Friday, August 31, 2007 1 comments

Purchase: TRB

After thinking about the previously mentioned merger-"arbitrage" situations, I decided to go with the Tribune (TRB) deal. This is the one that really interested me in the first place (the returns on the others weren't as attractive to me). The upside is around 25%.

The downside is uncertain and can be very large. If the deal does not complete, Tribune will end up being a heavily leveraged business in a declining newspaper industry. I can see the stock price dropping quite a bit (more than 30%). In such a case, I will likely sell with a loss. However, one should consider whether new bidders may emerge if the Zell deal fails. There were a few bidders before so Tribune may still be of interest to some (although, with a large debt load the interest may be less than before).

If the stock drops more and if I can save a few thousand more over the next month, I'll consider adding to this position. Right now the position is too small for my liking (it's around 5% of my portfolio).

Purchase Price: US$27.52
Investment Time Horizon: Short-term

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Thursday, August 30, 2007 1 comments

ABN, TRB, BCE Merger "Arbitrage" Update

As I have remarked before, merger "arbitrage" looks like the most attractive strategy to a newbie like me right now (I put "arbitrage" in quotes because this is a speculation, as opposed to an arbitrage, since I don't hedge by shorting (not possible in some of these cases anyway)). I find the mergers attractive because they are not dependent on the broad market, which is heavily influenced by economic growth, profitability, sentiment, etc (there is a lot of uncertainty with these numbers right now). Furthermore, the merger discount is very large right now due to credit issues and, supposedly, some merger-arbitrage hedge funds leaving the market (due to liquidity problems in other strategies within their family of hedge funds). You don't see such discounts during a normal scenario (i.e. during a typical bull market or bear market).

Of the announced mergers, the three I found attractive were ABN-Amro (ABN), BCE (BCE), and Tribune (TRB). You can read my prior write-ups here: ABN post; BCE article; TRB article.

You are guaranteed a positive return if the merger closes. So your risk is whether the merger will close. The risk of a failed merger can be large but I can handle it. In some cases, holding the failed merger company is quite risky (eg. Tribune will be a heavily leveraged newspaper company in a declining industry) whereas I can see myself holding some companies (eg. even if the takeout fails, BCE is a somewhat attractive slow-growth, dividend yielding, safe, company).

I have decided to take a position in one of the three now. Timing is very difficult, and also some deals like TRB may close very quickly (if FCC gives the OK, which I think it will). Here is my evaluation of the deal as of today.


  • BCE deal is in Canadian dollars for Canadian investors. BCE is also listed on NYSE and the American takeover price and conditions will be slightly different. The returns should be almost identical but there may be US$/C$ exchange rate risk for American investors.
  • ABN-Amro deal is for NYSE ADS holders. The European holders of the stock on the local exchanges have different prices and conditions. The returns should be similar but there could be slight differences due to exchange rate differences, non-identical prices between local stock prices of ABN-Amro in Amsterdam and the ADS stock price on NYSE.
  • All potential returns exclude dividends, transaction costs, and other minor items.
  • All prices as of 1:29 PM, Thursday, August 30, 2007

BCE Takeout

BCE takeover price: C$42.75
Shareholder vote: September 21, 2007
Closing Date: Q1 2008

Current price: C$ 40.03

Simple Potential Return (excluding transaction costs, dividends, etc): 6.79%

ABN-Amro Merger

Two Deals: One by RFS consortium; another by Barclays.

RFS: EUR 35.60 + 0.296 newly issued ordinary shares of RBS
Closing date of RFS offer: October 5, 2007

Barclays: EUR 13.151 + 0.5325 Barclays ADSs
Closing date of Barclays offer: October 4, 2007

Vote by ABN-Amro shareholders: September 20, 2007

Euro/US$ exchange rate today: 1.3694
Sterling/US$ exchange rate today: 2.0158
Stock price - RBS on LSE: 568 (pence)
Stock price - Barclays on NYSE: 48 (US$)

Stock price - ABN on NYSE: 46.71 (US$)

Value of RFS deal today = 35.60*1.3694 + 0.296*5.68*2.0158 = US$ 52.1398
Value of BCS deal today = 13.151*1.3694 + 0.5325*48 = US$ 43.5690

RFS simple return (excluding transaction costs, dividends, etc) = 11.6%
BCS simple return (excluding transaction costs, dividends, etc) = -6.7%

Tribune Deal

TRB takeover price: US$34
Shareholder vote: August 21, 2007
Closing Date: 4th quarter of 2007 (let's assume December 31st, 2007; note that it can be delayed)

Current price: $27.12

Simple Potential Return (excluding transaction costs, dividends, etc): 25.37%

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Sunday, August 26, 2007 0 comments

China: It was the best of times, it was the worst of times...

I came across a bunch of articles on China and thought I should talk about China. What is happening in China now can be best described by Charles Dickens' opening for A Tale of Two Cities: "It was the best of times, it was the worst of times..."

Top Economic Power by 2100

China will become one of the top economic powers--likely #1--in about 100 years. In fact, some analysts expect China to play a bigger role in the world economy than any other country by 2050. The chart below is from an HSBC report, where they project China's (and India's) impact on the world.

(source: From Hero to Zero and Back Again, by Robert Prior-Wandesforde and Garry Evans; India Watch (Issue 15), Macro - India Economics & Strategy, HSBC Global Research; August 17, 2007)

The fact that some Asian countries like China and India will start playing a bigger role should not be a surprise from a super-long-term point of view. In 1700 of the of the last 2000 years, either China or India has had a bigger GDP than any other part of the world (these are just estimates but the chart above alludes to this point). However, unlike most analysts or economists on Wall Street, I do not think China (or India) will overtake USA within 50 years. A lot of analysts are projecting the high growths rates of the past 10 years far into the future. I don't think the high growth rates can be sustained so my view is that it may take 75 years to 100 years for China to overtake USA. And that's just on the raw GDP; if we look at GDP per capita, it will take even longer for China to catch up to USA's wealth levels.

A Visit by an Old Visitor

A journalist from The Economist recently visited China, after having studied there in the 70's. There are a couple of great articles you can find here. If you have some time to kill, check out the personal experience of the traveller. I find it quite enjoyable to read.

I think it is quite insightful of the author to observe the emergence of the Chinese art scene. Chinese artists are gaining more prominence in the rest of the world. Whether you look at paintings, or contemporary multimedia art installations, or films, I am starting to see their fingerprints. Being a movie fan, I am interested in some of the Chinese film directors such as Zhang Ke Jia (The World) and Kaige Chen (Farewell My Concubine).

Sacrifice Of the Present Generation

The reason I started off this post with the Dickens quote is because it is so similar to Industrialization of Britain. Along with the benefits, which really didn't show up until well afterwards for future generations, there was a lot of suffering and pain. I think present day China is quite similar. There are many things to look forward to, but there are also horrible things happening.

A Toronto Star article I read referred to 18 deaths in Chinese coals mines every day. Such things happen in other countries but it is on a much larger scale in China. A tragic loss of life that no one--including the workers--seem to care about.

"You see that?" the gangly miner asks, pointing to a pile of coal just a shovel-length away at an open-air restaurant in this gritty, hillside town 100 kilometres west of Beijing.

"That's what makes this town. It's why thousands of men come from all over China to work here."

It's why the brothers Meng – Xianchen and Xianyou – came all the way from Inner Mongolia.

It's also why they died.

Working at night in an illegal coal mine, without safety equipment, for less than $10 a day, they didn't make it out when the earth began to shudder last Saturday.

People living in wealthy countries will have a hard time understanding why people put up with these horrible conditions, but that is what desperation is. If you are poor and you can't find any other work, death is an afterthought.

"Frankly, accidents here are a common occurrence," said one. "But villagers here count on these mines.

"There are thousands in these hills. If the government wants to shut these down, it will put tens of thousands out of work. Everyone here depends on them."

No one disagreed.

To make matters worse, the coal that is used as China's primary source for electricity generation causes a lot of pollution. Future generations of Chinese need to remember the hard work--some of it good, some of it foolish--of the present citizens. Life has never been easier...

Investing in China

Having read all of the above, you might think I'm bullish on China. Not quite. I think China has very good potential in the long run, but it is going to face some big problems soon. There are too many bubbles in China right now. They range from overcapacity in manufacturing, to property bubbles, to a wild stock market bubble (similar to NASDAQ bubble but not as big in monetary value). The fact that there are capital controls pretty much means that small investors have very little chance of investing directly in Chinese stocks or bonds. The only bet is to invest in the Hong Kong market or to take indirect bets by purchasing companies that benefit from business in China. In any case, until these bubbles burst, I do not feel it is worthwhile to invest in China. But keep it on your watchlist of the future...

