Thursday, July 31, 2008 0 comments

Oil Potentially Topping Out

Don't put much weight into my oil calls, but it does look like oil is topping out. I felt the same thing late in 2006 and that turned out to be temporary thing. Who knows for sure but I notice a few things.

Firstly...

First of all, price is off quite a bit...




Secondly...

Then ExxonMobil misses earnings for the second time in as many quarters. Missing earnings is not usually a big thing, except when it is a bellwether missing it during a huge bull market.

For the quarter, Exxon Mobil posted net earnings of $11.68 billion, or $2.22 a share, up from $10.26 billion, or $1.83 a share, a year earlier. The results narrowly eclipsed its previous record of $11.66 billion, set in the fourth quarter of 2007.

Despite the staggering numbers, Wall Street was underwhelmed. Investors polled by FactSet had been looking for a profit of $2.46 a share. It was the second consecutive quarter in which Exxon fell short of their lofty expectations. In a period during which crude-oil prices doubled, Exxon's profit was up a mere 14%.



One of my views has been that the bull market in oil, like other bull markets, will end as they always do. Namely, too much lofty expectations. Since oil&gas is a commodity business, its P/E ratio looks low but there is massive expectation built into these stocks (mostly resting on huge demand increase from China, India, et al.) Cisco became the largest internet networking company with billions in profits but the market expectations in late 90's was way too high.


Thirdly...

The final signal is word that Marathon is trying to split its business:

Separately, the company said its board of directors is "evaluating the potential separation of Marathon into two strong, independent, publicly traded companies."

As for the separation plan under consideration by directors, one entity would encompass the company's E&P, integrated gas, and oil sands mining businesses, while the other would be made up of Marathon's refining, marketing and transportation business.


I'm generally not a fan of financial re-engineering just because things don't look rosy in the short term. It's obvious why they want to split. The refining business has been a total disaster of late--as Bill Miller alluded to, you would have lost more money investing in VLO or TSO over the last year as you would have on MER or C--and a split will get rid of the bleeding. Who wouldn't love to own an E&P that will be rolling in the cash from high oil prices? Indeed, who wouldn't? That is until oil prices drop and the E&P starts posting losses and ends up bankrupt. Isn't this like looking in the rear-view mirror? Isn't it obvious that integrateds dominate the world because they have economies of scale? What will happen if oil actually turns out to be cyclical and these companies face a downswing?

I find this splitting idea to be risky. There is even pressure to split ExxonMobil. I will bet that if they split, they will be far worse off in 10 years than an existing major integrated oil&gas company.

(On another note, it wasn't even an year ago when some were calling for free money to be handed out (i.e. subsidies) to refiners because there weren't any refineries built in America in a decade. Some even wanted to fast-track changes in law allowing refineries to be built almost everywhere. Well, not only do we not need any more refineries, the existing ones aren't even making much money. As far as I'm concerned, the only refineries that need to be built are ones that handle sour crude but no one wants to build those here.)

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Geoff Gannon's Excellent Post About Benjamin Graham

Geoff Gannon of GannonOnInvesting blog has an excellent article on Benjamin Graham's thinking and investing strategies. The post was prompted by Jason Zweig, who you may recall is famous for being the editor of the latest version of The Intelligent Investor, says that Benjamin Graham would not invest in financials right now. Geoff Gannon says Graham likely won't either, but that Zweig's reasoning is incorrect. Tom Brown also doesn't agree with Jason Zweig but I am not sure how much of a vlue investor Tom Brown is (I'm not as familiar with him, although I have read nearly all of his public articles about the monolines.)

I haven't read Geoff Gannon for very long (only about one or two years) but I would say this is arguably his best post ever. I like how he ties in varying elements of a superinvestor like Graham--actual practice, tactics, thoughts and justifications--into the present world. If you are an investor with an interest in value investing, I highly recommend reading the post. Even if you don't follow Graham's strategies or thinking (most Buffett followers don't,) it is insightful to understand differing styles.

Before we can answer what Graham would do today, we need to know what he did do in his own lifetime. When writing about Graham, one needs to consider three separate categories: what Graham practiced, what Graham preached, and what Graham’s principles were.




On another note, a comment from a reader to the Gannon post asks who is closest to Graham now: Klarman, Whitman, etc. Anyone have any ideas?

I am not a pure value investor so I don't follow the various superinvestors as closely as some others, but I think Walter Schloss is the closest to Graham. A present-day Graham would be operating just like Schloss, and investing in things neither you nor me have heard of.

Seth Klarman also comes close to Benjamin Graham with one big exception. The exception happens to be the fact that Benjamin Graham generally held a diversified portfolio of many holdings, whereas Klarman is a concentrated investor. Apart from this portfolio tactic, Klarman's thinking is very close to Graham.

Warren Buffett doesn't come close to Graham anymore. The main reason is that Buffett is primarily a control investor, whereas Graham wasn't. Buffett also places heavy emphasis on management, ability to profit immensely from intangibles (eg. ROE can be much higher if company has high intangibles and low tangibles,) and his emphasis on paying fair price (Graham always went for the cheap price.)

Martin Whitman, who calls his style 'safe and cheap,' is also somewhat close. But he has said many times that he does not follow 'Graham & Dodd' as closely as Graham would have. Whitman's main argument is that SEC regulations in the 50's(?) has resulted in more public information being made available (this means you don't have to treat a company as much as a black box as Graham would have). Furthermore, Graham places far more emphasis on earnings than Whitman does.

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Preliminary US 2Q 2008 GDP Comes in at 1.9%... 4Q 2007 Revised Down to -0.2%

Well, the preliminary second quarter US GDP number came in at 1.9% so things are still neither good nor bad. But last year's fourth quarter was revised down to -0.2%, signalling a potential start of a recession.

Annual revisions in the report also showed that the economy contracted in the fourth quarter of 2007, falling 0.2% for the first drop in real gross domestic product since the recession of 2001. The economy grew at a revised 0.9% annual rate in the first quarter.


The second quarter was boosted by government stimulus (about $80 billion) so it's not clear what the actual rate would have been without the government help.

I am still of the opinion that there is a high probability that the economy won't deteriorate as much as many as expecting. I actually think that USA may grow very slowly (between 0% and 1.5%) for the time being. My thinking is based on the view that unemployment may not rise significantly in this slowdown. I am influenced by GaveKal's thinking and believe that the most cyclical elements of the US economy (basically manufacturing) has been outsourced away. So I really don't see the typical scenario of mass layoffs arising from too much production.

The risk for investors, in my opinion, is not the economic growth per se (most assets are pricing in a slowdown.) Rather, it's the possibility of inflation or deflation (i.e. no more goldilocks on the inflation front).

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Wednesday, July 30, 2008 8 comments

Bill Miller 2Q 2008 Shareholder Commentary

It has certainly been a tough period for Bill Miller. In his second quarter commentary, he shares his thoughts.

(source: Bill Miller Commentary, Bill Miller. 2Q 2008, Legg Mason Capital Management)

Mason Hawkins said, “Warren, I’m an optimist. I think this whole thing can turn quickly, and surprise people. Are you an optimist?” “I’m a realist, Mason,” the sage replied. Warren went on to say he was optimistic long term, and backed that up in a talk the next morning on the remarkable history of growth, innovation, and wealth creation the U.S. had produced over the past 200-plus years. He also offered a sober assessment of the current challenges we face, and said it would take some time to work through them.

He then made the perfectly sensible point that as we are all net savers, we should be happy if stock prices declined a lot more, so we could buy even better bargains.



Warren, of course, is Warren Buffett. Nothing new from Buffett, who has said in the past that it could take a while for things to recover. Warren Buffett is not a macro investor and isn't really good with his macro calls. But he does have a very sense of history and what is logical from a long term point of view. The problem I have with Buffett's point (that we could buy more) is that this isn't the case with everyone. For instance, I personally just don't have much more capital to add. Yes, young working class people like me are better off with the current situation (since our earnings are large relative to our assets; and lower valuations imply higher future returns) but it is still difficult to suck up and accept the notion that it's good to see low prices because we can buy more.

Having said that, contrarian investors live for months like now. I remember how just about the only things trading at really low valuations over the last few years were distressed companies. If anyone ever looked at my watch list (I didn't have a blog back then though,) you would have seen trashy companies like Spectrum Brands (SPC) or Celestica (CLS) or Nortel (NT). These were the type of contrarian opportunities that were available (as far as I was concerned--there are some sectors I ignore on purpose though.) In contrast, right now you can pick up historically solid companies for low valuations.

John Rogers, the founder of Ariel Investments, came in to see us last week. John has been an outstanding investor for 25 years or so, but like almost all value types, is going through one of his toughest periods now. His assets are down, similar to the experience we’ve had. He said it was the most difficult market he’d seen, a judgment I would have given to the 1989-1990 market, up until the frenzy erupted over Fannie Mae and Freddie Mac, which sent financials to what looks like a capitulation low on July 15. I am now in John’s camp.


