Thursday, April 30, 2009 2 comments ++[ CLICK TO COMMENT ]++

Commodity marginal cost of production tends to decline decline

I guess this blog is more about quantity rather than quality :) On a blogging roll in the last few days... Anyway...

One of the difficulties for commodity investors—a point often ignored during bullish times—is that the marginal cost of production can decline over time. In fact, this is what tends to happen for most commodities. The vast majority of commodities seem to deflate over time (I need to check this but that's my impression). I want to illustrate this point by referring to what Talisman (TLM), one of Canada's largest oil & gas E&P companies, is saying about natural gas:

Until recently, energy producers have found it too expensive to tap into the huge reserves of natural gas trapped in various shale formations. But as technology has improved, Talisman and several Canadian and U.S. firms have been flocking to the regions.

"The gas price at which our unconventional business remains profitable is coming down all the time. We can see ways to ensure profitability down to $4 gas prices, but we're not going to stop there," Mr. Manzoni [CEO] said.

CEOs are often wildly bullish about future prospects so who knows how correct this will turn out to be. Nevertheless, it is quite remarkable that Talisman thinks it can be profitable at $4/MMBtu with shale gas. Not many would have imagined a few years ago that you can be profitable at $4 with unconventional natgas (for those unfamiliar, unconventional natural gas, such as shale gas, is one of the most expensive sources on the planet.)

This post isn't predicting $4 natgas; rather, the point is that technological advances, efficiency improvements, government incentives, and the like, can bring down the marginal cost of production. If you are betting on a commodity business—by definition, a price-taker and hence only minor control over profitability—you better discount the marginal cost of production to account for technological and other changes.

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Montpelier Re doing something positive for shareholders

Montpelier Re (MRH), my only core investment right now, has been a dissapointment lately. I don't follow it closely but do keep an eye on it once in a while. It suffered huge losses on their investment portfolio last year, which is never a pretty sight when the insurer is mostly investing in supposedly "safe" assets. As I indicated in my outlook for 2009, I am bearish on insurers. If interest rates stay low, we may see a period like the 40's or 50's, when insurance companies, who mostly own bonds, don't earn much off their investment portfolio. For this reason, I am not too optimistic with these companies in aggregate. However, specific companies can be good investments.

In any case, in the latest quarterly conference call, I noticed something that I wish more businesses were doing. Namely, buying back bonds:

The second was a repurchase of 21 million of our outstanding 2013 Senior Notes or 15 million resulting in an immediate $6 million gain and a 1 million annual interest savings going forward.

Some would argue that buying back shares is the best thing to do right now. Shares seem cheap to many. I'm probably in the minority camp who feels that shares may not be cheap. Clearly we have many, including Warren Buffett (at least if we use his opinion piece from October of last year), saying that shares are undervalued. I'm just a newbie with little experience but I am not certain that shares are cheap here—even though we have seen two major stock market crashes in the last decade. Since, in my opinion, the risk to earnings is to the downside for most companies (i.e. corporate profit margin for the next 10 years likely to be worse than the last 10 years), buying back shares can be risky. Leverage cuts both ways and when earnings collapse, it will amplify the pain. If it works out, it will look great but if it doesn't, it would look like some idiot who bought back his shares at $50 only to see it trading at $30 two years later.

Others would argue paying out dividends is the best thing to do now. Dividends are becoming scarce and the hence it will be valued more by the market than it was possibly at any point in the last 20 years. By increasing the dividend by, say, 5%, you can attract the passive investors who blindly buy on screens (such as companies that are increasing dividends.) In Montpelier Re's case, dividends probably don't matter much since it is a very risky company and very few would consider it a 'divdend stock.' In general, though, I am not a fan of dividends and hence I don't like companies raising dividends.

On the other hand, I think it is probably better to buy back bonds, assuming you are certain you have excess cash. Bonds look even cheaper than stocks to me. Many bonds are trading 20% to 40% below par value. In this case, it seems Montpelier Re bought back the bonds around 29% below par value. Buying back bonds will also reduce leverage going forward. Some investors seem to like leverage but I don't view it as positively as many others, especially if one is not confident with future profitability.

So, companies that are sitting on large piles of cash, and are certain they won't be needing that cash, should start buying back their bonds.


One of the reason the market is rallying is because earnings are coming in strong

Bloomberg points out that companies are beating earnings estimates. I suspect this is one of the reasons the market is rallying.