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Thursday, August 23, 2007 0 comments

Recession Signals to Watch

John Hussman has an article on P/E valuations and how the general consensus may be misleading. Contrarians should permanently bookmark his site. It's worth reading the article but I'm going to quote the last part of his article which talks about some recession indicators.

1) The "credit spread" between corporate securities and default-free Treasury securities becomes wider than it was 6 months earlier. This spread is measured by the difference between 10-year corporate bond yields and 10-year U.S. Treasury bond yields (or alternatively, by 6-month commercial paper minus 6- month U.S. Treasury bill yields). This spread is primarily an indication of market perceptions regarding earnings risk and default risk, which generally rises during recessions.

2) The "maturity spread" between long-term and short-term interest rates falls to less than 2.5%, as measured by the difference between the 10-year Treasury bond yield and the 3-month Treasury bill yield. A narrow difference between these interest rates indicates that the financial markets expect slower economic growth ahead. If the other indicators are unfavorable, anything less than a very wide maturity spread indicates serious trouble, regardless of unemployment, inflation, or other data.

3) The stock market falls below where it was 6 months earlier, as measured by the S&P 500 Index. Stock prices are another important indicator of market perceptions toward credit risk and earnings expectations. While the economy does not always slow after a market decline, major economic downturns have tended to follow on the heels of a market drop. Stock markets tend to reach their highs when the economy "cannot get any better" -- unemployment is low and factories are operating at full capacity. The problem is that when things cannot get any better, they may be about to get worse.

4) The ISM Purchasing Managers Index declines below 50, indicating a contraction in manufacturing activity. This index is strongly related to GDP growth, and when combined with the previous three indicators, has signaled every recession in the past 40 years.

He mentions that all of the above satisfy the recession requirement, except for the ISM PMI number (4th one above). The following are additional indicators to watch:

A sudden widening in the “consumer confidence spread,” with the “future expectations” index falling more sharply than the “present situation” index (currently in place). In general, a drop in consumer confidence by more than 20 points below its 12-month average has accompanied the beginning of recessions (not observed yet);

Low or negative real interest rates, measured by the difference between the 3-month Treasury bill yield and the year-over-year rate of CPI inflation. Last week, T-bill yields plunged to about the same level as CPI inflation, so this indicator is now unfavorable;

Falling factory capacity utilization from above 80% to below 80% has generally accompanied the beginning of recessions. This is not yet in place.

Slowing growth in employment and hours worked. The unemployment rate itself rarely turns higher until well into recessions (and rarely turns down until well into economic recoveries).

I hate to quote so much but all of the above points are gems. Similar to John Hussman, I am not sure if we will enter a recession, but I think the economy will slow down materially. My expectation was for 1% to 2% growth this year (I haven't checked lately but I think Wall Street consensus is around 2% GDP growth this year).

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Sunday, August 19, 2007 1 comments

Excellent article by John Mauldin on the credit situation

John Mauldin has written one of his best articles ever on the current credit problems. He traces out the origins and explains what the problems are and suggests some solutions. I highly recommend that you check out the full article (quotes do no justice to the details behind this article). Here are some excerpts that I find insightful.

Part of the problem is the shift towards more ARM mortgages...

In the beginning, subprime loans were made the old-fashioned way. You had to have 80% loan to value and show you had a job and could actually pay back the money. And these loans were packaged up into a subprime Residential Mortgage Backed Security...But then in 2004 loan practices began to change and had got completely out of hand by 2006. In 2005-6, about 80% of subprime mortgages were adjustable-rate mortgages, or ARMs, also called "exploding ARMs." These loans are so-named because they carry low teaser rates that often reset dramatically higher, increasing the borrower's monthly mortgage payments by 25% or more.

The financial intermediaries, with the help of rating agencies, were able to turn low-quality debt into high-quality debt. This is where a lot of surprises come from...

But that's not really where the problem is. Let's go to a great chart from good friend Gary Shilling ( In an effort to make it easier to sell the lower-rated tranches, the investment banks put together a Collateralized Debt Obligation (CDO) composed of just the BBB-rated paper. And then got the rating agencies to give 75% of that paper an AAA rating! So we have turned 75% of BBB waste into gold with the alchemy of ratings...

Who owns this stuff? According to Inside MBS, foreign investors own as much as 16% of the total mortgage securities. Mutual funds have about 16%. Oddly, for all the publicity, hedge funds probably have less than 5%. But they were leveraged, so the losses are magnified.

As I have remarked before, the Yen carry-trade is unwinding...

Hyman Minsky famously said that stability breeds instability. The longer things are stable, the more likely investors are to become complacent and risk premiums drop. Because of the lower yields, investors tend to over-leverage to try and keep up their returns. The markets are then likely to have a "Minsky Moment" of instability, and then risk premiums rise and all sorts of assets are repriced.

And that is exactly what has happened. The markets are de-leveraging. The yen carry trade is going away, and hedge funds and Mrs. Watanabe are driving the yen back up in as violent a move as I can ever recall. Look at the chart below of the euro-yen cross.

The role played by ratings agencies such as Moody's, S&P, and Fitch did not help the situation. Their credibility has been called into question and when all is said and done, they have a lot of PR work to do...

n short, the ratings agencies were making huge amounts of money from the investment banks for rating these structured products. And let's make no mistake about it, they were selling their name and credibility. Everyone knew what a AAA rating meant when it came to a corporation or a country. And even though there were disclaimers in the 500-page documents accompanying the CDO sales material, the investment banks were clearly pointing to the ratings as they sold that paper.

The entire process hinged on the credibility of the rating agencies. Somehow, no one seemed to think that the default rates from "no-documentation" and "liar" loans would possibly be different. I am sure you can find a paragraph in the offering documents which will make that contention, at least obliquely. Lawyers are good at that stuff. But that is entirely beside the point.

A rate cut will not make a difference as to the credibility of the ratings, nor will it transform bad debts into good ones. But my view has been for a year that the economy is heading for a recession due to the housing market problems. Given the turmoil in the markets, a rate cut may be in the offing later this year. And given that lower rates will make mortgages cost less, that will help.

John Mauldin's stance above is similar to mine. I am not sure if the Federal Reserve will cut rates to bail out the mortgage sector, investment banks, and other speculators, but I had been expecting the Federal Reserve to cut rates due to a slowing economy.

Saturday, August 18, 2007 1 comments

Article on Tribune (TRB) merger

Bloomberg has a good summary on the current situation with Tribune.

Billionaire Sam Zell has a knack for buying low and selling high -- which is why his $8.2 billion takeover of Tribune Co. may return 35 percent to anyone who now buys the shares and 11 percent for anyone purchasing the bonds.

So you are looking at around 30% return in just under 6 months. A Lehman Brothers analyst supposedly thinks the chance of a close is only 50%, and has a price target of $5 if the deal falls.

Lehman Brothers Holdings Inc. said this week the deal has no better than a 50-50 chance of being completed as scheduled, and credit markets indicate a 57 percent probability of insolvency if it is.

I am sure the shareholders will vote for the deal and Sam Zell will be ok with the deal, but the question is with the financiers. Three big banks are supposed to raise debt and certain conditions have to be met:

For lenders to renege, adjusted earnings would have to plunge further than a 22 percent decline in the first half, Holden said.

I think sales will drop quite a bit but I really wonder if earnings will drop far enough to trigger a failure. It's definitely a risky call and if you are investing, you have to nail that call.

BTW, it's amazing how he can buy out Tribune, a company worth billions, for around $600 million in a few years. It is certainly out of favour and risky but if you had a lot of money, deals like this are what make you super-wealthy.

The shareholder vote is next Tuesday so will the stock move up if shareholders accept the deal? I'm thinking a 'yes' vote is already priced in so no point rushing.

I'll finish off with this funny comment about a big boy trade (LOL):

The risks to Tribune mean investors need to carefully weigh potential rewards before buying the stock or bonds, Simonton said. ``These are all big-boy trades.''

Friday, August 17, 2007 0 comments

Purchase: Takefuji (8564)

I placed a limit order to purchase Takefuji on the Tokyo Stock Exchange (symbol: 8564; PinkSheets: TAKAF). My broker, HSBC, is very slow to post transactions online so I'm not sure of exact purchase details. But I'm sure it went through given that the price dropped a lot more than my limit price. This is my first purchase on a foreign exchange (ignoring US exchanges (I'm in Canada)).