Bill Miller is one of the few value investors who often goes out on a limp and makes specific macro calls. I'm highly respect him but most of his "off the wall calls" turn out to be wrong. This July 15 call might turn out to be wrong as well. Recall that Miller thought that the collapse of Bear Stearns was the bottom in financials a few months ago and it turned out to be wrong.

I am reminded of what John Maynard Keynes, himself a great investor, said once about investing, “It is the one sphere of life and activity where
victory, security, and success is always to the minority and never to the majority. When you find anyone agreeing with you, change your mind. When I can persuade the Board of my Insurance Company to buy a share, that, I am learning from experience, is when I should sell it.”


Keynes captures the truth quite well. Investing, if you look at it as a business, is one of the toughest businesses out there. Only a small minority actually make any money through investing. There are a lot of wealthy folks on Wall Street and Bay Street but most of them become wealthy through selling financial instruments (brokers), cutting deals (rainmakers), or from fees (fund managers). There are a lot of millionaire fund managers but they make most of their money through fees. I think if you take a somewhat contrarian path, it may lead to success--at least that's the strategy I'm pursuing.

It has been explained to me that it was obvious we should not have owned homebuilders, or retailers or banks, and that I should have known better than to invest in such things. It was also obvious that growth in China and India and other developing countries would drive oil and other commodities to record levels and that related equities were the thing to own. “Don’t you even read the papers?” was a common comment.


That is a point that I find annoying. There are a lot of people--bloggers, message board posters, journalists, investors--that claim that some of the things that happened were obvious. If everything was so obvious I wonder why they are not millionaires now. If you thought oil&gas were going to do really well, all you had to do was to put down $50k to $100k on some high-cost E&P--these have the most leverage to oil and natural gas prices (example would be oil sands companies or coal-bed methane companies)--and you would be a millionaire now (most of them went up 10x or more). Similarly, if you thought housing was going to go bust, you could have shorted homebuilders like Beazer, or building material suppliers like USG, or housing oriented retailers like Sears and you would have cleaned up easily. You wouldn't have made as much as going long (since maximum from shorting is 100%) but it would have been plenty. Of course, buying long-term deeply out-of-the-money put options would have made you a bundle (these options would have been so cheap on these high flyers).

Sir John Templeton died a few weeks ago, full of riches and honors, as he so deserved to be. The legendary value investor got his grubstake by famously buying shares of companies selling for $1 a share or less when war began in 1939. He didn’t know then that the war in Europe would spread to engulf the world, nor how long it would last, nor how low prices would ultimately go. He always said he tried to buy at the point of maximum pessimism, but he never knew when that was. He was, though, a long-term optimist, as is Mr. Buffett, as am I.


The only thing is... I'm not sure if we have reached the point of maximum pessimism...

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Tuesday, July 29, 2008 0 comments

Opinions on the Future of Newspapers

Everyone has an opinion on the future of newspapers and I list some I found on the web below (some of the articles are a few years old.) Anyone crazy enough to cotemplate an invest in a newspaper company should probably read some of the following.

Hard News Daily Papers Face Unprecedented Competition... (Washingon Post, 2005)

Do Newspapers Have a Future? (Time, 2006)

Newspapers: The Future (Washington Post, 2005)

What is the Future of Newspapers? (CBC, 2007)

Can't get more contrarian than newspaper stocks but it's very scary. Newsosaur, an excellent blog covering newspapers, had a post a few weeks ago showing the performance of various newspapers since 2004. Nine of the publicly traded newspaper stocks are down 71.6% from 2004 to July 15th 2008. And that's without an economic slowdown. Wait until the economy slows (although the market is likely pricing in a lot of the negative effects from a potential recession already.) Truly, truly, ugly numbers...

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Monday, July 28, 2008 5 comments

Merrill Lynch Commutes Bond Insurance Contracts with SCA

Merrill Lynch announced some writedowns along with a big capital raise this afternoon. Of interest to me is the fact that they commuted bond insurance contracts they had with SCA:

Merrill is being paid $500 million to commute, or rip up, guarantees it bought from bond insurer Security Capital Assurance. It's also negotiating with other bond insurers to try to commute similar guaranty agreements.


This is good news for the tainted bond insurers (and hence bad from a competitive point of view for the untainted ones: FSA, Assured Guaranty, and Berkshire Hathaway Assurance.) Generally this is a negative for the industry since it weakens the argument for buying insurance in the first place. Nevertheless, given that the bond insurance industry itself is almost on the verge of being dead, I don't think it hurts the industry as much as it generally would have.

SCA, the worst bond insurer out there (partly because their contracts required them to post collateral upon downgrade,) looks like it is paying $500 million to Merrill Lynch to get out of the contracts. Depending on the details, Ambac and MBIA will probably be paying around $1 billion to $3 billion to get out of their contracts (even then, this would only be a portion of their contracts.) I think it is less likely for Ambac, MBIA, CIFG, or FGIC to commute much of their exposure. A lot of the projected losses are coming from a few contracts (at least in the case of Ambac) and it may not make economic sense to get out of other well-behaving insured assets.

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Asian Subsidy Scheme Ready to Collapse

It has become evident over the last few months how disastrous the Asian subsidies for energy (among other items) is turning out to be. My opinion is that the subsidy scheme is about to collapse. Bloomberg has a story which almost seems to imply that stagflation is on the horizon for many Asian countries. I am not too sure about the stagflation case but I do agree with some items in the article.

One thing that is not clear to me is if the GDP growth rates quoted in the article are nominal growth rates or real growth rates. If it is real growth then there is a big flaw in the article. The article compares GDP growth to inflation and implies that inflation that is higher than GDP growth portends to bad things. That is only true if the GDP growth that is referenced is nominal growth rate. If it happens to be real GDP then inflation is already taken into account (i.e. real GDP = nominal GDP minus inflation). I'm too lazy to look up the original reference and see what is actually quoted but I would urge anyone reading the article to keep this potential error in mind.

Asian governments from India to Malaysia, clinging to budget-busting fuel subsidies, may end up paying an even higher price: saddling their economies with an extended period of stagflation.

...

Governments are being forced to choose between two unattractive alternatives: run up bigger deficits by continuing to shield citizens from soaring energy prices, or start to withdraw subsidies, fueling inflation and political backlash. Inflation has already reached decade highs throughout the continent and played a role in destabilizing politics.



Some investors seem to think the Federal Reserve and the US government are in a tough spot when it comes to inflation versus the slowing economy. Well, the ones caught in a tough spot are Asian countries such as China, India, Vietnam, Pakistan, Thailand, and so forth. These countries are seeing high inflation along with slowing growth and spectacular government deficits. On top of this, the vast majority of the citizens are very poor so removing a fuel subsidies can significantly hurt the majority of the population in the short run. In the long run, subsidies distort the market and actually hurt the poor but the short term is another story. It is extremely difficult to be a politician in those countries right now.

Below-market fuel and power costs made it cheaper for manufacturers in export-dependent economies to operate, giving them a competitive advantage over rivals in other markets. Subsidized prices also left consumers with more disposable income, boosting demand for goods and services.

Now, higher costs will erode the export edge. That may lead to more shuttered factories in countries such as China that already have more manufacturing capacity than they need to meet domestic and foreign demand, putting millions of people out of work.


One of the reasons I'm bearish on China, India, et al, is due to the reasons cited above for their growth. It's not clear how sustainable any of the the current growth is. Keeping the currency undervalued, subsidizing fuel costs, and so on, are not sustainable in the long run. Can China, India, et al, grow without such distortions in the market place? China bulls such as Jim Rogers seem to think so but I'm sitting on the sidelines for now.

As the Asian economies slow, commodity consumption should decline substancially. If I'm right then the high growth rates being projected for most commodities are going to be totally off the mark--just like internet penetration rates turned out to be wrong 8 or 9 years ago. I've been an oil bear for over an year--and been totally wrong--but my view has always been that oil will enter a bear market if and only if the Asian demand drops off (which will only happen if subsidies are removed.)

To see how unsustainable some of these subsidies are, check out India's fuel subsidies:

Even after India raised fuel prices, Prime Minister Manmohan Singh's government will still pay about $42.5 billion in oil subsidies this year, more than twice as much as last year, and about six times the entire education budget.


Six times the education budget. Two times last year's subsidies. Those are some wild numbers. On top of causing massive government deficits, these subsidies distort the market and result in inefficient use of energy.

Adding to his problems, Fitch Ratings this month cut its outlook on Indian debt to negative, citing spending on food and fuel subsidies. Standard & Poor's and Moody's Investors Service cut Pakistan's credit rating in May. S&P, Moody's and Fitch all lowered their outlook for Vietnam's debt in May and June.


