Random Articles for the Last Week in May

My posting has been erratic lately because I'm more off-line reading (i.e. books or other printed material:) ). I'll try to post a summary of some books I have read. I also printed out Martin Whitman's shareholder letters for the last 10 years or so, and will post my thoughts on them.

Here are some articles that I found interesting. Click on the link or read my full commentary:

  1. Monolines Have Taken Bond Insurance Losses And How About Others?
  2. Martin Whitman's Shareholder Letters: Hard to implement for small investors but may provide general insights
  3. Oil Bubble (If It Is One) Won't Bust Until Subsidies and Price Controls Are Removed: An article pointing out that half of the world's oil is subsidized one way or another.
  4. Inflation Should Enter Everyone's Radar Screens: Article one... article two...
  5. Japan: Shareholders Finally Own Their Companies?: A tiny positive trend in Japanese corporate governance

CDS Losses By Hedge Funds

Monoline insurers have taken huge losses on their CDS-like insurance but how about others? Have you wondered what happened to all those non-insurance parties who wrote CDS contracts? Well, this New York Times article sheds some light on the next chapter in the credit collapse. Namely, the article talks about the battle between Parax Capital, a hedge fund, and UBS, an investment bank, over compensation for losses on CDS contracts. There is a dispute and needless to say the lawyers are getting ready to do some battle.

Situations like this illustrate the counter-party risk that is inherent in the CDS swap market. What the monoline insurers underwrote is small compared to what hedge funds, investment banks, wealth funds, and others have underwritten. You will likely hear more and more stories about CDS writers not being able to pay. Bond insurers are heavily regulated whereas the hedge funds writing CDS contracts are highly questionable.

Martin Whitman's Shareholder Letters

People may find it interesting that I have never read all of Warren Buffett's letters and, instead, am spending time with Martin Whitman's letters. This is probably the dumbest thing anyone has heard but I feel like I know there is everything to know about Warren Buffett strategies and thoughts. Yes, I haven't read all his letters or books about him, but things are getting very repetitous for me. Furthermore, Martin Whitman is more of a contrarian than Warren Buffett. Although Whitman's strategies are hard to replicate by small investors (you need to be a skilled credit analyst or have the capability to buy distressed bonds and the like), I'm just trying to glean his philosophies that can help me.

You can find his shareholder letters for the past 10 years from the Third Avenue Funds website. I'm reading them chronologically, starting from 1998 to the present. The letters are a good casual read and you can skip stuff that doesn't interest you and jump to some of his key messages.

Oil: Impact of Government Intervention

One of the reasons oil prices aren't weakening even though many of the big consumers (mostly developed countries) are slowing is due to the fact that many developing countries have heavy government intervention in the oil markets. This can range from subsidies, to price controls, to outright running of state-owned oil companies at losses. This following chart from the Economist summarizes the cost of gasoline across various countries (source: Morgan Stanley and The Economist):

When reading charts like this, do keep in mind that the fuel may not be identical across countries (unless the source provider adjusted for that). Taxes also vary widely. Nevertheless it provides a rough estimate of the situation.

As the article in the Economist mentions, almost a quarter of the world's gasoline is sold below market prices (Morgan Stanley estimate). Furthermore, I don't think it is a big deal when oil-producing countries set low prices versus oil-importing countries setting low prices.

I have been bearish on oil for over an year and been wrong. My opinion is that oil prices likely won't drop until the developing countries stop distorting the prices. Free market forces are powerful in the long run, so most of these subsidies/price controls/etc are on the verge of collapsing. One of the examples in the article is Malaysia paying 7% of GDP to fuel subsidies. This is a massive cost and is unsustainable. Similarly, China and India will be unable to pay huge subsidies to oil companies or oil consumers in the future.

One of the reasons oil may be in a bubble (I'm not entirely sure though) is due to these subsidies. Oil bulls project high long-term oil prices but never seem to factor in the possibility that most of the price is supported by government subsidies in poor countries, who are the last ones that can afford to pay. Most of the bullish oil views are based on supply constraints but the demand side is more problematic in my opinion. I could be wrong but, as it stands, I feel that the oil demand is unsustainable.

Inflation: The Long-term Threat

I've been meaning to write a long post on inflation based on the following two articles from The Economist but I just haven't gotten around to it (I may still do it in the future):

Article about inflation in emerging markets (The Economist)

Article about the inflation threat (The Economist)

Although I'm more in the disinflation camp, there is the likelihood that inflation will go up in the long-run simply because it is low right now. If inflation rises, and bond yields rise, all financial assets are going to be discounted at a higher rate--something developed world investors haven't been familiar with in 30 years.

I'll try to write a long post on inflation so I'm not going to say much right now. I wouldn't blindly invest based on some macro trend that may or may not materialize (value investors don't do that and even a non-pure-value investor like me doesn't either). But it's something to consider. A P/E value of 18 looks reasonable if inflation is 2% and bond yields are 3.5%; but very few would consider it cheap if bond yields or inflation ticks up and stays there.

Japanese Shareholders Win One Battle (Do They Lose The Next?)

As I have talked about before--and this will be like a needle going through the heart of an American capitalist--shareholders in Japan don't really own their companies. Really, no joke. On paper they own it, but that's about it. The general view seems to be that Japanese companies are run for the country (nation), employees, and society as a whole. Asking for a higher dividend, even if you own 20%+ of the company, is a no-no. Well, that was the case but things seem to be changing (albeit slowly).

I am kind of exaggerating a bit but Japanese companies really aren't run for shareholders. It is hard to get rid of executives, change the board of directors, or even get anything non-standard passed in a shareholder meeting. This article from the Economist sheds some light on some positive win for shareholders:

Yet the metaphor of shareholder democracy is misplaced, quips one government official, since Japan is barely a functioning political democracy: the ruling Liberal Democratic Party has been in power nearly continuously since 1955. Besides, he continues, Japanese managers treat all stakeholders equally: they do not only ignore shareholders, but everyone else too. As Alex Emery of Permira Advisers, a large British private-equity fund, puts it: “Japan is not just closed to foreigners—it's closed to everyone.”

Foreigners have been calling for change for years, to little effect. But lately there have also been calls for change within Japan. In May the Council on Economic and Fiscal Policy, an influential group appointed by the prime minister, put forward a series of proposals, the boldness of which is a strong rebuke to the insular ministries and their managers.

Here's hoping that this is the start of something...

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