This is a long-term purchase that is more characteristic of a value investing purchase (very little speculation in this one). You can read my original investment evaluation analysis here but do note that numbers will be slightly out of date. Since I posted that analysis, the stock has dropped around 20% more. The forward P/E ratio is around 11 with the p/bv around 1 right now.

Purchase Price: Yen 3270
Investment Time Horizone: Long (2+ Years)

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Purchase: Harmony (HMY)... thoughts on gold

I purchased Harmony (HMY) this morning at US$9.11. Ok, I have to admit that this was a questionable move done without too much deep thinking. To make matters worse, the online website for CIBC World Markets (Canada) was very slow this morning so I didn't have time to track the price closely to see if I can pick the bottom.

Having said all that, I think I would have gone into gold at some point over the next couple of weeks. So it isn't as impulsive of a decision as it seems. I came across a link to this week's Donald Coxe conference call where he was expressing his bullishness for gold (thanks to some poster on the message board at for the URL link). If you have some time, check out Donald Coxe's comments. I personally don't like his convervative views (just like I'm sure he wouldn't like my liberal views :) ) but he is a thinker with insightful non-mainstream views. He has been very bullish on commodities over the years but now it looks like he likes gold. His view is that gold should do well since he expects the US$ to decline.

I had been thinking about gold stocks over the last few weeks but didn't really decide on a company. The main decision I had to make was whether to go with a junior or an established company. Gold bullion was also another choice--a safer choice--but I wanted higher returns. Gold equities haven't performed well relative to bullion in the last 2 years but historically that isn't the case. Theoretically, gold equities should outperform bullion. Equities have higher risk (management risk, fraud risk, discovery/failure risk, environmental issues, etc) so they should compensate shareholders more or else no one would invest in them. So I only thought about gold stocks and sort of ignored bullion.

I have had good success with producing juniors (I only look at juniors in production or close to production) in the past (Nevsun, Desert Sun Mining), and obviously the juniors have more leverage. But this time around I was thinking that juniors may be a bit risky. My concern was with the fact that the market may not be so enthusiastic about these companies if base metal juniors struggle (which I think they will if the economy slows as I expect). Furthermore, with the market starting to discount risky assets, such as subprime debt, junk bonds, emerging market stocks (hasn't happend yet), and so forth, junior miners may be discounted heavily by the market as well. Note that the market was accepting low returns for risky assets a few years ago so junior miners, just like junk bonds, performed exceptionally well. So I was leaning towards the mid-cap and large-cap gold producers.

The question that was running in my mind was whether to look at high-cost producers, which have far higher risk, or the low-cost ones. As I remarked in one of my prior posts, high-cost producers have higher leverage so the returns can be much higher. The way I look at it, there are two "types" of high-cost producers. Some have high costs because they have marginal assets; while others have high costs because cost of production is higher. The first category of producers tend to have ores with low gold density. Many of these companies either do not develop these assets into mines and simply wait (or spend their time on more exploration). The latter category tends to have decent ores by modern standards but their costs are high. Typically the problems are with high labour costs, deep mines (as opposed to the cheaper open-pit mining), high energy costs, or bad currency exchange effects.

I decided to go with the latter category of miners who have decent gold orebodies but higher production costs. The best area to find such companies is in South Africa, although some parts of Canada and Europe also have high costs. Some of the biggest gold companies in the world are South African and the ones I looked at were Goldfields (GFI) and Harmony (HMY). There are a lot of issues being faced South African producers:

  • Deep pit mines: A lot of South African companies are having to dig deeper and deeper to find more gold
  • Rand strength: The Rand has strengthened considerably versus the US$. Gold priced in Rand hasn't kept up.
  • Labour costs: Labour costs are increasing sharply due to government actions and stronger unions
  • High healthcare costs: Something like 30% of Harmony's employees are HIV positive for example.

A lot of investors will run away due to these issues but I think the stock price of HMY reflects a lot of the negativity. As well the stock got hammered when the CEO abruptly resigned, in a quarter where an expected profit was an actual loss. I can see the stock falling further if HMY doesn't turn its operations around. Harmony has been trying to turn around things for the last few years and most people thought it finally turned a corner only to see it posting a loss last quarter. But I'm hopeful. I know hope has no business when it comes to investing but if the gold price appreciates a bit then HMY should post a profit. Given that HMY is a high-cost producer, it should see huge increases in profits if gold actually goes up quite a bit. Some of negative issues also have more upside than downside. For example, labour costs are probably close to stabilizing and the Rand may not have much more room to appreciate even if the US$ index falls (I think the US$ will fall mostly against the Yen, not some currency like the Rand).

Purchase Price: US$9.11
Expected Investment Time Frame: short to medium (max 2 years)

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Random Thoughts for the Day: Friday Aug 17 2007

Well, I guess the wild week ends on a wild note with the Federal Reserve lowering the discount rate. Note that this a weaker tool in the Federal Reserve's arsenal, with a cut in the Federal Funds Rate being the last action that has the biggest impact on the economy and financial assets. Some analysts think the FedRes is not going to cut the Fed Funds Rate. I suspect they are trying to avoid that since that is inflationary.

This move was a surprise to me but it wasn't that out of the norm. The markets recouped some of their losses from yesterday but it wasn't really a strong rally. Most of the markets opened higher and then declined slowly through the day. The key things I observed today are:

  • The Yen carry-trade unwinding still seems to be ongoing. The Yen index weakened a bit today but it gave back hardly any of its gains from yesterday. But the US$ index declined today, and gold was up a little bit (not quite as much as I would have thought given the decline in the US$ and the FedRes lowering the discount rate). I'm sure some hedge funds, not to mention the so-called Japanese Housewives, would have taken massive losses on the Yen carry-trade this week. People will certainly be thinking hard about the carry-trade if things keep going as they have recently. Supposedly, this was the best week for the Yen since 1998.
  • The market rally was weak. Yes, it did go up but it started weakening as the day progressed. Unless some positive economic or corporate news come out, I think the markets will resume their downtrend.
  • Analysts still seem unsure if the Federal Funds Rate will be cut. The big debate seems to be about whether this is to save asset price declines or whether it is to avoid a credit squeeze. If it is the former, the FedRes will likely cut the Fed Funds Rate; but if it's the latter then the verdict is still out.

Needless to say, the next few weeks will be pivotal and we'll know how things play out. But, as investors, we need to anticipate what will happen. That's how we try to make money. I know pure value investors will disagree with that thinking but that's how I act. I am bullish on gold now (read my next blog post).

The way I have my portfolio now, it is almost like a market-neutral fund. It hardly moves much in either direction because it has few holdings and the TSX short counterbalances my (long) MRH. This isn't due to design but that's how it is right now. Given all the uncertainty in the markets, I would like to add more holdings for some diversification (but not diversification for diversification-sake). The problem is that I don't have much free money so I have to save as much as I can every few weeks.

Thursday, August 16, 2007 1 comments

Random Thoughts for the Day: Thursday Aug 17 2007

Well, today was a wild day in the markets. Many of the markets were down more than 2% during the day, with the higher-beta emerging market or commodity-sensitive ones down a lot more, but there was a massive rally near the end of the day and the losses were pared. S&P 500 even finished in the positive (just barely). Here is a chart of the S&P/TSX Composite which finished with a loss of -1.53% but was down around -4% during lunch.

(source: The Globe & Mail)

Almost everything sold off and ended up with losses. If it weren't for the big rally near the end, some sectors like materials and energy would have been down quite a bit. The S&P/TSX is close to negative, if it isn't negative already (same goes for the Dow and S&P500).

The most important thing to note is that there was a massive rally in the Yen:


This is an amazing appreciation for a currency in one day. Things like this just doesn't happen often so one should pay attention to it. I don't know if this is a permanent unwinding of the Yen carry-trade or not.

The verdict is still out on whether this is just a correction within a bull market or if this is the start of a bear market. Hard to say at this point but whatever it is, I am thinking of my next move. As I have remarked before, I will most likely buy ABN or TRB in the hope of profiting from the announced merger.

Wednesday, August 15, 2007 0 comments

P/E Values May Not Be Cheap: Graham & Dodd Way

One of the big question marks for those like me who think the markets are overvalued is the seemingly low P/E ratio on stocks. Right now the P/E on S&P 500 is around 16. This is not expensive so why be cautious (bearish)? Well, one view is given by Marc Faber, who implied that there isn't a valuation bubble but there is an earnings bubble. If the 'E' part of the equation is "bubbly" then the P/E ratio will be low. That is a view that can be proven in hindsight (we just don't know if earnings are sustainable or not). How about P/E ratios from a historical point of view?