I haven't looked at the prices lately but one of the biggest bubbles out there over the last few years, in my opinion, has been emerging market debt. I am not sure about right now but EM debt spreads over US Treasuries has been extremely low for the last 5 years. This has mostly been because investors have been ignoring history and assuming that EM debt won't default all of a sudden. This thinking was likely driven by the high growth in some countries (China, India, Vietnam, etc) and/or improving government balance sheets (Russia, Brazil, etc). Unfortunately, some are going to be in for a shock pretty soon if these countries slow down further and their government deficits keep deteriorating.


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Saturday, July 26, 2008 2 comments

New York Times: A Proxy for the Newspaper Industry

Businessweek has an article presenting the situation at New York Times. NYT is a good proxy for the industry. Some comments to article bash the NYT for its liberal stance but obviously none of these commentators are stock market investors for they clearly must have missed how conserivative outlets like News Corporation (NWS) is also down around 50% in the last year. Anyway, the description provided in the article is quite similar to the Canadian Torstar.


(source: How Can The New York Times Be Worth So Little? by by Jay Yarow and Jon Fine. July 2008. BusinessWeek)

At its current $12.48 stock price—down 46.3% from a year ago—Times Co. has a $1.79 billion market cap. To put this in perspective, CBS recently acquired tech publisher CNET, a much weaker media brand, for $1.8 billion. Add in the company's $1.1 billion of debt, subtract $42 million for its cash on hand, and the company's total enterprise value—a valuation measure that totals up those items in such a fashion—is just $2.85 billion.


The CNET acquisition may be overpriced (not sure) but, nevertheless, it sort of provides an indication of the value disparity. CNET is a valuable and dominant brand in the online world but NYT is the #1 visited news site by a wide margin and about.com is a valuable online property.

In a research note published on July 9, Lehman Brothers (LEH) analyst Craig Huber estimated the Boston Globe and the 14 regional newspapers the company owns could be sold for $575 million after taxes. Huber valued the 17% stake in the Boston Red Sox, after taxes, at $152 million and the Times's portion of its new headquarters building in midtown Manhattan at $750 million after taxes. The company paid $410 million three years ago for Web property About.com; according to an estimate by tech blog Silicon Alley Insider, that could be sold for approximately $600 million today. That sounds low to us, since About has consistently reported increasing revenues. Let's conservatively kick that up to $700 million and assume a 20% tax bite on the Times's $290 million gains in that sale, which is $58 million. So $642 million, aftertax, for About.com.

Totaling up those figures gets you to just over $2.1 billion. Subtract that from the enterprise value, and you get $750 million for the company's remaining assets.


What is described there applies to many newspaper companies (although it varies.) If you back out strategic investments, property values, and the like, the actual papers are being valued at really low valuations. In one of my posts about Torstar I indicated similar results, where the newspaper seems to be valued as almost nothing (e.g. less than a junior gold mining company that is nowhere near finding gold.) In the case of Torstar, saleable assets consist of Harlequin book publishing, strategic investments in Black Press and CTVglobemedia, and workopolis. I don't think these companies should be broken up (it will be unlikely with the dual-share structure anyway); all I am doing here is to try to figure out what price the market is placing on the core newspaper business.


Does The Dual Class Share Structure Hinder Matters?

I have historically been totally against dual-class shares. In fact, I made up my mind never to invest in such an undemocratic structure. However, I have decided to make an exception for newspaper investments. One of the reasons is that I think everyone, including the families or trusts that own the voting shares in many newspapers, are in the same boat as common shareholders. We are talking about an industry fighting for its survival. Most of these companies are run by professionals and I think everyone's goal is to survive. The families and trusts that own these papers have a huge chunk of their wealth tied up in these companies so their interest will be similar to an outside shareholder. In contrast, a company like Hershey (HSY) is not in survival mode and I doubt my interests will ever align with the voting shareholders.

If some of these companies did not have dual class share structures, they would be broken up more easily or sold to private buyers quickly. But I really wonder if that does much for long term shareholders. There have been quite a few sales recently, with the Tribune takeover by Sam Zell being the most prominent recently. It's too early to say but how much as the privatization of Tribune helped? Very little. If you owned shares in the private Tribue right now, your returns will be no better than before in my opinion. As for asset sales, they seem like a short-term fix that does not improve the company's competitive position or revenue base.


Dividends May Be At Risk

One of the risks for newspaper investors is that their dividend may be cut. I suspect the NYT will keep its dividend (around 7% right now) since it can finance it from cash flow. But Torstar, whose dividend is also close to 7%, may have to use debt to finance the dividend depending on how things unfold as the economy slows down (I am generally against issuing dividends or buying back shares by issuing debt.)


Clearly the market is pricing newspaper companies--not just NYT but practically every one out there--at these prices because of losses in the future (i.e. further impairment that reduces value.) Like in most investing, it's difficult to know if this bearish scenario will play out in real life.

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Thursday, July 24, 2008 3 comments

Cutting Taxes Can Be Bad

One of the big differences in economics between those leaning towards the left (e.g. liberals) and those leaning towards the right (e.g. conservatives) often centers around tax cuts. I hate to paint everyone with a broad brush but conservatives often have this blind faith in tax cuts. So-called libertarians also often have the view that tax cuts are almost always good. Liberal such as myself, who are in favour of balanced budgets (I wished more on the left were), are not a fan of cutting taxes across the board.

One of the flaws with the conservative/libertarian tax cut thinking is their unrealistic expectation that tax cuts also implies government spending cuts. This is almost always false! In fact, you can consider it almost a law of politics that government spending cuts will rarely be enacted--and even if they were, they won't stick. It doesn't matter what type of government is in power. They are all unlikely to cut spending. The guilty pleasures for the left are social spending, healthcare, and education; the guilty pleasures for the right are military and corporate grants. If you don't believe this, you need look no further than the George W Bush administration over the last 8 years. George Bush is a hardcore conservative who ran a platform of fiscal conservatism (if you don't believe me, look at what prominent conservatives were saying before his first election, with respect to how much better he will be (than Clinton) when it comes to government finances.)

One of the big problems with USA right now is the fact that it is running a massive fiscal deficit. Most of this is due to the so-called 'tax cuts for the wealthy' that were enacted (the other is mostly due to military spending; some of it is also due to healthcare spending (this is due to Democrats.)) In his latest weekly letter, John Hussman talks about the disaster the tax cuts have become (that expiring tax cuts may actually be a big election issue this year.) Hussman is one of the few that I have encountered who claims that the main cause of the current account deficit is actually from government fiscal deficits.In contrast, mainstream thinking seems to pin the current account deficit on reasons such as excessive consumption, high consumer debt usage, and the attractiveness of US assets.


If you find anything I quote below interesting, I urge you to read the full article. Some of the points in the article are not quoted by me.

(source: How the War, Tax Cuts, and the Swaps Market Debased the U.S. Financial System, by John P. Hussman. July 21, 2008.)

In 2001, the U.S. initiated a series of major tax cuts amounting to about $500 billion, benefiting primarily individuals with a high marginal propensity to save, despite an already large fiscal deficit. (As an investor, my only defense to the inherent hypocrisy of criticizing this is that all of my own benefit has gone to charity). In addition, the Iraq war heaped on further direct costs of $500 billion. Nobel economist Joseph Stiglitz recently estimated the long-term total of direct and indirect costs of the war to the U.S. economy at $3 trillion.

It is widely believed that the enormous fiscal deficit created by these policies has been “stimulative.” The key question is, “stimulative to what?” Surely, not much of the answer can be found in stock valuations. Stock prices reflect the discounted present value of future cash flows. Even if the entire $500 billion was the present value of long-term cuts in dividend taxation, the “fair” present value of the U.S. stock market would increase by exactly the amount of the reduced tax burden. On a total stock market capitalization of about $15 trillion, $500 billion in tax cuts work out to a gain in value of about 3.3%. Clearly, the Bush tax cuts provided little impetus for anything but a short-term bounce in stock prices.


Even though I benefit somewhat from capital gains or dividend tax cuts, I am generally not a fan of them (I will admit up front that my job is far more important than my investments so my benefits will be different from the wealthy.) I personally would prefer if income taxes (either personal or corporate,) or gasoline tax, or tobacco tax, or a similar tax were cut. I also think it's better to do something to improve capital expenditures by corporations. For instance, instead of cutting, say, dividend tax, I think it may be preferable to let companies write off more of (or more quickly) their capital expenditures (i.e. depreciation expense.) My preference for the latter is because capital expenditures by businesses (i.e. plant, equipment, technology, etc) increases productivity and helps society in the long run.