Corporate earnings worldwide haven’t been the disaster analysts predicted as companies from Ford Motor Co. to Siemens AG beat earnings estimates through job cuts, factory consolidations and a dose of lowered expectations.


Some 188 members of the Standard & Poor’s 500 Stock Index have topped analysts’ estimates, or 69 percent of the 271 companies reporting so far. That’s more than the 62 percent for all of the previous quarter, Bloomberg data shows. In Europe’s Dow Jones Stoxx 600 Index, half of the 110 members reporting so far beat estimates, up from 38 percent in the previous quarter.

If the strong earnings can be maintained, it's very bullish and signals the possibility of a strong recovery later in the year.

Wednesday, April 29, 2009 0 comments ++[ CLICK TO COMMENT ]++

Opinion: One political party in America is equivalent to 2 or 3 elsewhere

(This post is about politics and has nothing to do with investing.)

Paul Krugman recently commented on his blog that the Republican Party is getting marginalized, with the defection of Arlene Specter to the Democrats, and I spent some time reading some of the commentators (instead of doing something more productive with my life ;). I have to say I disagree with some commentator's opinions about the dominance of two parties in America.

Although two parties dominate America, I would actually say that each party is equivalent 2 or 3 parties in a British-style parliamentary democracy. The lack of choice in American parties is mostly an illusion in my eyes.

Under the American system, there has almost always been only two parties competing. It has ranged from Federalist Party vs Democratic-Republican Party, to Democratic-Republican Party vs Whig Party, to (old) Democratic Party vs (old) Republican Party, to the present Democratic Party vs Republican Party. There are some minor parties such as the Green Party, Libertarian Party, and so on, but they have never influenced American politics.

In British-style systems, being practiced in countries such as Britain, Canada, Israel, India, and so on, there are generally at least 3 parties with significant support, and another 2 to 5 depending on the size of the country. Canada, a fairly small country, has seen 4 fairly dominant parties in the last two or three decades: Liberal Party, Conservative Party, Reform Party (defunct), Parti Quebecois, and New Democratic Party. The popularity and dominance has shifted over time but all of these have played major roles.

I see quite a number of Americans seemingly disgruntled with their choices largely limited to two. I have to say that, although more parties the better, this is not as terrible as it seems.

First, the downside to the American system. The one area where the two-party system hurts America is with the presidency. Americans have little choice—they have to pick between the candidates from the two major parties. In a British-style system, there is no president—even if there were, like in India or Isreal, they are weak positions and largely ceremonial—so the voter does pick among many choice (i.e. the leader of the party with the most votes generally becomes the prime minister and that is the position that is equivalent to a president in America.) So, there is indeed a lack of choice when it comes to the presidency.

When it comes to all other aspects—Congress, Senate, state elections, etc—the situation is not so bad. Even though two parties dominate, each party is made up many factions. The American parties, in my view, is more like an umbrella group that joins two or three factions together. In British-style systems, each faction is a separate party. I'm left-leaning so let me illustrate the left wing.

It's never the same across all countries and I hate to generalize too much but a faction that favours socialist policies would have its own party in Canada (NDP), one that favours the environment would be its own party (Green), while another faction that is liberal but is more free-market oriented may have its own party (Liberal). Generally, it is common to have one that favours labour called Labour as well (but it's not called Labour in Canada.) Obviously you could have a mixture, and you always get mergers and separations, but the main point still stands. Although there is nothing to prevent these factions from forming separate parties in America, they, instead, tend to favour the Democratic Party. Nearly all the voting by the left wing goes to the Democratic Party (similar thing with the right wing.) In most British-style parliamentary democracies, the 3rd or 4th parties can get more than 10% of the vote. In America, the 3rd party would be lucky to get even 3% of the vote. The Democratic Party and the Republican Party span a wide spectrum, far more than any single party in the British-style system.

Another way of looking at it would be to say that the Democratic Party in America spans from the far-left to the center-right. In contrast, Canada's NDP is probably far-left to left, Green is far-left, while liberals are left to center-right. (The labels are somewhat subjective so I can see some disagreeing.)

Perhaps most importantly, the members of the American parties are very independent and do not act as if they are part of one party! There are senators and congresspersons in the Democratic Party who will vote against a major Democratic bill; similarly, Republican senators or congresspersons vote against their own party bill. In British-style systems, this is rare. Liberal members in Canada, for example, would almost always vote for their own bills. In fact, if you are a member of a party and you vote against a bill introduced by your party (say the prime minister was from your party), you can get kicked out of the party! This doesn't always happen but it does happen for bills where failure can be considered no-confidence (e.g. budget bill.) In contrast, in America, it's common to see party members voting against a bill introduced by their own party or their own president.