I came across a very good article in the New York Times by David Leonhardt talking about measuring long-term P/E ratios. Graham & Dodd suggested that one should use a long-term P/E ratio to look at valuation. Instead of simply looking at one year's P/E ratio, a 10 year ratio would be better. Here is a chart of what the trailing 10 year P/E ratios produce:

(source: Remembering a Classic Investing Theory By DAVID LEONHARDT, Published: August 15, 2007)

If you look at the trailing 10 year P/E ratios, the valuations don't seem low.

Based on average profits over the last 10 years, the P/E ratio has been hovering around 27 recently. That’s higher than it has been at any other point over the last 130 years, save the great bubbles of the 1920s and the 1990s. The stock run-up of the 1990s was so big, in other words, that the market may still not have fully worked it off.
None of this means that a collapse is imminent, but it does imply that a correction is likely or that future returns are likely to be low.

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I'm Not the Only One Who Finds Mergers Attractive... Buffett's Dow Jones Stake

I have commented that announced mergers are some of the most attractive in my eyes these days. Given all the market volatility, an announced merger presents good return (5% to 10% for the reasonably safe ones) regardless of market direction. The only thing is that the deal needs to close.

I'm not comparing myself to the greatest investor of all time by any means but Warren Buffett just filed a report saying Berkshire Hathaway took a stake in Dow Jones. Recall that Buffett said he did not like investing in newspapers (they are glamour stocks trading at high valuations, similar to sports teams, fashion houses, etc) so this is purely an "arbitrage-type" situation. It isn't a true arbitrage because it isn't risk-free profits (that's the definition of arbitrage). There is no way to purely hedge your position here. In any case, Buffett was clearly confident that the deal will close.

Buffett has done a lot of "arbitrage-type" investments in the past. If I remember correctly, he did a lot in the 60's (don't recall if this was with his private firm or when he was working for Benjamin Graham). Also, anyone who thinks Buffett only invests in large-cap value stocks is grossly mistaken (I would recommend that they check out the young Buffett back in the 60's).

I'm looking into these situations seriously these days. I invested my mom's money in ABN-Amro (ABN), hoping to profit from that announced merger. I'm considering whether I should put my own free capital (don't have much) into ABN-Amro and then hopefully sell out by October (closing date) and switch into Tribune (TRB). I'm not sure if Tribune's stock will be trading so low by then. I'm leaning towards buying Tribune outright soon (if I think the market correction is going to stabilize). I wish I had more free money right now. I have some money but that's in my Yen-account and I don't want to swap out of that. I also have around 20% of the my portfolio in the S&P/TSX 60 2x short ETF (HXD.TO). If the TSX drop another 5%, I'll consider selling that short ETF and putting more into one of these "arbitrage-type" situations.

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Tuesday, August 14, 2007 0 comments

Two Important Currency Charts

I consider the following two charts to be some of the most important charts to watch. They are the currency charts of the US$ index and the Yen index.

If the stock market goes into a correction, I expect the Yen carry-trade to unwind. So that's something we should watch for.

If the US$ rallies during a correction, it likely means capital flight to safety. Contrary to some people's opinion, the US$ is still the safest currency around. A sharp rally in the US$ will likely result in corrections in emerging markets as well. Not only will capital fly away from the unsafe emerging markets to the safe US$-denominated assets, but an impetus will also be provided by the fact that returns in foreign markets in US$-terms will not be so attractive. The decline in the US$ in the last few years has meant that American investors had an incentive to shift capital to foreign markets.


DFC: Capital Injection

Delta Financial announced its earnings and mentioned that it received $70 million of additional capital.

"First, we obtained a $60.0 million financing facility from an affiliate of Angelo, Gordon & Co., a leading alternative asset management firm. The financing is collateralized by all of our currently existing securitization cashflow certificates. As part of the transaction, Angelo, Gordon & Co. will receive warrants to purchase 10.0 million shares of our Common Stock with an initial exercise price of $5.00 per share, expiring February 2009, subject to extension if we do not obtain stockholder approval for the warrant issuance within 90 days of the closing date. The fair value of the warrants issued will be amortized to interest expense as a non-cash yield adjustment over the life of the associated financing facility."

"At the same time, we have agreed to issue $10.0 million of convertible notes to funds managed by Mr. Mohnish Pabrai, one of our largest stockholders," Mr. Miller explained. "The notes are convertible into an aggregate of 2.0 million shares of our Common Stock, at a conversion price of $5.00 per share. The exercise of most of the warrants and the issuance of all of the shares upon conversion of the notes are both subject to shareholder approval, which we intend to pursue in the near future."
So basically a hedge fund and Mohnish Pabri provided capital in return for some warrants and convertibles priced at $5. This is a low risk investment for Pabri but nevertheless it shows his confidence in this company. DFC's price right now is $4.87 and has a market cap of around $115 million. So the dilution is huge but necessary.

The question is how long DFC can survive on this capital. I'm thinking that DFC has 6 months to turn things around. If the situation is the same (or worse) by then, it's not going to be a pretty sight.


Another merger opportunity: the high-risk Tribune (TRB) buyout

I don't know if it's greed or if it is the best area right now but I'm looking more and more at announced takeovers. The experts consider it arbitrage but since I don't short it is only speculation (on a side note, even having the ability to short won't help in the cases I'm looking at because it is next to impossible to hedge some of the cash deals with questionable debt offerings). Takeovers look attractive to me because:

  1. Market is selling off so even "safe" deals are being indiscriminately being sold (to raise capital I assume). It is hard to find the present situations at other times of the market cycle. One can pick up almost 10% from a "somewhat safe" announced deal.
  2. If the market has entered a correction (one is never sure--I have been wrong for at least an year on some key calls) then picking up 5% to 10% on reasonably "safe" deals is amazing. Yes, it is speculation but it is a different kind of speculation from betting on, say, oil right now or whatever.
  3. Nothing else looks attractive to me. Since I don't short, and I'm a newbie, I don't feel comfortable with many others that I'm tracking. Even for securities that I feel are undervalued (say Takefuji (TSE: 8564) for example), I think the prices can drop. This is why I'm not a pure value investor (or even close to one). Value investors try not to predict these bottoms but I do.

Anyway, of many of the risky deals, the one I find attractive right now is the Tribune (TRB) deal. Unlike others trading way below their announced takeover price, this isn't in a questionable industry (like mortgage lenders) but it is certainly weakening and out of favour. For anyone not familiar, Tribune has announced that it is selling itself to Sam Zell. Get the full details here. There are multiple stages involved in the takeover, with complicated actions being performed along the way, but for my purpose I only care the last stage. Just to quickly summarize:

TRB takeover price: US$34
Shareholder vote: August 21, 2007
Closing Date: 4th quarter of 2007 (let's assume December 31st, 2007; note that it can be delayed)

Current price: $25.51

Simple Potential Return (excluding transaction costs, dividends, etc): 33.3%

Obviously the market thinks there is high risk to this deal given the potential 33% return.

What's the downside?

I don't know much about this company so it's hard to say how far the stock can drop. I follow newspapers and paper forestry stocks and I know newspapers are suffering with declines in circulation/sales/etc. So the company will likely post weak earnings numbers in the future. But most of the negativity is likely priced into Tribune (just like with most other newspaper stocks). I would say the downside is probably around -10%.

Furthermore, if you look at the long-term chart below, you will see that the stock is trading at a 52wk low.

It is unusual for takeover targets to be trading at such lows. I'm interpreting this to mean that the stock is already near a short-term bottom. Sure, it can drop a lot more (due to negative fundamentals) but it is cheap for a takeover target.

Is this deal going to go through?

I think so. I only know a little about Sam Zell but supposedly he is a contrarian investor. I doubt he will pull out even if earnings weaken before the deal closes. The risk clearly lies with the banks and other financiers providing debt financing. The market is clearly thinking that one or more banks may run into problems providing capital. Obviously this is a guess but I think the financing will come through.

I think the worst that will happen is that the takeover price may be negotiated down (but I think the price will still be much higher than what it is trading at right now) and/or the deal closing may be delayed. Since I'm just a small investor who really can wait, a delayed closing is fine with me (as long as it is only a few months and doesn't take a full year or something).