Put simply, the massive fiscal deficit of recent years has required the U.S. to run a deep current account deficit. Moreover, our need to foist government liabilities into foreign hands has resulted in a large depreciation in the value of the U.S. dollar (if foreigners were eagerly snapping up our “stuff,” the U.S. dollar would be appreciating instead). When the domestic savings of the nation as a whole are insufficient to finance government deficits and private investment, foreign savings must be imported through the sale of securities. Our insufficient national saving has had the effect of strengthening the hand of foreign competitors, and continues to require us to sell U.S. assets into foreign hands to finance the shortfall (last week's agreed takeover of Budweiser – the Great American Beer – to a foreign company is particularly emblematic).


I'm not as nationalist as Hussman seems to be but I don't see how one can argue against his main point. By running a big fiscal deficit, you are simply strengthening others and weakening yourself.

John Hussman goes on to point out that, instead of investing in capital expenditures or something productive, we ended up with overinvestment in residential real estate.

So the policies of recent years have indeed been stimulative. But stimulative to what? Primarily to unproductive investment and poor credit. There is nothing wrong with debt that is incurred to obtain productive assets, legitimate national security, or the relief of suffering. In this instance, there is little to show but liabilities. The U.S. is now saddled with a burdensome federal debt, a deep current account deficit, reduced competitiveness, a weakened financial system, a tragic and needless loss of life on both sides of the war, and a growing indebtedness that allows major U.S. companies to be picked away by foreign hands like apples from a tree.


Sometimes bubbles aren't as bad as they seem. This is certainly true if the spending went into plants, roads, or some such thing. One of the points GaveKal had made in the past was that the tech bubble was a disaster but it left behind some useful assets such as communications networks, Internet equipment, and so forth. Unfortunately, the residential real estate bubble is going to result in nothing other than dilapated houses that no one wants to live in (check out this story of how no one wants to buy a formerly $110,000 home for $5000!)

To complete the story, we have to ask how such a destabilizing amount of high-risk lending was able to take place just because government interest rates were low. Didn't the markets make risky credit expensive enough to limit the exposure of the U.S. economy to financial strains and default?


Hussman goes on to answer this question with an explanation the side-effects of swap contracts.

So far as policy is concerned, the way toward renewed peace and prosperity is to move in the direction of fiscal discipline, increased risk-based regulation of entities that draw directly or indirectly on government assurances, credible and even-handed diplomacy, and a reaffirmation of our commitment to human rights (as Jefferson saw them, not as a grant of the State, but as an inalienable aspect of humanity itself).


Easier said than done but it's something that American needs to pursue if the situation is to be improved. Some may not agree with all that (certainly the hawks won't give up war) but balacing the books is something that is critical. It doesn't have to happen now (deficits during slowdowns/recessions are ok in my eyes) but America better start getting its government books in shape in 2 or 3 years.

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City of Los Angeles Sues Bond Insuers and Investment Banks

Not entirely surprising and I expect many more lawsuits will be filed before all this is said and done. Reuters is reporting that the City of Los Angeles is suing more than 30 bond insurers and investment banks in what seems like an accusation of mass conspiracy to defraud the bond issuers, as well as accusations of bid rigging. The bond insurers are also being accused of violating California's anti-trust laws. It's not clear but I think there are multiple lawsuits being filed, some against the insurers and some against investment banks.

The city of Los Angeles sued more than 30 municipal bond insurers and Wall Street investment banks, accusing them of fraud and antitrust that it said cost taxpayers millions of dollars...

In the complaint against bond insurers, including Ambac Financial, MBIA Inc's MBIA Insurance Corp and Financial Guaranty Investment Co., the city claims it was forced to purchase insurance from a triple-A-rated guarantor in order to benefit from that top rating.


It's interesting that the city is claiming it was forced to buy bond insurance. This is a bizarre accusation given that you can issue bonds without insurance (that's why bond insurance penetration was nowhere near 100%.)

City Attorney Rocky Delgadillo blamed the situation on a "dual credit rating scheme" maintained by bond insurers to take advantage of taxpayers by compelling cities to purchase unnecessary bond insurance.

"Bond insurers' cynical use of this discriminatory credit rating system and inexcusable failure to disclose their high-risk investments in the subprime market also violates California's anti-trust laws and common laws," Delgadillo said in a statement.


It looks like the city is trying to weasle its way out of its committments, while the lawyers make out like bandits. Interestingly, they don't sue the rating agencies.

In the lawsuit filed against Wall Street banks and others involved in investment of the city's bond proceeds, the city accused the firms of colluding to rig the bidding process that was supposed to result in the most competitive rates for the investments, which included guaranteed investment contracts and swaps.

Delgadillo said that as a result, Los Angeles did not obtain competitive rates, losing tens of millions of dollars it should have earned.


Pretty serious accusations but I'm not sure who any of this is going to be proven. I'm not a lawyer but I would imagine that bid rigging should be easy to prove generally, but if you are accusing almost everyone in the industry then such mass conspiracies may be hard to prove.

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Tuesday, July 22, 2008 2 comments

Assured Guaranty Being Sold Off... But a Potentially Positive Sign

UPDATE: An anonymous reader pointed out that the mark-to-market gains seem to be due to marking down liabilities. So this isn't as positive as it seems (I retract my somewhat-bullish opinion :( ). One of the quirks of fair value accounting is that you can end up with positive results simply because the value of your debt went down, for example. I haven't calculated it but I think companies like Ambac would have negative book value if it weren't for this benefitial result (I mentioned this before.)

Assured Guaranty is off 50% in heavy trading and I'm not sure what it will do now. I guess the likely rating cut of AGO and FSA likely means the Connie Lee idea is off the table for Ambac. Anyway, there was one positive piece of news that Assured Guaranty released in their earnings call. Around $500m of their mark-to-market losses reversed in the last quarter. I don't know the breakdown of Assured's insurance portfolio but this is a positive sign. The monolines, as well as the banks, are not going to get out of the mess until the marks reverse. The Assured reversal is a first sign. Although things may deteriorate further (they may have in the last month,) it is still a good sign...

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Monday, July 21, 2008 16 comments

Wow, Moody's Potentially Close to Cutting Assured Guaranty's and FSA's AAA Ratings

I'm actually quite shocked by this. Moody's is reviewing Assured Guaranty and FSA for a potential downgrade of their AAA ratings.

Moody's Investors Service on Monday said it may cut its top ratings on bond insurers Assured Guaranty Corp and Financial Security Assurance, citing concerns about securities they guarantee and raising questions over the future need for bond insurance.


It's one thing for the tainted monolines to be cut but it's another for these two to face ratings dowgrade threats. Assured Guaranty steered clear of the subprime mortage bonds and didn't insure any of those risky stuff since 2004 (if I recall). Similarly, FSA has very low exposure to subprime RMBS, CDO, and CDO-squared. Assured Guaranty also received around $1 billion capital infusion from Wilbur Ross early this year so it is way above capital requirements.

As has been the mantra at the rating agencies lately, the rating cuts are coming due to uncertainty over future business. I don't know if they are going to put BHAC on ratings watch but if they don't, it's highly questionable in my eyes. If you are going to cut FSA and AGO, both of which have capital way above requirements, and one of your big reasons is that the future of the industry is in question, then it's totally ridiculous to leave Berkshire Hathaway Assurance at AAA. If FSA doesn't have a franchise value, BHAC does not either!

I don't know if this means they are going to cut Ambac, MBIA, FGIC, CIFG, and SCA further. It's also not clear if S&P and Fitch will make similar moves. If Ambac is not cut further this is good from a competitive point of view. However, it is very negative from an industry point of view because it literally means that no one--including seemingly overcapitalized firms--can get an AAA rating, regardless of what the agency capital requirements say. If they don't cut BHAC, they are also saying that only new entrants can get AAA. I want to see if they give a AAA rating to the new one being set up by Macquarie. If they don't, it really begs the question how BHAC can be rated AAA while others aren't.


In other news, Ambac's 2Q08 earnings call will take place on August 6th.

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Torstar Valuation (Part II)

There are many ways to value a business but one way is to lump all the techniques into two methods. One focuses on earnings, while the other concentrates on asset values. Typically each method suits a particular type of business, although you can apply both when looking at a business. Martin Whitman would consider the first method (earnings-oriented) when looking at "earnings common stocks"; while the asset value method is more useful for "wealth creation common stocks."

The earnings method is what is most common on the Street. It basically involves trying to determine the value of a going concern based on future earnings.

The wealth creation method is more rare, but Martin Whitman's Third Avenue Value Fund generally specializes in these. This method involves unlocking value through corporate restructurings, share buybacks, spin-offs, asset sales, and so on. Looking at earnings will not capture the possibility of wealth creation potential for these firms.

Check out Jeff's analysis of Sears Holding to see how you can look at company using the two different approaches. In the Sears case, the earnings method is when you look at it as a retailer; while the wealth creation method is if you look at the value of Sears' assets.

