that corporate profits have generally grown faster than inflation:

Over the last eight decades, corporate profits have tended to grow faster when inflation is higher. In such periods, companies have been able to pass along higher costs to their customers. As a result, even though higher inflation leads to a greater discounting of future years’ earnings, those earnings tend to be bigger than they would have been otherwise. The net result is that the current value of a company’s future earnings remains relatively stable in the face of rising inflation.


Not all companies are created equal but most manage to keep their inflation-adjusted earnings growing even in inflationary periods. You would be hard-pressed to find too many other assets that can do as well as stocks can during inflationary periods. Even the much vaunted commodities will correct hard--50% drop is not unusual--and leave you questioning your returns. The only thing that can beat stocks is gold but, contrary to what goldbugs say, it requires precise timing (look at the almost 20% drop in gold or 40% drop in silver within the last two months--such a move would be a major crash for broad market stocks but is nothing unusual for precious metals.)

The risk for investors, though, is that the market will start discounting stocks using lower inflation-adjusted returns during inflationary periods. Even if stocks will outperform most other assets during inflationary periods, stocks with rosy built-in projections will get re-priced.

Contracting Profit Margins A Greater Threat

The biggest threat to stocks right now is not inflation but the unsustainably high corporate profit margins. Many stock-market investors don't realize that most of the profits over the last 5 years has been accumulating to businesses and this will likely reverse. Warren Buffett also alluded to this a few years ago when he referenced a chart showing corporate profits as a percent of GDP (refer to this post from Rational Angle for some past views from Buffett.) It is a certainty in my eyes that corporate profits as a percent of GDP will decline in the future. So be prepared for it! On top of bogus profits--such as "profits" from subprime loans to people who clearly were never going to pay them back--dissapearing, the most likely way corporate profits will decline is with higher taxes.

A future Democratic Presidential administration under Barack Obama will likely reverse the so-called tax-cuts for the wealthy (some of these cuts never should have been enacted in the first place.) A John McCain administration likely won't immediately reverse the massive Bush tax cuts but will still increase taxes in my view. The US government deficit is getting totally out of control and hence I think taxes will be raised regardless of who is drawing up policy (cutting some inefficient branches of the government or war spending is the ideal route but that ain't happening.)

Anyway, the market will likely discount stocks (downward) when profit margins contract. If you are a contrarian or a value investor buying with a big margin of safety, this won't have a big impact; but if you are buying close to market valuations, it will likely be a bigger issue than inflation.


(NOTE: Everything I say here applies to developed stock markets and USA/Canada in particular. Developing markets are totally different, with inflation being a huge problem almost at all times. Far more businesses in developing countries will have problems earning above inflation than in developed countries. It is much harder to pass down prices due to price controls, price ceilings, etc.)

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Friday, August 15, 2008 8 comments

Georgia: Nationalism & Saakashvili's Incompetence

UPDATE (Aug 16 12:08 PM): Mark Mackinnon of The Globe & Mail wrote, what I consider, an excellent piece on the blunder by Saakashvili. It parallels my thinking and questions the whole motive behind the Georgian president's move. Make no mistake; there are no righteous heroes in this conflict but I think the worst move came from the Georgian government.

UPDATE (Aug 16 12:12 PM):One point for any investor reading this... It may be obvious already but if you are a shareholder or a potential shareholder of BP, it is worth noting how much their fate has taken a turn for the worst. I always thought of BP a supermajor who is widely diversified but it seems that they have most of their future tied up in either Russia or Central Asia. The disputed TNK-BP operation in Russia is something like 25% of their reserves (or something like that); and they are also a big backer of the Baku-Tbilisi-Ceyhan pipeline running through Georgia.


This is a totally political post so ignore it if you don't want to hear my rant.

You can see the destructive power of nationalism by observing the events unfolding in Georgia. No doubt it's a tough situation for everyone involved. Here we have a situation where a province has "broken away" from Georgia and the Georgian government is trying to bring it back into its fold. If you were a true democrat or a libertarian or an anarchist, you would let the province's citizens rule themselves. That whole Caucausus region has had violent rivalries for ages. Divided autonomous states is the most stable solution in my view. However, nationalists will have none of that.



Although the conflict was simmerring behind the ground for a while now--including supposedly some massive internet attacks against Georgia from Russia--it begs the question why Georgia decided to go into South Ossetia now? They basically had no chance against the Russian superpower and simply resulted in senseless deaths. The forceful Russian response was inevitable after the deaths of numerous Russian "peacekeepers" (these peacekeepers have nothing to do with the peacekeepers you may have in mind.)

The real question I have is who came up with the great idea that increasing military action in South Ossetia was going to work in Georgia's favour? Clearly someone like Mikheil Saakashvili, educated as a lawyer in New York's Columbia Law School, couldn't be dumb enough to take on Russia? Or can he? Or is someone calling the shots behind the scenes? I hate to throw more gasoline on the conspiratorial fires but it's hard to imagine Georgia, whose main ally is USA, doing something without briefing the US on its plans.