As with my comments regarding the other merger deals in prior posts, if I don't find anything else attractive, I may take a position in this. I am still leaning towards taking a position in the ABN-Amro (ABN) deal and then possibly consider this later. If I feel TRB's stock price will run up before the ABN-Amro deal then I might purchase TRB.

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Monday, August 13, 2007 0 comments

John Hussman: The Fed Didn't Bail Out Anyone

John Hussman has a good write-up talking about recent liquidity injections into the market. Contrary some people's opinion, the Federal Reserve did not bail out anyone. All they provided was very-short-term loans that need to be repaid. Good analysis of the situation by John Hussman.

Here is his view on the present market:

I noted a few weeks ago that increasing volatility at 5-10 minute intervals tends to be a precursor to significant market weakness. Indeed, a variety of systems, both in the physical world, and in networks, display a “signature” prior to chaotic instability, similar to how tremors precede earthquakes. These signatures are sometimes measured in terms of very arcane features, but in the stock market, you can observe it prior to other historical panics and crashes as a combination of surging trading volume coupled with rising volatility at increasingly short frequencies (so that the time dimension “collapses,” and you begin to observe fluctuations in 10-minute, 1-hour and 1-day periods that would normally take several days, weeks, or even months).

It is of some concern that we are seeing this sort of behavior here, but this does not mean that a crash or further panic should be expected. There are certainly some positive factors, or at least factors that investors believe are positive. For example, Treasury yields are falling (albeit because Treasuries are being sought as safe havens), and stocks look cheap to investors who believe in misleading measures like forward operating earnings, and aren't aware that the historical norms they are applying are actually based on trailing net earnings and normal profit margins. While I believe that these perceived “positives” are largely empty arguments in terms of valuation, we have to allow for the fact that enough investors believe them to potentially act on them.

So, he thinks there may be some signs of a change in market direction but we cannot be sure and we shouldn't expect it.

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Sunday, August 12, 2007 0 comments

Comments from a superbear: Marc Faber

Here are a couple of good interviews with Marc Faber. Both interviews are pretty similar so if you want to check out only one interview, listen to the Bloomberg interview.

Marc Faber Interview at Business News Network (Canada) [scroll to around 1/3 of the way through]

Marc Faber interview with Bloomberg

In case you have never heard of Marc Faber, he has been superbearish on the markets for a while now. He has had a big influence on me, not so much with my investing methodologies but with his contrarian off-the-wall thinking and worldly views.

If you want to hear the bear case, check the interviews above. If you don't have time, here are some key insights I picked up from his comments. Note that I'm paraphrasing a lot of his points and adding my own comments.

Insights from Marc Faber (As of August 2007)

Start of a bear market

Marc Faber thinks this may be the start of a bear market. He points to some technical signs, such as the fact that 400+ stocks were hitting yearly lows even though the Dow was hitting its high back in July. He says that near the end of a bull market, the leadership thins and only a few big-name stocks keep pushing the markets up while the rest start showing weakness.

I share the opinion of Faber that a bear market can be short. A 25% or 30% quick drop with recovery fits my view of a bear market. In contrast, some people treat a bear market as something that is drawn out and lasts for years. That is not necessarily the case. A 33% decline, for example, wipes out 50% of gains so that is sufficient to constitute a bear market in my opinion. Furthermore, if the broad markets drop 30%, then there are sectors (usually the wildly overvalued ones like mortgage companies right now) that will drop much more. Examples of short, quick, declines are 1987 and 1997, where the market dropped something like 40% and 30%, respectively.

Valuations are not what they seem

Marc Faber points out of a couple of reasons why valuations may not be as cheap as they seem. The S&P500 P/E is something like 16 and that is cited by many bulls as a reason for not being bearish. Marc Faber points out that:

  • A big chunk of the index is made up of energy stocks and financial stocks--two sectors that have low P/Es. Without these, the P/E is closer to (probably) 18 or so.
  • We may not have a valuation bubble but we may have an earnings bubble. In 2000, we had a valuation bubble but right now earnings may be too high. I have felt that corporate earnings are unsustainable (Buffett also commented on that, pointing out that corporate earnings as a percentage of GDP is near all-time high). If earnings are too high, then the cheap-looking P/E ratios are misleading.
Economy may do well but stock market may not

Contrary to what many investors seem to think, it is quite possible for the economy to do well while the stock market does not. I have understood this point ever since I came across this report from Crestmont Research (I highly recommend that you visit Crestmont Research and check out their free reports, most of which are insightful on various topics). Marc Faber pointed out that the Middle Eastern stocks markets peaked in late 2005/early 2006 yet their economies have been humming. There is still lots of oil money sloshing around, lots of construction projects, good jobs, etc. Yet the Middle Eastern stocks are down.

Emerging markets and commodities vulnerable

This is a view I have felt for a long time. Emerging markets are vulnerable to big corrections. Faber remarks that it is possible for the money that has flowed into these countries to fly away any minute. A lot of EM and commodities bulls don't realize how much foreign money has propped up many of these equity markets. Along with EM, commodities are also vulnerable.

Sign of the end of a bear market

One sign that will make Faber feel comfortable that we are near the end of a bear market, and that valuations are attractive, is if Apple (AAPL), RIMM (RIMM) and Google (GOOG) fall 30% or so. He considers these to be some of the leaders and I imagine he considers such a big correction to mean that speculation has left the market.

Unlike Faber, who is partial to commodities, I personally think a correction in some of the commodity high-flyers, such as ExxonMobil (XOM), Valero (VL), etc, is a sign of an end.

Will the Federal Reserve cut rates?

Faber doesn't take a strong position on whether the Federal Reserve will cut rates to stem a collapse in Wall Street banks (he hates central banks--most Austrian Economists do). He thinks they may not be able to. He points out that when the FedRes cut rates back in 1997 during the LTCM crisis, commodities were in a secular decline. In contrast, commodities are high right now, and a rate cut will almost likely lead to inflation. I completely agree with this view. I'm in the deflationist camp who thinks inflation is not an issue, but if rates are cut, it will likely lead to inflation. If the FedRes cut rates by 2%, I am pretty sure you are going to see inflation spike like the 70's. (As a side note, do note that cutting rates by 0.25% isn't going to do anything. When Cramer screams for help for his Wall Street frinds, he is really calling for 1%+ cut.) If the FedRes cuts interest rates, gold is probably a good place to be.

On a side note, the FedRes has one more tool before they cut the Federal Funds Rate: they can lower the discount rate. Basically from what I understand, the FedRes has 4 tools: usage of words to influence market psychology, inject liquidity, lower the discount rate, and lower the federal funds rate. Lowering the federal funds rate is the most significant and has repercussions throughout the economy.

What is he bullish on?

As Marc Faber points out, if you are bearish, you need to be bullish on something else. In his case, he says he is bearish on the broad US markets and bullish, in particular, of cash. In addition to cash, he likes 2yr US treasuries. He thinks high-quality European bonds are ok too. He is also bullish on the following...

He, as always, likes gold (I personally am not sold on gold yet because hedge funds and others may sell gold during a liquidity crunch). He, like most gold bulls, like gold because they think central banks will print a lot of money during a crisis. Although that is possible, it is not a certainty in my eyes.

If central banks do not cut rates (read the point above), he is bullish on US$ (if FedRes cuts rates, US$ may fall precipitously so you wouldn't want to long). This is a totally contrarian stance. Most people out there are bearish on the US$. There isn't a week that goes by without articles talking about US$'s demise (the latest last week was China's financial "nuclear weapon" to be unleashed based on potential US government policies against it). I have been bullish on US$ for over an year and have been wrong. However, I'm sticking with it.

He thinks real estate in some parts of Asia are still cheap based on future demographics. He mentions that real estate in cities like Ho Chi Minh City and Manila are cheap. I think small investors like us can rule these out since we don't have enough information or the capability to invest directly.

He reiterated his past view that farmland looks cheap. I'm not sure what region of the world he is talking about. If I recall, he mentioned farmland in Argentina in one of the Barron's roundtables but not sure what he feels about farmland in USA, Canada, or places like that. This is another area that small investors like me will have a hard time accessing.

So to recap, here are the areas he is bullish on:
  • US$ (if rates not cut)
  • 2 yr US Treasury bonds
  • High-quality European bonds (I assume denominated in the local currency (eg. Euros, Pounds Sterling, etc) but not sure)
  • Gold
  • Real estate in select Asian areas (eg. Manila, Ho Chi Minh City)
  • Farmland

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Saturday, August 11, 2007 6 comments

Good website of announced M&A

I found a good website listing all the announced M&A from a posting by the user, MergerArb, on the WSJ blog. Obviously one needs to double-check the numbers that are posted and dig into the details to see the risk but it's a good site. You can find the M&A merger arbitrage site here.