Whitman seems to like buying earnings stocks at peak-P/E ratios below 10, while he seems to like buying wealth creation stocks at a 25% discount to readily ascertainable net asset value. If you are a contrarian type and looking at beaten down stocks or distressed industries, I personally think that you should not buy anything if the asset value discount is smaller than 40% or if the peak-P/E is above 7 or thereabouts. There are so many things that can go wrong with distressed companies that your margin of safety needs to be really large.

Let me take a stab at evaluating Torstar. If anyone has any input or corrections, feel free to leave a message or e-mail me.



Earnings Method

Torstar's net income in 2007 was $101.4 million (I'm rounding all the numbers). Looking at the stock price may not show it but 2007 was actually a very good year for Torstar. It's likely to be a peak and earnings will be far lower in the near future due to slowing economy (decline in advertising revenue), potentially declining subscriptions, restructuring charges for shutdowns/layoffs/etc (although I ignore these one-time charges,) and expiry of US$ currency hedges for Harlequin. In 2006, a weaker period, its net income was $79.1 million. Operating margin was 10.5% in 2007 and 8.1% in 2006.

The difficulty is in trying to figure out reasonable income in the future. Since we are looking at a declining industry (at least the paper side, particularly the big-city dailies,) income looks to be lower in the future. However, counterbalancing that is the fact that the book division is fairly stable and Torstar's investments in CTVglobemedia (particularly TV and cable channels) is more stable as well.

Given a market cap of around $749m right now, you are looking at a P/E of 7.4 if you use 2007 earnings, and a P/E of 9.5 if you use 2006 earnings.

If you use the Benjamin Graham formula for implied P/E, well, a company with zero growth should have a P/E of 8.5 or lower (this is just a rough formula that Graham provided but I like it better than trying to rely on a DCF.) I think the 2007 earnings are too bullish but think the $70m in 2006 is more conservative and reasonable. I think Torstar may post a loss or very low earnings this year due to economic slowdown but $70m seems reasonable as a long-term earnings estimate.

Torstar isn't quite at 8.5 P/E level based on 2006 earnings but if its stock price drops 10% more (quite likely given how the stock is being sold off,) it is attractive. So one should consider buying when the price hits around $9.5, according to this evaluation.

One might ask how I can go with a 0% growth rate, rather than a negative growth rate. After all, isn't the newspaper industry declining and going to end up with zero profits soon? Well, the answer is not obvious. Although the industry is struggling, revenue is holding up for many of the companies. It's not growing much, if at all, but if non-paper sources (websites, books (for some), content licensing, etc) can grow, I think a zero growth rate seems achievable. Ideally I would want a positive growth rate but we are looking at conservative evaluation here.


Asset Value

(source: The danger zones of 2008 by ROB CARRICK. The Globe & Mail. Friday, July 04, 2008 )

Why mark time with Torstar when you can buy fast-rising oil and mining shares that deliver instant results? "Torstar sells for 50 cents on the dollar right now," said Wade Burton, manager of the Mackenzie Cundill Canadian Security Fund. "If you sold [Torstar] piece by piece, you would get $25 to $30 per share."


I'm just a newbie and I'm not sure if the quoted analyst is looking at Torstar the same way I will be but let's see how the market is valuing the company.

Torstar's current market cap is $749 million. Its book value (1Q2008) is $897.8 million, to yield a price-to-book-value ratio of 0.8. So the company is trading below book value but there are a couple of caveats. On the downside, around 60% of book value is goodwill, which cannot be converted into hard cash. If you prefer to look at companies using enterprise value, it happens to be $1.4 billion ($749 market cap + $671 long-term debt.)

According to the June presentation to shareholders, Torstar's initial investment in CTVglobemedia was $378m (original cost) and Black Press stake is $80m. This sums to $458 million. All of these companies are privately held so we don't know what their current price is. In the long run, these assets are likely to be worth much more than Torstar's original investment value. Black Press will likely do OK given that its papers are in the booming west, and CTVglobemedia may face near-term headwinds but its dominant TV and cable holdings should do well in the long run. Torstar is carrying these investments (along with Q-ponz) on its book at a value of $432.8 million.

So a full 50% of its book value happens to be its strategic investments. So Torstar, excluding these investments, has a book value of around $291m.

The presentation also implies that its workopolis investment is likely worth $150m. Although workopolis doesn't make much money now (this is my impression; Torstar doesn't break it out,) it is becoming more and more valuable by the day. Workopolis is well on its way to dominating the online job search market, a crown that used to belong to Monster I believe. If you take out this workpolis value, along with the strategic investments, you end up with a book value of around $141 million.

So, Torstar, including 100+ rural papers, The Toronto Star (highest circulation paper in Canada,) goldbook directory publishing, Harlequin, and several online properties (these are all money-losing or insignifcant right now) is being given a book value of around $141m. To me, that seems like an attractive bet if you think the company can survive. I don't think one needs to do any hard calculations to determine that this is at least 50% undervalued (Harlequin alone is probably worth $150m).

Now, I should note that one can never be sure what any of these properties are worth. Is workopolis really $150m? It could be lower; but it could be higher too. I'm just basing my opinion on what can be considered as close to a hard fact as possible. Furthermore, the company is not going to be broken up just because it is undervalued. The company is controlled via a dual-class share structure with voting power left to some family members of the original founder. So there will be no rush to break up the company or unlock shareholder value any time soon. But, having said that, what the asset value indicates is that even if things totally fall apart, the company has enough assets and is in a position to sell them off if needed.

The next thing to determine is how long it will take for the discount to be made up--assuming the market will close the gap. Given that Torstar voting shares are not held by the public, the discount may persist for a long time. In fact, I do expect the company to trade at a slight discount. Although one can never be sure what the families with voting shares will do, I feel that they will undertake restructuring of the company if this gap stays as large as the present. Even if they don't want to do anything drastic to change the business, they can sell off their strategic investments in CTVglobemedia and Black Press.

The timing is uncertain but even if it takes 5 years, I think the current prices are attractive (assuming there aren't permanent material losses.) For exampl,e if we assume the stock will always trade at a discount of 20% and assume that the company is trading 50% below fair value (meaning 100% upside from current price), then there is an 80% upside over 5 years. That works out to 12% annualized, which is good enough for me (note that this is with zero earnings growth).

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Sunday, July 20, 2008 0 comments

Rupert Murdoch and the Last Newspaper Battle In America

I have been thinking of investing in newspaper companies so I have been reading up on them lately. I ran across a nice long-form journalism piece from The Atlantic covering Rupert Murdoch and his takeover of The Wall Street Journal. In Mr. Murdoch Goes to War, Mark Bowden sketches out Rupert Murdoch's final battle to decide the winner of America's newspaper market. Given how a day doesn't go without some newspaper on the verge of shutting down, this is a winner-takes-all battle. Murdoch is slightly altering the WSJ to battle directly against The New York Times, and whoever that wins will likely be the dominant voice of America--assuming print still exists and garners the respect it used to.

No one really knows what Rupert Murdoch is thinking but the article suggest some possibilities. The article is also quite good in tying in some of the history of the industry into Murdoch's present-day strategies.

(source: Mr. Murdoch Goes to War, by Mark Bowden. July/August 2008 Issue. The Atlantic.)

Murdoch is given credit for great business acumen, but he is less a pioneer and visionary than a wealthy and aggressive collector. He has vast resources and is constantly adding and subtracting companies to and from his empire. He identifies potential markets, and then, like a rich art buyer writing big checks for the work of artists who have already achieved critical recognition, he buys into companies that have demonstrated promise in reaching those markets...

When it comes to running a newspaper, this combination of traits—buccaneering and collecting—makes Murdoch a throwback to the great journalism pirates, William Randolph Hearst and Joseph Pulitzer, who reigned during the days when most major cities had multiple dailies duking it out on street corners for readers. Back then, the name of the game was street sales, and the way to outsell the other rags was to have something hot that they did not. Reporters vied to get out in front of a story, to be one step ahead of everyone else. The more sensational the scoop, the more copies you sold. Reporters weren’t so much writers as hustlers and con men. The very idea of serious social reform—or, perish the thought, literature!—was laughable. Reporting was about scooping the competition. Stories were to be written clearly and concisely. Sentences were short and simple, language plain. Editors prized the breaking front-page story that could be told without “jumping”—without forcing the reader to turn to an inside page.

This is how Murdoch understands journalism—as content, a word he uses all the time, rather than as a form of literature or public service, and as a commodity whose value largely derives from its instant retail malleability...

This means that, at a time when every big newspaper is tinkering with futuristic business models, Murdoch is doing so with both feet planted firmly in the past. His strategy for success in 2008 is to behave as though the year is 1908. So while his competitors retrench, Murdoch is going to war—by challenging The New York Times, in particular, to an old-fashioned newspaper battle. Except this time the stakes aren’t nickels in Times Square, but dominance in America, and the world.

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Toronto Housing Performance

The value investing mantra of buying an asset at low (undervalued) prices apply to housing as much as to stocks. The following excerpt from a Toronto Star analysis shows the performance of housing over various points of purchase over the last few decades.