America may only have two parties but because of the independence of the congresspersons and senators, they are almost like 4 or 5 parties. Combined with the fact that states have more rights in America essentially means that there is a lot more choice and freedom than appears on the surface.


A new compensation controversy in the making... at Chesapeake Energy

A lot of the controvery over compensation schemes have mostly centered on financial companies. The most famous so far is the Merrill Lynch bonus payments just before it was purchased by Bank of America—I'm sure to the shock of many involved, this has opened up a can of worms, with potential illegal actions by various government officials and the CEO of Bank of America. Another big one was the bonus payments to AIG Fincial Products employees. The controvery this time had to do with the fact that the employees that bankrupted the company and ended up requiring $100+ billion bailout by the US government was being paid bonuses. Admittedly, some of the key employees who brought down the house don't work there anymore, although many others, mostly lower level, likely still do. I mean, even my Ambac has paid more than $10 million to the executive who was on the board (at that time) overseeing the expansion in structured finance. Ambac hasn't caused any controvery yet though--mostly because taxpayers haven't paid anything.

Now, we have a different sort of controversy brewing. This time it's Chesapeake Energy, whose share price has completely collapsed, although I'm not sure if the change in fundamentals justifies all of the price change. It seems that the CEO of Chesapeake was paid more than $100 million, which will probably make him the highest paid CEO last year:

On Apr. 21, the Oklahoma City-based company disclosed what may turn out to be the largest CEO pay package of 2008. In a year when Chesapeake shareholders saw their stock fall nearly 60% and the company's profits drop by 50%, McClendon's pay soared fivefold to $100 million. And as they say in late-night TV commercials, that's not all. The company also agreed to purchase McClendon's personal art collection—vintage maps that had been hanging in Chesapeake's corporate office—for $12.1 million. In addition, the company's proxy filing notes that Chesapeake paid $4.6 million to sponsor the Oklahoma City Thunder, a National Basketball Assn. team in which McClendon owns a 19% stake. The filing says the company received TV air time and other sponsorships in return.

McClendon, 49, ran into financial trouble last October with the market's steep slide. He had borrowed money to buy Chesapeake's once high-flying stock and had become the company's largest individual shareholder. With Chesapeake's shares tumbling along with commodity prices, McClendon received margin calls and was forced to sell nearly all of his shares over three days. A stake that was worth $1.9 billion just a few months earlier vanished almost overnight, and McClendon said in an Oct. 10 press release that he was "very disappointed" by having to sell. But McClendon's board supported him and in December offered him a new pay package. According to public filings, the company designed his new plan to keep McClendon from leaving and to reward him for four large deals he negotiated last year. Chesapeake sold interests in four of its fields to BP (BP), StatoilHydro ASA (STO), and Plains Exploration and Production (PXP) in transactions that raised $10.3 billion.


McClendon and former partner Tom L. Ward founded Chesapeake in 1989. Through canny acquisitions and a big bet that new reserves could be found under thick shale deposits, the pair turned Chesapeake into the nation's largest producer of natural gas. Ward has since left the company, but McClendon continues to be part of an unusual arrangement Chesapeake calls the Founder Well Participation Program. McClendon is allowed to invest his personal money for an up-to-2.5% interest in any wells the company drills. That program was a big part of McClendon's compensation package last year. Rather than have him pay out of his own pocket, Chesapeake paid $75 million to cover McClendon's share of the well investments.

This is basically what I call the 'founder problem'. Many entrepreneurs and founders who take their companies public treat them as if they were the sole owners. A lot of questionable behaviour related to compensation, such as getting the company to pay for their art collection, or making the company pay for their private transporation, don't pose a problem when the companies are private and the founder generally owns 100% of the company. Unfortunately, many still maintain their behaviour even after taking a company public and ending up with way less than 50% of the ownership (generally the case.) There are supposed to be independent boards but when you stack their with your allies, which is almost always the case with these situations, it's questionable whether anyone is independent.

To make matters worse, the founders tend to be very valuable to the company and hence it is not in shareholder's interest to lose him/her. So how do you compensate properly in such a situation? An oil & gas driller like Chesapeake probably doesn't want to lose its founder so what is the proper compensation?