According to the numbers from that site, the top 10 potential profits as of today would be one of the following (note: these are not annualized profits):


Note that the list doesn't seem to include announced foreign deals (such as the BCE or ABN-Amro deal) and the risk in these are very high. The risk in the BCE and ABM-Amro deal are likely low IMO but the ones above are very high (I can see many of them not going through).


Another Merger To Consider

Thinking about BCE led me to consider another proposed takeover: the ABN-Amro takeover. There are two competing offers, one from a consortium of RBS, Fortis, and Sander (RFS), and another from Barclays. Similar to the BCE situation, the market is thinking that Fortis may not be able to raise financing via debt. This is actually an attractive deal although although with much higher risk than the BCE deal in my opinion. I have laid out the information I can gather below (I can't guarantee 100% accuarcy with some figures so click here for actual information about the takeover from ABN-Amro). Also note that I am only taking about the offer for the ABN-Amro ADS trading on NYSE (the local shares trading in Netherlands have different conditions).

Key Details

RFS: EUR 35.60 + 0.296 newly issued ordinary shares of RBS
Closing date of RFS offer: October 5, 2007

Barclays: 0.5325 Barclays ADSs + EUR 13.151
Closing date of Barclays offer: October 4, 2007

Vote by ABN-Amro shareholders: September 20, 2007

Euro/US$ exchange rate today: 1.3692
Sterling/US$ exchange rate today: 2.0236
Stock price - RBS on LSE: 562 (pence)
Stock price - Barclays on NYSE: 52.34 (US$)
Stock price - ABN on NYSE: 46.80 (US$)

Potential Return

Value of RFS deal today = 35.60*1.3692 + 0.296*5.62*2.0236 = US$ 52.10982
Value of BCS deal today = 0.5325*52.34 + 13.151*1.3692 = US$ 45.8774

RFS simple return (excluding transaction costs, dividends, etc) = 11.3%
BCS simple return (excluding transaction costs, dividends, etc) = -2%

So is it worth it? It certainly looks attractive to me. I think a potential 11% in 2 months isn't bad, with a downside risk of -2% (it can be worse if neither deal goes through but I think that's unlikely). This transaction has way more complications than the BCE one. There is some exchange rate risk along with a risk of decline in the stock price of RBS (but note that the ADS is trading below the cash value of the RFS offer). For investors like me, who are in Canada, the Canadian $ exchange rate fluctuation is another issue.

Overall, I'm going to be keeping a close eye on this one. If I don't find anything else I like in the next 2 weeks, I'll buy the ABN-Amro ADS.

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Friday, August 10, 2007 0 comments

BCE: Worth Considering

I am considering whether to invest in BCE (ticker: BCE). A takeover deal has been announced for C$42.75 (note: I'm looking at the Canadian info; the US numbers will be slightly different) but the stock is trading right now at $C38.84. The deal is expected to close early next year (Q1 2008), while shareholder vote will happen on September 21, 2007.

Obviously the market is concerned that the deal won't go through since it involves raising a lot of debt. I think the chance of the deal failing is pretty low (BCE is a pretty solid telecom in Canada and if bond investors would want to finance anything, it'll be something like Bell Canada). You are basically looking at around 10% return in 9 months (excluding transaction costs and any potential dividends). The downside is that the deal won't go through and the stock price falls down back to whatever it was before the deal. There is also a risk that the deal may be delayed if financing can't be raised in time (I view this as unlikely).

If I had a lot of money, I would consider taking a position but I think I can find better opportunities (especially if this market keeps selling off pricing securities lower) so I'm going to pass for now. If I don't find anything in a few months, I'll revisit this strategy.

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Story on those pink sheet spam e-mail

The Globe & Mail has an interesting article on those spam e-mail touting stocks. Supposedly, the greatest promotion of a stock occurred recently with billions of e-mail being sent.

Over the past two days, more than a half a billion e-mails have landed in inboxes around the world touting obscure little Prime Time Group Inc. of Branson, Mo., according to transmissions tracked by international Internet security consulting firm Sophos Inc. That makes Prime Time the subject of perhaps the most widespread Internet e-mail stock-pumping scam in history.
The sad thing is that people actually fall for this. I have started to look at OTC, Pink Sheet, and TSX Venture stocks lately (I used to avoid them before) and this is something one needs to keep in mind. If you invest based on some fundamentals and check a long term chart of a stock, one should be able to weed out the bogus spikes. It also helps if one tracks these microcaps for months before actually purchasing them. That way, you can get a handle on the trading pattern and know if something is artificially high at the present moment.

Thursday, August 9, 2007 0 comments

Delta Financial (DFC) Delayed Financials Update

Delta Financial (DFC) filed a report with the SEC saying why their earnings were delayed:

Delta Financial Corporation (the “Registrant”) was unable to complete and timely file its Form 10-Q (the “Form 10-Q”) for the three months ended June 30, 2007 without unreasonable effort or expense. While completing the proposed filing, the Company began to negotiate one or more arrangements to add new sources of capital, and the results of these negotiations would directly and materially impact the disclosures and financial condition of the Company to be set forth in the Form 10-Q. The Registrant expects to file the Form 10-Q within 5 days of the date hereof.

So it looks like they were having problems raising capital for their loans. This was my guess and it remains to be seen what the impact of this will be. Since DFC, like most mortgage lenders, has very low equity relative to debt, issuing shares is very expensive--especially at the current depressed prices. I don't think the company is anywhere near bankruptcy but it needs to find sources of capital.

The SEC filing also gave their earnings for the recent quarter. The earnings declined substantially and I'm not sure what the market was expecting.
The Company’s net income for the three months ended June 30, 2007 was $777,000, or $0.03 per share basic and $0.03 per share diluted, compared to net income of $7.2 million, or $0.32 per share basic and $0.31 per share diluted, for the three months ended June 30, 2006. The Company’s net income for the six months ended June 30, 2007 was $5.7 million, or $0.24 per share basic and $0.23 per share diluted, compared to net income of $13.8 million, or $0.64 per share basic and $0.61 per share diluted, for the six months ended June 30, 2006.

The company says it will file a full report within 5 days. I think a lot of the bad earnings news is already priced into the stock. The real question is the liquidity issue. Where are they going to find capital? Do they have to dilute shareholders? Going to be interesting tomorrow. I can see the stock going either way.


Random Thoughts for the Day

When it comes to some ideas and thoughts running in my head, I'm not sure if I should post seperate, longer, blog entries or lump them into one post. For now, I'm going to post once a day with seemingly random thoughts. I'll mention whatever I find insightful. You won't find general market commentary here, unless I find it worthwhile (other sites can do a better job of providing the general picture).

Market-neutral Hedge Funds Failing

Another big sell-off today but it came off big rallies in the last two days. As is typically the case with these broad-market sell-offs, almost everything is in the red except the Japanese Yen. I have maintained for a while that gold (including bulliion) is not safe during a market sell-off. Today is an example of gold selling off sharply along with the broad markets. Historically gold has had negative correlation with equities but that hasn't been the case in the last few years. The central banks in Europe and Canada also injected liquidity into the markets today.

Anyway, the point I was going to make is that market-neutral hedge funds have been running into problems. I don't know much about hedge funds but these funds are supposed to go long as well as short securities at the same time. In essence they are supposed to do well during up, as well as down, markets. Obviously this hasn't been the case. This is surprising to me because the present markets are supposed to be their strength. They underperform during bull markets (they do) and they underperform during bear markets (short funds or bond funds can theoretically beat them) so what's the point in anyone using them?

Given all the heavy swings in the market (1%-2% changes almost every other day), I think we may be at an inflection point. This could be the battle between the bears and bulls to decide whether we will enter a bear market. I'm bearish and think we will enter a bear market.

Japanese Stocks

I finally set up a Yen account and am ready to buy Takefuji (TSE: 8564). I have an interesting situation on my hands. If we enter a bear market in the US, the Yen will likely appreciate while the Japanese economy and stocks do poorly. I wonder if the Yen appreciation will off-set the Japanese equity market problems. I still like Takefuji regardless but I am curious to see how this plays out.

I mention this because currencies can sometimes move big. The Canadian dollar moved up sharply against the US$ this year. I have most of my holdings in US$-denominated stocks so I am actually negative for the year in C$ terms even though I'm marginally positive in US$ terms. I wonder if I'm going to get the opposite case with the Japanese stock.