The table includes various statistics, including prime rate (interest rate charged to prime borrowers), inflation, house price to income ratio, and TSX (stock) return. A user comment to the story mentions that the stock market return seems to be price return only (so you should add roughly 3% to 5% to account for dividends.)

One of the points that stands out, not surprisingly, is how the returns on the house depend on the time period of purchase. For example, if you bought the house in 1989, your return was roughly 1.9% per year, whereas if you bought it in 1979 or 1999, you made 6.1% per year. Housing peaked somewhere near 1990 and it collapsed after the recession in 1990 so buying in the late 80's wasn't exactly a great idea (assuming you were buying the house to make money and not to live in it.)

Ratio of housing price to income was also relatively high (3.58x) in 1989 (versus less than 3x in prior and subsequent period.) The ratio also looks really high today (4.18x) so it is possible that housing will underperform or even decline over the short to medium term. However, the possibility of weak housing performance in the future is not certain for Toronto. Even though the house price to income ratio is high, prime rates are low, so mortage costs are likely to be much lower. Furthermore, housing is heavily dependent on population growth. Toronto has fairly high population growth, mostly due to immigration, so demand may be higher than in some of the prior periods. Yet, one shouldn't blindly rely on immigration to support housing because a lot of immigrants don't have enough money and the prices may out of reach.

One of the points I, as well as many analysts, have made is the possibility of stocks being under pressure due to higher inflation and interest rates in the future. The table illustrates clearly how present day interest rates are quiet low from a historical point of view. The 60's, 70's, and 80's had prime rates above 8% whereas it is 4.75% right now (I will note, however, that interest rates were lower in the 30's to 50's). Inflation and interest rates have been quite low in the last two decades due to globalization (particularly labour wage arbitrage) and rapid advances in technology (technology is inherently a deflationary force.) Some of those forces may be weakening and won't have as big of a downward pressure on inflation in the future. I am not in the inflation camp and don't see it being very high in the future. Some people expect interest rates to be much higher but I am not certain of that. All I am certain of is that interest rates (and inflation) will be higher than now (since it has been so low in the last few decades.) The question on whether it will get out of control remains to be seen.

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Saturday, July 19, 2008 0 comments

The Housing Crisis: Stock Market May Recover Long Before The Recovery Is Evident

Ever heard the expression that the stock markets are forward looking? Well, here is an illustration of that.

The New York Times has a story on the housing collapse, summarizing various aspects of the economy. Anyone following the markets or reading up the economy would not find much insight in the story, but there are some nice charts illustrating the housing price decline and stock market recovery for various housing crises in the past. One of the key things that stand out in the charts--at least for me--is how the stock market in past crises recover long before the housing downturn stabilizes. The following charts, courtesy of The New York Times, shows the cumulative change in real home prices (top chart) and cumulative change in real stock prices (bottom chart):





The three lines in the chart represent the present day USA, banking crisis average, and top 5 banking crisis average (the top 5 happen to be Spain 1977, Norway 1987, Finland 1991, Sweden 1991, and Japan 1992.) The thing that jumps out at me is how the stock market rebounded half-way through the prior crises. This is a clear example of how the stock market is not coincident with economic indicators (in this case real home prices.)

Having said all that, you will notice that present-day US stocks never corrected except in the last 6 months (faint gray line shows a big dip.) So the situation will clearly unfold differently. Furthermore, like all stock market statistics, the sample size is small and there are too many variables at play for anything to repeat identically. Nevertheless, the lesson from these charts is that the stock market can bounce back up long before the housing price bottoms out. Since the market never really corrected until recently, I think there is room for it to fall more, but it should recover before a recovery is evident. (The superbears will argue that this time it's all different and that we are looking at another Great Depression but I don't share that view presently.)

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Friday, July 18, 2008 7 comments

Are Newspapers the Modern Day Horse & Buggy Whip?

Looking at the share prices for the newspaper industry, you would think that this is like investing in the horse & buggy whip just before the ascent of the automobile.



The 5-year chart above illustrates the beating taken by the leading North American newspaper companies. The main candlestick chart, along with the P/E ratio and yield is for Torstar, one of the leading Canadian newspaper companies. Practically every single company is down 50% to 90%.

One of the interesting things is that the market is pricing well ahead of any severe collapse in profits. You would think that all these companies are posting big losses and on the verge of bankruptcy but, ignoring the several that are heavily leveraged or really struggling, they will still post profits and do not have liquidity or insolvency issues. Either the market is wrong with the industry; or it is re-pricing for a new future. Even if the companies survive, market expectations are much lower right now.

Another interesting thing, from what I could gather, is that newspapers in other areas of the world are doing fine. Newspapers in the developing countries are in their infancy so they are booming (think the 1930's in USA); and newspapers in Europe seem to be doing ok from what I understand (they seem to depend more on subscription but I suspect they are a few years behind the US and will face similar problems.)

Newspapers are one of the ultimate contrarian areas... but they also may be a textbook example of a value trap that investors will study decades from now. Certainly anyone that invested in them in the last 5 years will tell you that it is starting to resemble more and more like a cage that they can't get out of...

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Wednesday, July 16, 2008 0 comments

China: Long-term P/E Ratio

Bespoke Investment Group has a nice chart of the Shanghai market showing P/E ratio versus the index:




The P/E ratio seems to have been between 30 and 60 in the late 90's and early 2000's. It hit a low of around 16 somewhere in 2005 and then rose to around 50 in 2007. According to Bespoke Investment, the P/E is right now 20.95, and had averaged 36 in the last 10(?) years.

Contrarians who think a P/E of 21 is cheap (compared to a historical average of 36) may want to start looking at China. It's impossible for foreigners to invest directly in the local exchanges but you can (i) invest in the Hong Kong market, which has a lot of cross-listed shares or companies that do a lot of business in China, (ii) invest in a US-listed Chinese company (many of the smaller ones are usually shell companies incorporated in a tax haven), or (iii) invest in multi-nationls that operate in China. One of the popular techniques is to bet on China through commodities but I perceive that as being the riskiest strategy of all (commodity bulls would disagree with that... they would consider stocks to be riskier than commodities.)

Whatever your strategy, the biggest risk in Chinese stocks is not the price risk (i.e. overvalued) but political risk!

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Opinion About the Markets; Ambac Sued by New England Patriots, and S&P Suggests Rating Changes

The market is totally driven by short selling and short covering, and rumours. Even some company like Sears Holdings (SHLD) was up 6% today on likely short-covering (one of the rumours I read a while ago was that a lot of shorts have taken big positions in anticipation of Bill Miller being forced to liquidate his large Sears position--this is just some wild rumour.)

The interesting thing to me--and I mentioned this a while ago--is that the US economy does not seem to be bad. So even though people are throwing around phrases like "worst since the Great Depression," it is nowhere near that. In fact, I think it does a disservice to the severity of the Great Depression to compare the present to that. In fact, I remember seeing a chart in my local paper showing that consensus estimate has Canada with a lower GDP growth rate this year than the US (Canada has no problems with any real estate bubble (so far) but it depends heavily on the US and the high C$ is killing manufacturing here.) Estimates for US GDP growth may decline in the future but I personally don't see a big contraction.

Even in terms of the stock market, the panic seems quite high compared to the actual losses. The markets are down only 20%. However, I will admit that anyone that was not heavily overloaded with energy or materials (and does not hold bonds) is probably down 30% to 40%. Those who fled the US markets to seek refuge in emerging markets based on the 'decoupling theory' probably wish they never heard of those words. If you think the US economy is having problems, some emerging markets are facing potentially huge problems with inflation. Not only is high inflation going to weaken those economies, it may lead to political instability (everyone loves to ignore political risk in emerging markets) and it may potentially cause a big decline in the currency.

It's too early say for sure but I sort of alluded to the possibility that the stock market may enter a bear market while the economy does OK (not spectacular but not terrible either.) I think there is a high probability of this happening. It is quite possible for corporate profitability to decline, which hurts stocks, while the consumer and government does fine. Corporate profits as a percent of GDP has been really high for almost a decade (it's near multi-decade highs) so it is likely to revert to a lower level. If this occurs without mass layoffs, the economy will grow slowly but surely. So far this is what you are seeing. The housing bust has been unfolding for almost 2 years now, while the credit crisis has been ongoing for almost one year now; yet, unemployment rate is fairly low.


Onto some news about Ambac...

It looks like S&P is contemplating changing their ratings of select structured products to account for "credit stability." According to Research Recap, S&P expects the ratings to specifically impact ABS CDOs, CPDOs, and LSS (leveraged super-senior) structures (I have mentioned CDOs and CPDOs before but am not sure what LSS means). Essentially they want to account for economic slowdowns and recessions into the ratings (yikes, you mean they didn't account for this before :( ). I'm not familiar with credit ratings but thought the rating was based on probability of default, even during adverse conditions.