To complicate matters further, should compensation be tied to share price performance or not? Some argue it should be based on fundamental performance. Investors such as Warren Buffett argue that compensation should be based on fundamentals. But even that doesn't solve the problem. If it is so, as long as the executive performs well on fundamental metrics, high compensation is proper regardless of share performance. This is clearly the stance of the Chesapeake board in this case. The board argues that the CEO cut some deals, possibly to avoid a bankruptcy--of course it's questionable why the CEO put the company in a bankruptcy-prone situation but no one really asks these questions. Similarly, basing pay on fundamentals would have led to cases like Home Depot in the early 2000's when its CEO was paid $245 million over 5 years even though the stock price declined 12% (versus its arch-rival which was up +173% and its CEO was paid less than $35m.)

The main reason Buffett, who advocates pay for fundamental performance, doesn't run into this problem is because he is very cheap and sets very low compensation. Furthermore, Buffett tends to purchase businesses owned outright by their owners which is quite different from the case of an executive who owns less than 5% of a company. However, I have a suspicion that Berkshire Hathaway will run into all sorts of compensation problems (i.e. will end up paying out hundreads of millions for dubious performance) after Buffett passes away because new management and board will behave more like contemporary corporate America.

Anyway, going back to Chesapeake, there is no easy answer to all this. If they didn't pay the $100 million, I'm sure the CEO would have walked away and the company would have faced some difficulties.

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Gary Shilling interview with Advisor Perspectives

Sticking to my contrarian knitting, albeit with the potential to go completely astray and lose my shirt, let me go against a strongly rallying market and present a bearish view from Gary Shilling. Thanks to GuruFocus for pointing me to a Gary Shilling interview with Advisor Perspectives.

For those not familiar, Gary Shilling is considered by the mainstream to be a perma-bear since he has mostly been bearish and called for a deflationary bust that never materialized in the late 90's. I dismissed him a few years ago, similar to my ill-advised dismissal of Jeremy Grantham, because he seemed too bearish.

One of the things that has separated Gary from other bears is that he is an economist and approaches things from a macro point of view. In contrast, many other bears tend to be traders that rely on technical analysis (Mike Shedlock of Mish's Global Econmic Analysis blog, for instance, says a lot of economics but seems to make his investment decisions off technical analysis.) In addition, unlike most bears, who tend to think that hyperinflation or collaspe of US$ and hence USA, or some scenario like that is most likely, Gary Shilling is a deflationist who has historically been bullish on long-term US government bonds and US$.

From what little I understand, Gary made his money from betting on long bonds in the early 80's. He used leverage to become financially independent but even if you didn't use leverage, someone rolling over the long bond for the last 30 years would have outperformed stocks. Someone reading present history 200 years from now would probably be more amazed at the bull market in bonds the last 28 years more so than the technology boom or the housing boom or globalization boom. (I have an investment idea on this in an upcoming post.)

Anyone interested in some of my thoughts on what Gary is saying, click through to read more.

Robert Huebscher: You’ve been forecasting deflation for some time, and the March CPI numbers validated these forecasts – the first deflationary month since 1955. Can you summarize the major forces in the economy that will continue to keep the CPI numbers in negative territory?

Gary Shilling: In the short term - for the duration of this recession, which will be at least another year - four very deflationary forces are at play.

First is the ongoing weakness in commodity prices, which takes time to work its way through the system...Second are excess inventories, which are the mortal enemy of price increases...

The most interesting phenomenon, which we are now seeing for the first time since the 1930s, is wage cuts and shorter hours. In the post-World War II period, the only way employers could cut costs was to lay people off. Under high inflation, employers used another method of controlling labor costs, which was to freeze pay or raise pay less than the rate of inflation. Now, however, there is no inflation and we are back to the 1930s, when deflation reigned. To lower costs, you must get rid of people or cut hours. About 6% of employers have cut wages or hours in the last year, and another 10% plan to do so. This is less than the number of employers that have had layoffs, which in the 20% area, but it is growing and it is highly deflationary.

The fourth and final deflationary force is excess capacity in the economy. The Commerce Department has an interesting measure, which shows the excess capacity versus demand across the economy. An interesting and powerful relationship is apparent, which shows that excess capacity reduces the CPI with a six-month lag.

For the duration of this year, deflation is the odds-on bet.

Right now, almost everyone is expecting inflation. Even the bond market, which was signalling deflation, has switched to an inflation stance right now.