Should I add to Delta Financial (DFC)?

DFC has been very volatile lately (just like all mortgage lenders). I am still not sure what is going to happen. There is a possibility of this company going bankrupt but it's all murky right now. I'm not sure what management is doing right now (no press releases after delaying the earnings call). The stock dropped around 40% today (from yesterday's closing price, which was already a 40% drop from peak) and then recovered all of it (you can see how volatile this stock is).

My guess is that DFC is facing margin calls. I suspect that management is trying to secure sources of lending. Some posters on some message boards speculate that DFC has 6 months of capital if the sources dried up. If that is correct then I suspect that DFC is nowhere near bankruptcy. This is probably why management did not say anything. They probably want more time to resolve these matters. If DFC is almost bankrupt, I think management would have announced their sourcing difficulties and/or halted the stock.

As crazy as this may sound, I'm thinking of adding to DFC. Or should I wait? My position right now is way too small (2% of portfolio) so it will have no meaningful impact on my portfolio. There is no point holding such a small position IMO. I need to increase it or I shouldn't have even taken such a small position. I can also wait until we hear what management has to say and then increase the position (since the thesis of the investment is that this will be a survivor, and this isn't really a bet on trying to pick a bottom).

I wonder what Mohnish Pabri is thinking? Is this his Berkshire Hathaway (recall how Buffett's Berkshire Hathaway, the original textile mill, was a disaster)? Does he have to take an active role in this company? Or is Pabri buying through all this turmoil and uncertainty? Someone has been scooping up the shares today (amazing that DFC finished +2.74% when there was a big sell-off in the markets).

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Wednesday, August 8, 2007 2 comments

Purchase: DFC; Crisis at Delta Financial Corporation (DFC)?

I had been tracking Delta Financial Corporation (DFC) for a few months now. Delta dropped around 40% today after delaying their earnings call. The way Delta Financial handled the situation seems bizarre. They didn't even release a formal press release, and instead just posted a brief note saying they are delaying the earnings call just before the earnings announcement before market open. The following analysts comments pretty much captures the shareholder's thoughts I imagine:

Richard Eckert, who follows the mortgage-lending industry for Roth Capital Partners in Los Angeles, said the postponement came as a major surprise."I'm wondering what they know today that they didn't know yesterday or two days ago," Eckert said. "If they were planning to postpone the earnings report, why didn't they issue a press release? Why wait until this morning? Why leave it for people to find out by themselves?"

(source: Delta Financial, LI subprime lender, puts off earnings report, stock hammered By James Bernstein, 5:57 PM EDT, August 8, 2007,

The unprofessional nature of the situation can mean that there is fraud or something sinister; or something happened between yesterday and today. I like to think it is the latter. It is quite possible that Delta got margin calls on their warehouse loans this morning (or late yesterday). Some companies have been unable to meet these margin calls and have had to declare bankruptcy. Hopefully that isn't the case with Delta. One thing to note is that, like most of the small-cap and mid-cap lenders, liquidity is very low at Delta (there is hardly any cash on the books).

In any case, I decided to take a very small speculative position in DFC @ $5.50. The stock is already down 20% but it can move in either direction quickly. This is the type of position that can go to zero or go up 100% very quickly. It's totally dependent on news and credit market conditions. I am wondering whether I should add to the position. It's definitely very risky but has the market oversold the danger?

Why Pick Delta Financial?

I am bearish on real estate but I always felt that some of the beaten-down stocks are worth investigating. For instance, I think one might be able to pick up Owen's Corning (OC; OCWAZ.PK) or USG (USG) at attractive prices when housing slows down. The companies that are most interesting, while also being one of the riskiest areas in all of investing right now, are the mortgage lenders. Almost 50 lenders, not all of them large or publicly listed, have either gone bankrupt or sold themselves off during a crisis. On top of all the credit tightening in CDOs and ABSes, the lenders have complicated financials that are difficult to understand (at least for me). One can never tell what the booked profit of these lenders really mean, or what the true value of assets on their balance sheet. But all these issues also mean big profit potential. It is often profitable to pick the last man standing. I'm thinking that Delta can gain market share while other lenders fall.

Here are some reasons I like DFC...

Most of DFC's loans (unless management changed their strategy recently) have been mostly in the fixed-interest mortage area. These are safer than subprime and defaults shouldn't be that bad. DFC can still run into problems if the credit market locks up (as it seems to have lately) but the problems will be much easier than competitors who are all over the sub-prime market.

DFC has also avoided California and Florida for the most part. These two have some of the most overvalued real estate in USA so I would want to avoid these states for the time being.

DFC, although small, has been in the business for many years so it isn't quite one of those fly-by-the-night mortgage lenders. Management seems competent and owns a big chunk of the company.

Lastly, Mohnish Pabri, a value investor with a good albeit short track record, has a big stake. This in and of itself means nothing but it does give some confidence. Monish has written up some articles (let me know if you want me to link to those articles).

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Leverage with high-cost gold producers

One of the most counter-intuitive things with gold mining companies is that, if you are bullish on the price of gold, high-cost producers can potentially result in greater increases in profits. High-cost producer leverage is somewhat similar to debt leverage for a typical business.

The spreadsheet below shows an example of a high-cost producer (I picked Harmony's 2007 cash cost estimate from HSBC) versus a low-cost producer (Goldcorp's 2007 estimated cash costs). I am simply picking 1 million ounces of production (that's not the actual production by these companies).

When gold goes from $600 to $700, it increases by 16.7%. GG's profit increases by 27.3%, while HMY's profit increases by 45.9%. Similarly from $700 to $800, gold increases by 14.3%, while GG is 21.5% and HMY is 31.4%.

So, for the same amount of increase in the gold price, the profit on the high cost producer increases much more than with a low cost producer. The low cost producer will still make a higher gross profit for all gold prices. But the increases (or decreases if gold dropped) will be far larger for the high-cost producer.

But high-cost producers are no free lunch. If the gold price declines or doesn't go up (if the price doesn't go up, I would assume that the market has priced in the current price into the stock price), they will suffer much more (just like how companies with higher debt suffer more if sales decline).

So, low cost miners are the safe ones. If gold does not rise or goes flat, they will do better. But if you are superbullish on gold or are a speculator then high-cost producers should yield greater results.

If someone is looking for high-cost producers, one needs to look no further than the South African gold producers. These companies tend to have high labour costs, extremely deep mines (open-pit or shallow shafts have lower costs), and low grades (this depends though). Another area to look for high-cost producers are junior production companies with marginal assets.

I am not bullish on the gold sector right now but I've been looking at Harmony (HMY) since it has sold off lately (CEO resigned; future guidance lowered; higher than expected costs). It is a large-cap (5th largest gold producer in the world) so it isn't going to move as much as the juniors but there is no exploration risk.

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Tuesday, August 7, 2007 0 comments

Past Historical Evaluation of My Investments

I decided to evaluate my investments and to see how I have evolved. I am a newbie and only started investing a few years ago. My record has been satisfactory in that period (nothing great, but not horrible either). My returns in 2004, 2005, 2006, and 2007 YTD are: 5%, 15%, 30%, -12% YTD. This year is turning out to be a disaster (mostly because the Canadian $ appreciated strongly against the US$ and most of my holdings are in US$; and because my short of the TSX has not gone well) but the verdict is still out.

I started within a bull market so the returns are higher than what I would expect. Also, my portfolio is tiny (basically started with $0 so small positive returns have had a big effect). The tough part is yet to come as we enter, what I think will be, a bear market. After all, everyone is a genius during a bull market...

My strategies have changed over the years. Here is how my strategies have changed:

Less speculation now

Before I was more into speculative stuff--although not as speculative as what a typical 'speculator' or 'trader' would do. Nowadays, I am more into value investing (I still speculate, especially on turnaround situations or potential takeovers, but not as much). Since I'm a newbie, I think everything I do is a speculation to a large degree.

Almost entirely contrarian investing now

I used to be heavily into a strategy called sector rotation but have shifted over to contrarian-value investing. Sector rotation entails trying to pick what sectors one thinks will outperform. I used to be bullish on gold and oil&gas sectors, among others, a few years but turned bearish (very early it seems). I still think of sector performance--more so than what a value investor would do--but I approach it as a secondary criteria after picking a stock. In the past, it would be the opposite (i.e. I would pick the sector and then look for a stock within that sector).

I was still into contrarian investing before (it's my personality so it fits me) but now it is my main strategy.