If the proposed changes are made, it is likely to be negative for the bond insurers. It will likely impact all of the ABS CDOs. I'm not really sure what all these rating changes will actually accomplis. In any case, I think the suggested changes may adversely impact Ambac's ABS containing student loans, auto loans, and the like. I think the changes will have minimal impact on subprime mortage ABS or CDOs since most of them are being downgraded on fundamentals anyway.


On another note, it looks like Ambac is being sued by the New England Patriots, a football team in the NFL. New England Patriots are trying to recoup some fees related to their dbacle in auction rate securities. This seems to be the first big lawsuit against a bond insurer related to the ARS problems. It remains to be seen how Ambac responds to this.

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Tuesday, July 15, 2008 2 comments

Preliminary Look At Torstar (TS.B) [Part I]

I'm really intrigued by the idea of investing in a "newspaper" company. I hope this isn't my next great shooting-for-the-stars idea that's going to end up in flames. I have been reading up on the industry, as well as comparing some companies, and they look interesting. First thing to keep in mind, though, is that they are risky (especially if you don't know what you are doing like me.) You will certainly be going against the Street consensus which is that newspapers are in a long-term secular decline. It's not easy to argue against that, if you focus on the printed news side of things.

Based on my read of history, newspapers have faced some industry-altering events in the past. The last big crisis faced by the newspaper industry was probably the rise of television news. The thinking back then was that television news was going to seriously damage printed news and possibly make it obsolete. It hurt the industry but not to the degree some anticipated. However, the present threat of the "free" Internet is a far greater challenge.

Most newspaper companies that I'm interested in are involved in multiple activities so you can't necessarily compare them directly. Washington Post (WPO), for example, generates something like half its revenue from an education-related business. In contrast, some company like Torstar (TSX: TS.B) generates about 25% to 30% of its sales from (women's) books. One of the readers mentioned Pearson (PSO), which owns the Financial Times, and generates about 80% from books (primarily education). So these companies are quite different from each other and you need to understand what you are investing in. I have narrowed down my decision to Torstar (but I may change my mind to another, such as New York Times, if the situation changes.)

Here is my first look at Torstar...


Business Mix

Torstar is involved in several different businesses as shown below:



Torstar dominates the newspaper landscape in Ontario, Canada's most populous province. On top of owning 100+ community newspapers (most of these are weeklies), it owns the flagship Toronto Star, the most popular newspaper in Canada. Its other big business is Harlequin, which is famous for publishing women's romance novels.

Torstar has a 19.35% stake in Black Press, which publishes newspapers in Western Canada and in some parts of the US. Given that economic growth has been strong in the west (mostly due to booming commodites), the Western papers should do better. However, the long-term future is up in the air. I think the big-name newspaper properties may be able to capture a critical mass on the Internet but I'm not sure about the smaller papers.

A big investment is Torstar's 20% stake in CTVglobemedia, which is a leading media company in Canada with some key television channels, radio stations, and a leading national newspaper, The Globe & Mail.

The following charts (from June 24, 2008 Torstar presentation) describe the revenue and EBITDA breakdown:



It generates about 70% of revenue from newspapers and about 30% from books. Its Internet revenue is very small (less than 5% depending on how you break it down). Torstar also has additional strategic investments in internet sites/television/radio/etc, which contribute about 20% of earnings.


Long-term Problems

The main problem plaguing Torstar is the general decline in newspaper readership and advertising revenue. Less people are reading newspapers (particularly true for people under 30) and businesses aren't advertising in the paper as much either. Canadian newspaper readership has been declining around 3.1% per year (CAGR, compound annual growth rate) over the last 8 years. On top of that, highly profitable segments in a newspaper like classifieds have moved online (ebay, craigslist, etc).

Harlequin, its book publishing arm, has had problems over the years due to the strong appreciation of the C$ against the US$--but this has come to an end for hte most part IMO. It is a slow growth business with its own set of threats from Internet digital books sales, to difficulty with direct mail campaigns (it used to rely heavily on this it seems.)

The Internet properties generally do not generate much revenue right now and are a drag (some of them are fine but most are not). Although it is necessary to build out the Internet business, the fruits, if any, will be long time coming. As I will mention in a future post when I detail my thinking regarding the Interent properties, some of the properties seem to have a good possibility of dominating certain sectors in the future. In particular, workopolis.com, 50% of which Torstar owns, already seems to be the #1 job search site in Canada. Although job sites come and go, anyone that can stake a strong claim now can possibly develop a large moat in the future. Although somewhat of a long shot right now, I also think wheels.ca and toronto.com have potential to develop their brand and capture a life-time customer. Those sites likely need more work but they have a good shot.

Similar to, say, auto manufacturers, one of the difficulties for newspapers is that they have high fixed costs (printing presses, bulk paper orders, distribution network, etc.) The publishing system, throughout time, has been optimized to maximize units sold (just like car companies.) As sales decline, it is very difficult to cut costs. Paper costs go down and labour may decrease slightly (most are unions and hard to lay off workers--labour really isn't an issue though), but the cost of the printing presses, energy used in factories, and so forth, stay the same. Having said that, if they can successfully transition to the Internet (or some digital media distribution system,) their costs will drop significantly.

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Wow... Crazy Day... SEC Limits Naked Shorting on Fannie, Freddie, Lehman, Morgan, and Goldman

Wildest day--and I'm not even a day trader :) In what seems like an unprecedented move, SEC is limitting naked shorting of Fannie Mae, Freddie Mac, and the primary dealers (Goldman Sachs, Merrill Lynch, Morgan Stanley and Lehman Brothers):

Christopher Cox, chairman of the Securities and Exchange Commission, said on Tuesday that the regulator will try to limit so-called naked shorting of shares in Fannie Mae, Freddie Mac and primary dealers including Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs. The SEC will issue an emergency order stating that all short sales of shares in these companies will be subject to a "pre-borrow" requirement, Cox explained. This will last for 30 days, he added. The SEC is also planning more rule-making focused on the broader market, Cox said.


I'm not sure what this means for shorts who took positions in the last few weeks, such as William Ackman and others, if they can't deliver the shares. I suspect it probably applies to new positions and it only applies to naked shorting. Naked shorting, for those not familiar, is when you sell short a stock without actually borrowing a physical share. Naked shorting is generally not illegal and some, such as Patrick Byrne of Overstock.com, have argued that it hurts businesses.

The problem faced by financials is that a lot of people (generally the efficent market crowd) perceive market prices as being reality when in fact it may or may not be. In other words, financials depend on trust which comes from the share price. This is one reason some are suggesting that Lehman Brothers should go private. Even though the fundamentals won't change if Lehman were private, it won't be subject to rumours like it is facing now.

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One Big Risk With Investing in Financials

One of the big risks cited by some for the financial services industry is the possibility that a structural change may be occuring (to the detriment of financials.) Financials have been above-GDP-growth earnings from the late 90's to the early 2000's. FT Alphaville refers to a Deutche Bank report illustrating the above-GDP-growth profits and asks whether profits are reverting to the mean (ironically they also point out that a lot of problems with CDOs were because the mean-reverting assumption built into the CDO models turned out to be wrong.)



I brought up this point a few months ago when I mentioned an article from The Economist dealing with the same point. Are we seeing a negative structural change for financials? Will their revenue (relative to GDP) decline in the future? Will their profits (relative to GDP) decline permanently? If you are investing in financials (or thinking about it), and are a long term investor, this is an important point. If future profitability is lower, the earnings multiple (or whatever method you use to value businesses) will be lower in the future. The profit margin from the past will be higher than what's in store in the future.

I don't have a strong opinion either way, yet. Clearly a lot of the profits booked in the early 2000's were either bogus or were unsustainably high. But I'm not too sure about the structural change argument. The world has changed quite significantly over time. Just like how the internet industry is a big chunk of the economy, the financial services industry is larger now. For instance, very few people invested in stocks, bonds, or whatever, 20 years ago, whereas practically everyone under the age of 40 invests one way or another (even if they are not stockpickers, they invest in passive mutual funds.) A huge chunk of commerce (especially the retail side) is conducted using credit cards rather than cash these days. Businesses also can do things now due to advances in financial services that they had difficulty doing before (for example, hedging currencies (even for a medium size business) is quite affordable and easy to do now.) So the verdict is still out on the future of the financial services.

Having said that, if you are investing with a contrarian, turnaround, tactic in mind then the future change in the industry may not matter as much. If you invest in severely beaten up stocks, the upside is large even if future profitability isn't as good as it was in the past. The market is pricing many financials as if they are close to or almost insolvent. All it takes to make money is for mark-to-market losses to reverse (assuming they do.)

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Sunday, July 13, 2008 4 comments

John Templeton: The Ultimate Contrarian, And More

Wherever we are and whatever we are doing, it is possible to learn something that can enrich our lives and the lives of others... No one's education is ever complete.