Saakashvili has a reputation as being a human rights fighter who has battled corruption so it begs the question why his forces were shelling South Ossetia. USA, as well as some European members, seem to be rallying behind him for the time being but I expect him to be out of power very soon. It wouldn't surprise me if his own population turns against him.

Georgia's plan, whatever it was trying to accomplish, seems to have completely backfired. The truce brokered by Sarkozy contains so many loaded provisions in favour of Russia that Georgian is powerful. For instance, New York Times reports that it lets so-called Russian peacekeepers perform stabiliation operations within Georgia. Essentially Georgia was in no position to negotiate and basically ended up not only losing what little control they had in South Ossetia but also losing control over its country.

Maybe it's just me being a bleeding-heart anti-war liberal but it's truly dissapointing to see the New York Times essentially blaming Russia and almost asking the US government to get involved. After the big blunder with the bogus war on Iraq I can't believe the NYT hasn't learned its lessons. Leave it up to the conservatives to wage the war and stay out the way. George Bush, pushed by Condoleeza Rice and Dick Cheney, is going to get involved no matter what. And potential future president John "We are all Georgians" McCain will likely send troops over there in the future anyway. What's the deal with the NYT becoming so pro-war all of a sudden?

I'm no fan of Putin's Russia, which is well on its way to becoming a totalitarian country. I even think the proper title for Putin is 'Czar Putin'. But this is one situation where it is hard to criticize Russia. I sincerely hope for everyone involved--both the pro-Russian and pro-Georgian--that Russia doesn't turn this into a bloody mess that has become Chechnya. George Bush may have looked into Putin's eyes and seen Putin's soul but I don't know how Saakashvili was going to outsmart a former KGB agent. Total incompetence by Saakashvili and if his goal was to advance the prosperity of Georgia, he managed to set them back a decade or more. No doubt more money will flow into Georgia from USA and Europe now, but it will never overcome the strategic losses and the deaths.

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Greenspan the Free-Market Maestro & the GSEs

For a devout follower of Ayn Rand, Alan Greenspan is weird even by Randian standards. I do not hold him in high regard like many on the Street--the Maestro they call him--but I do not hate him like some others do either. However, whatever Greenspan says always seems contradictory and meaningless to me. Consider his latest view that the GSEs, Fannie and Freddie, should be nationalized:

His quarrel is with the approach the Bush administration sold to Congress. "They should have wiped out the shareholders, nationalized the institutions with legislation that they are to be reconstituted -- with necessary taxpayer support to make them financially viable -- as five or 10 individual privately held units," which the government would eventually auction off to private investors, he said.


Taking a page out of William Ackman's playbook--although Greenspan is no famous short seller--Greenspan implies that the GSEs should be nationalized without any material problems. Why is it that all the famous and "smart" people on the Street always call for nationalization well in advance of any deterioration? It wasn't even an year ago when, as you recall, Jim Cramer was calling for the nationalization of the bond insurers. One might imagine that Cramer was calling for that in order to save his own friends and his personal investment positions; but what about Greenspan?



I have no qualms with breaking up Fannie and Freddie. They are clearly way too big and would be better off operating as smaller, more nimble, entities.

One can also argue that they shouldn't be backed by the government since it privatizes profits and socializes risk. But I suspect liberals and conservatives will disagree on that. If you want to promote home ownership then the current arrangement makes sense. The government has to pay up if it wants some service (in this case improved home ownership) to occur. This is no different than the government paying to build roads to lowly populated rural areas (huge profits accrue to private construction companies while risk with any debacle lies with the governemnt.) It would be even worse--far less efficient and more bureaucratic--if the government owned these GSEs outright while maintaining the home ownership mission. Some question the benefit provided by the GSEs but you need to look no further than the current situation, where the GSEs are the only ones providing liquidity in the real estate market, to see how they can be helpful in times of stress. The housing market, and consequently the US economy, would be in far worse shape right now if it weren't for the GSEs.

The real question is whether government should be in the business of promoting home ownership. For now, no one with any power or influence has come against this notion. Perhaps the best thing would be if the GSEs promote home ownership during times of stress (depressions, wars, recessions, etc) while stepping back during prosperous times--the ideal Keynesian strategy. Unfortunately, such thinking has always remained theoretical given that government rarely downsizes during prosperous times as needed.

Going back to Greenspan, his crystal ball seems some light in the real estate storm:

"Home prices in the U.S. are likely to start to stabilize or touch bottom sometime in the first half of 2009," he said in an interview...


However, true to Greenspan's infamous opaque nature, he hedges by saying that the date may futher off:

Tracing a jagged curve with his finger on a tabletop to underscore the difficulty in pinpointing the precise trough, he cautioned that even at a bottom, "prices could continue to drift lower through 2009 and beyond."

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