More into smallcaps and microcaps

I used to look at large-caps and other so-called "safe" investments in the past. There was a time when I was scared of Pink Sheet, OTC, and TSX Venture (Canada) stocks. Now I actually don't mind investing in them. I really haven't done that yet but that's one area I look at these days. I shifted to the smallcaps and microcaps because the large-caps are more efficiently priced. Also, since I follow more of a value investing style, I think I am more comfortable with these stocks. For example, I generally only consider stocks that are trading 'net-net' (i.e. current assets > total liabilities) or are way below book value.

More into foreign stocks

This isn't anything special (I would have done this anyway) but I look at the whole world now. Before I mainly looked at foreign stocks listed on the NYSE or NASDAQ but now I am willing to consider buying stocks on foreign exchanges. It's too expensive for small investors to buy directly on foreign exchanges (commissions are high, taxes can be higher) but as my portfolio gets larger, this becomes more of an option. Since getting information in English is not easy, I have only looked at British, Japanese, and South African companies so far. I haven't invested in any of them yet but my feeling is that I'm going to go big into Japan. I think Japan may be ready to rise from its long deflation.

Monday, August 6, 2007 0 comments

Japanese Retail Investors & the Yen Carry-Trade

I came across a two-week old article from by Daniel Harrison talking about the Yen carry-trade. Apparently so-called "Japanese housewives" (BTW, this does not necessarily refer to stay-at-home women; It is a general term applied to retail investors it seems) are betting on foreign currencies and sectors like gold. They seem to be moving into the South African Rand, pushing it up and hurting export-oriented goldminers such as Harmony (HMY) and Gold Fields (GFI). Net income is down 50% in some of these companies because the Rand has appreciated much more than their their sales in US$.

I have always known most of what was said in the article but I didn't realize how big the Yen carry-trade speculation was. It seems like the speculation on currencies has taken on some bubble-like proportions:

In Japan, the carry trade is reminiscent of the dot-com bubble in 2000, he explains, in which foreign-exchange speculators include Japanese housewives, cab drivers and hairdressers. "This decline in the value of the yen has become some kind of speculative bear market," he says. "There's a bubble characteristic to it. In ordinary bookshops in Japan, there are books on options and swaps. People are beginning to take advice from cab drivers."

The above situation, assuming it is true and widespread, means that one may be able to benefit by going contrarian by betting on the Yen. I am bullish on the Yen, and have opened up a brokerage account denominated in Yen (unfortuately you earn no interest on the account since the rate is so low but I'll be using this to buy stocks anyway). As for what can reverse the carry-trade:

Currency traders say the catalyst that may begin to ease the bearish yen bubble would be positive CPI figures in Japan, although consensus is that this won't happen for at least another two quarters, despite recent strength in Japanese retail numbers.

Still, others, including Sean Darby, head of Asia Strategy for Nomura, are skeptical about the strength of the yen carry trade. "We see an increased risk that the carry trade has once again overwhelmed financial assets," he writes in a research report issued last week to Nomura's clients. "As we have pointed out before, the carry trade remains at risk from a change in overall capital flows induced by a bout of risk aversion."

My view is similar to the above. Namely, I think the Yen carry-trade will unwind if there is a market correction. If you are bearish on the markets, it may be profitable to go long with the Yen or Yen-denominated assets. If one is looking at Yen-denominated stocks, make sure that the companies aren't export-oriented or else their sales can decline due to Yen strength (eg. companies like Toyota and Sony, not that I would consider them right now, are probably not safe).

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Saturday, August 4, 2007 0 comments

Credit problems & other weekly thoughts

Credit Problems Impacting the Markets

Finally the yields on low-quality bonds are rising. A lot of peole like me have felt that the yields were too low and didn't price risk properly. Bear Stearns, one of the 5 big Wall Street investment banks, is facing a series of problems due to the re-pricing of mortgage debt such as CDOs. Bear Stearns seems highly vulnerable since a big chunk of its dealings seem to be in the mortgage securities. The stock (ticker: BSC) is down more than 30% in the last few months and may drop more if further problems are revealed.

The real question is who else is impacted by these problems. The Economist has a good article on the winners and losers in the credit meltdown. It looks like a lot of banks may be vulnerable to some losses due to bridge loans they are holding (bridge loans are temporary loans that banks loan out while trying to sell debt to investors--if they can't issue debt then the banks are left holding the bag). I wonder if any Canadian banks are going to have any surprises. There have been a whole hoard of takeover deals over the year and some of them may run into problems if the credit markets remain tight.

Sowood Capital Losses Similar to LTCM

Sowood Capital is a hedge fund that made some bets--obviously poor ones in hindsight--on the mortgage market and lost big. Its capital was almost wiped out and it sold its funds at depressed prices to the much-larger Citadel hedge fund. What is interesting to me is that I see a subtle similarity between this blow-up and LTCM (Long Term Capital Management).

LTCM's strategies were correct but they didn't have enough time to weather the storm. Well after LTCM went bankrupt, one could verify that their positions were profitable. It's just too bad that LTCM couldn't handle the temporary move where the position went totally against them. Sowood Capital's strategy seems to have followed a similar path.

Here is what Sowood says their strategy was (source: MarketWatch article dated August 3, 2007):

Sowood had built positions in the senior debt and bank loans of companies. Those stakes were cushioned because these companies had other debt that ranked lower in their capital structure, Larson explained.

In many cases, Sowood shorted, or bet against, the subordinated debt and the equity of these companies. The firm was hoping that if the market declined and credit spreads widened on the senior debt, that widening would be much more pronounced for the lower-quality debt and would be accompanied by a drop in the companies' shares, Larson said.

"We saw relatively strong balance sheets, little to no chance of loss even in default, no near-term liquidity pressures, and no fundamental reason to expect extraordinary widening in those corporate credit spreads," he explained.

What I bolded above was the fund's strategy. It is something that I would expect to happen as well. Obviously it never happened in time:

However, in June spreads widened sharply on senior corporate debt, but the accompanying moves in subordinated credit and equities that were expected by Sowood didn't happen. The firm's hedge funds lost 5% that month.

That pretty much was the beginning of the end of Sowood Capital. Things just kept getting worse and the fund was doomed. In my opinion, the strategy is plausible. I think the yields on the lower quality debt would have gone up eventually. However, the fund obviously didn't have enough liquidity or a long enough time frame to simply wait. LTCM couldn't wait and neither could Sowood Capital. That pretty much sealed their fate. The ability to sit on a losing position, as many value and contrarian investors can, is a powerful advantage for the small investor--psychologically it's difficult though.

Just like the Russian default was the anamoly that did LTCM in, Sowood's culprit seems to have been forced selling of high quality positions by some hedge funds:

Larson didn't say why he thought markets acted in this way. However, several other hedge funds have been under pressure to raise cash in recent weeks. In weak markets, managers sometimes sell their highest-quality assets first because they can get better prices. If lots of people do that at the same time, that can knock the prices of high-quality assets more than lower-quality securities.

Another thing to learn from this debacle is that a strategy can be profitable early on and then fail spectacularly. In this case, it looks like Sowood had a 16% return in 12 months ending June. This is a lesson that most investors will learn in their lives. What seems to be working ends up being completely disasterous!

Jim Cramer Not a Happy Fellow

It looks like Jim Cramer, the popular commentator, blew a fuse. He seems to want the Federal Reserve to bail out his friends. I don't think the Federal Reserve should cut rates just to help out all these overleveraged individuals, whether they are hedge funds, investment banks, or house buyers. If the Federal Reserve is to cut rates, they should do so if the unemployment situation worsens while inflation remains low. Otherwise, they will a bad precedent and allow speculation to get out of control. The fact of the matter is that yields on high-risk assets are too low and a re-pricing of them (such as junk bonds, CDOs, etc) was bound to happen at some point.

New Contrarian Areas to Watch

Given all the carnage due to the credit debacle, I think some new contrarian areas have emerged. I think mortgage lenders, homebuilders, mortgage debt, and similar areas, are good places to watch.

One company I'm watching is Delta Financial (DFC), which is a pick by the value investor, Monish Pabri. It has sold off around 30% in the last couple of months and it might drop more if the market continues to sell off on credit worries. There are some good comments on the Yahoo Finance message boards (for a change, it isn't all trash :) ). I took a quick look at this company and I'm not sure what to make of it. The company, its revenue model, its accounting, and its competitive advantges all seem hard to pin down. Like most finance firms, the company just looks too hard to understand from an accounting point of view. However, I'll be watching it off and on...

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