-- John Templeton (1912-2008)



As many are likely aware by now, John Templeton, one of the top contrarian investors of all time, passed away last week. While everyone is running scared in the week when we had the second largest bank failure in US history (it isn't as big as it seems when adjusted for inflation) and rumours of imminent collapse of Freddie Mac and Fannie Mae circle the world, I suspect John Templeton would have been cool, stayed calm, and probably started looking at investing in some names.

Although many investors would not pick the quote I show above, I think it sums up the essence of what John Templeton was. John Templeton was very religious and, myself being an atheist, I am sure I would disagree strongly on many of his views on life. Nevertheless, I respect people who can be spiritual even during the worst of times. The fact that he prays for everyone--even so-called enemies--after 9/11, while Ann Coulters of the world call for nuclear bombing the Middle East, says something about the man. It almost feels like he found bliss on earth. (Click here to read an overview of John Templeton's life from The New York Times.)


I can't say I know much about, or have been directly influenced by, John Templeton. He stopped investing by the time I started getting into investing, and he didn't really publish many books on investing. However, many of his ideas are so influential that it is ubiquitous in present-day investing whether one realizes it or not.

The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell.


If there is a contrarian investing hall of fame, John Templeton may be the first one to be inducted. I can't think of too many others who made such bold moves going against the crowd as he has. The most famous of his contrarian investments was when he bought 104 stocks trading below $1 on the NYSE in 1939, after the Great Depression and the beginning of World War II. Of the 104, 34 went bankrupt and on the rest he made around 284% in 4 years. It would have been totally unfashionable to invest as the war was breaking out and everyone was panicking. Yet, Templeton did it and immortalized himself in contrarian investing lore. The other big contrarian investment he is known for are his investments in Japan in the 60's, when it was totally out of favour and no one really thought of investing there.

The four most dangerous words in investing are "This time it's different."


Although most of John Templeton's ideas are well known by contrarian investors, it is still good to review them. To get a feel for them, check out this post by Rick of Value Discipline where he summarizes Templeton's 22 maxims (thanks to ControlledGreed.com for original mention). John Christy of Borderless Investor also has a short summary of Templeton's key ideas (thanks to seekingalpha.com).

I'll finish off by mentioning the quote from Templeton that I find most insightful and try to based my investing on...

If you want to have a better performance than the crowd, you must do things differently from the crowd.


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Saturday, July 12, 2008 0 comments

Has Everyone Forgotten About the Yen Carry-trade?

The Yen carry-trade, which used to make the news a few years ago, seems to have been forgotten by many. The carry-trade is still alive and will be so until interest rates in Japan go up and/or investing within Japan becomes more attractive than overseas. Contrary to the popular view of hedge funds being the big players in the carry trade, my opinion is that the carry trade is due to local Japanese investors investing overseas. I have posted articles about this point in the past but to recap, Japanese investments are so unattractive that locals (mostly Japanese women supposedly) invest overseas. I ran across a post by Schreyer at GaveKal's forum examining the relationship between the Yen carry-trade and stocks. Schreyer provides the chart below showing MSCI World stock index versus Euro/Yen currency cross:



Although this is a short-term covering only 2 or 3 years, it does provide a quick glance of the relationship between the Yen carry-trade and stock market investments. Both stocks and the Euro/Yen have moved together in perfect tandem for a few years now; but the relationship seems to have broken down this year, after the stock markets of the world started correcting sharply.

One of the hypotheses was that capital (via the carry trade) is being funnelled into some other asset such as commodities. Will Denyer of Gavekal takes a stab this idea and provides the following chart of the Euro/Yen cross and some Euro oil index. I'm not familiar with the oil index being plotted, and not entirely sure if it is a crude oil index (i.e. commodity itself) or some sort of index of oil shares.



Again, the chart is very short-term and one should draw any strong conclusions from it. Nevertheless, it does seem like the Euro/Yen rate has been moving in lock-step with the oil index lately.


People had been accusing speculators of driving up the oil price. I personally don't think speculation is the main reason (my view is it is based mostly on demand at the margin from developing countries) but if you had to pin the blame on a speculator, I think we have found our speculator. No, it's not some hedge fund or some pension fund overloading on commodities. Nope. It's the evil Japanese carry-trade investors hell-bent on finding higher returns than at home ;) On a serious note, the time frame is too short and I have no idea how much the Yen carry-trade is contributing to the commodities boom. We'll just have to wait and see.

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An M&A Deal to Consider: Energy East Acquisition by Iberdrola

One of the few strategies that can do well during bear markets is risk arbitrage. If my understanding of Warren Buffett is correct, he made a big chunk of his gains in his partnership days during bear markets from risk arbitrage or similar specialist tactics (generally they are known as 'workouts'.) Deals can blow up--the Penn National (PENN) deal comes to mind--but if one can side step the failures, they should be able to post positive returns in a tough market. The only holding in my concentrated portfolio showing positive returns so far is the BCE M&A position. One of the deals I have been thinking about over the last few weeks is the Iberdrola acquisition of Energy East (EAS).

Energy East is a utility operating in the Northeast (New York and Maine.) Iberdrola is a Spanish utility that is one of the largest utilities in the world. The Energy East friendly takeover was announced last year and all the requirements have been met (shareholder approval, financing (finally a deal without financing risk :)), most government approvals) except for one issue. The New York regulator is yet to rule on the takeover and a non-binding suggestion by a judge was for the deal to be rejected. The stock is trading 14.6% below the buyout price due to the risk of the deal being rejected.


In an attempt to placate the regulator, Iberdrola has suggested that it will invest up to $2 billion in wind energy in New York. Charles Schumer, a key politician (US Senator) in New York, along with other government bodies seem to be in favour of the deal if the wind investment is made. But Iberdrola needs to make a firm committment on the wind investment, rather than suggesting it is a possibility. The deal will come down to this investment (or a similar investment plan for New York) in my opinion.

One thing to point out is that Iberdrola can walk away if it doesn't like the terms. Although Energy East is benefitial to own, they have a million other options and have no need to compromise much. There are many other utilities, some rumoured deals in Australia and New Zealand, that it can buy. Iberdrola is already the second largest wind energy producer in the US (if I'm not mistaken; not entirely sure about this) and has a presence in the US already so the Energy East deal is not critical to their future.

The deal is well past the initial projected closing date. It can close as soon as the regulator gives approval. Press articles seem to imply that a ruling will come before mid-August.

I still haven't made up my mind but I find this deal attractive given the quick pending decision. The scenario is easy to understand; but pegging the downside seems tricky. Even an arbitrage specialist wouldn't be able to hedge this given that it is a cash offer. Even if you attempt to hedge by shorting Iberdrola in Spain, the deal is very tiny compared to the rest of Iberdrola (Iberdrola stock price will move largely on other events.) Having said all that, I think cash offers are the best risk arbitrage plays for small investors (you can't hedge but you have no worry on the upside other than currency risk.)

One of the things one should consider is whether to hold a stock if an M&A fails. This is where the difficulty with this deal comes (at least for me.) I don't know much about the utility sector so I don't know if Energy East's TTM P/E of 16 and forward P/E of 17 is high; or if its debt/equity ratio of 1.2 is risky; or if its price-to-book of around 1.2 is high for utilities.


Buyout price: US$28.50
Current price: $24.87

Return upon success: 14.6%
Probability of success (guess): 75% (need to think more about this)
Return upon failure (guess): -26.1% (I need to do more work on this. I'm assuming the stock drops to $22 given the stock price low over the last 3 or 4 years)
Probability of failure (guess): 25% (need to think more about this)

Expected return: 4.4% (14.6*.75-26.1*.25)

Return looks low but remember that we should know the outcome of the deal within a few months. Also note that this is not an annualized return. Risk arbitrage investors always annualize their returns but I don't for a few reason

Anyone like me thinking about taking a risk arbitrage position in this really needs to be confident of the downside. One of the big reasons I'm still thinking about this deal, even with seemingly low returns and big regulatory risk, is due to the fact that utilities typically do fine even if the economy slows. So holding the stock if the deal fails may be acceptable. Your risk is not decreasing sales and profits, but rising interest rates and/or the market placing a lower multiple on the company. As for interest rates, I think the probability of them going up significantly over the next year are low (I think inflationary threats are overblown and is really an issue in developing countries rather than here.) The market lowering the valuation placed on the company is something I have to research more. P/E of 17 is not extremely high for a relatively "safe" utility paying a stable 5% dividend, but it may not be cheap either. Utilities did very well a few years ago and I want to be sure that they are not in a "bubble" of some sort. I'm bearish on most of the sectors that have performed well over the last 5 years (foremost bearish on energy and materials sector) and when the market chops them down, I don't want to be anywhere near them--are utitlities going to be priced down?

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