The wild card in my eyes will be worker compensation. If workers are cut or if wages decline (say due to work-sharing) it is hard for me to see much inflation. Unemployment lags and, historically, this never meant much since we had strong recoveries that materialize within an year. Right now, however, I think unemployment will have a material impact. We still haven't seen the ripple effects from unemployment because it always lags everything. The fact that the severe problem in America lies with the consumer (i.e. worker) also likely means that unemployment will have all sorts of side-effects, unlike anything we have seen in the last 50 years. For instance, even though unemployment was even worse in 1982 and 1974, the impact of the consumer on the economy will likely be more meaningful right now. Things like credit card losses, decline in durable purchases (e.g. cars), defaults on mortgages, and so on, will be far more damaging now.

(On a side note, what is discussed here are the bad deflationary forces. On top of all this, we have the good deflationary forces of technological advancement, cheaper foreign labour, improved efificencies, and so forth.)

What are your reasons for this economic decline?

Gary Shilling: I see five factors inhibiting economic growth.

First is the de-leveraging of the consumer sector, which was on a leveraging tear for three decades...

Like the consumer sector, the financial sector is de-leveraging, after having been on a leveraging binge for three decades. A lot of that leveraging was financial fluff, but it did finance important goods and services. Growth in Eastern Europe and the Baltic region was financed by Western banks. Banks are going back to spread lending, which we can see now, for example, in the recent announcements by Bank of America. With skill, luck, hard work and unlimited free government money, they can’t fail. Their balance sheets are still terrible, though. We don’t know how much bad paper they have and we can’t figure it out. Apparently, the banks don’t know either, and were making calculations until the last minute before releasing their numbers. Going back to spread lending will have a big negative effect on economic growth, but is hard to quantify.

Third, we are at the end of the commodities boom. Big commodity producers were spending at a high level, as were smaller countries like Zambia, Peru and Chile, who produce copper. During the boom, buyers lost while producers won, and now the reverse is true. But the buyers are the big industrial countries, so the countries suffering now are the smaller ones. Oil is a very minor part of our GDP, but for Saudi Arabia it is everything.

Increased government involvement has decreased economic efficiency. Banks are wards of the state. They are not interested in taking risk, just in preserving their empires. Government intervention stifles initiatives, and it never quite works. Wall Street will figure their way around regulations, and Sarbanes Oxley is the prime example.

The final factor is protectionism, which is growing rapidly. Protectionism started in the financial sector.

Well known reasons and I think the market has priced all this in. It's interesting that Gary considers various government actions in the financial sector to be protectionist. Now that I think about it, he seems to be right. Of course, very few in the financial sector, whose jobs and fortunes are dependent on bailouts, consider these as protectionist.

Q: In late January you wrote that it is “way too early to get back into U.S. stocks.” Is that still your recommendation? What signs are you watching to determine when US equities will be attractive?

Gary Shilling: Stocks anticipate the economy. It’s normally five to six months before the end of a recession that they hit their low point. If we are right that the economy will bottom a year from now, then stocks will bottom late this year. Since stocks are a leading indicator, the question is what leads this leading indicator.

Three things must happen to clear the path for stocks to recover.

First, we must eliminate excess housing inventories...If nature runs its course, it will take until the end of next year to get down to where home prices will level off. We need another 15% decline (for a 37% total decline) in housing prices. Half of homeowners with mortgages - about 25 out of 50 million people - will be underwater, to the tune of one trillion dollars...

Second, we must deal with additional financial problems that are surfacing. So far, our problems have been related to residential mortgages, but consumers are treating payments on other kinds of loans – credit cards, auto loans, home equity loans, student loans – as discretionary. Financial responsibility is going out the window. The TALF is supposed to deal with this, and we will see if it really works. As it stands, the Fed can buy only AAA-rated paper, but the problem lies in paper that is not rated AAA.

Commercial real estate (except for hotels) is suffering from overbuilding. We have excess capacity in warehouses, malls, and offices. Sublease space is competing with new space. Hotels are facing declining occupancy. The underlying problem was refinancing that added leverage, and a lot of this debt is coming due and will be difficult to roll over.

Markets still face a problem with junk bonds (which are now at 18% spreads) and leveraged loans. Delinquencies and charge-offs are just getting under way. Holders of these securities have not anticipated the write-offs that will come.

Third, the fiscal stimulus is too small to break the cycle of lack of consumer spending, inventory build-up, production cutbacks, and unemployment...

Couple of thoughts...

My feeling is that the stock market is not going to rally 6 months ahead of the bottom. I'm reading Anatomy of the Bear and major bear markets have seen the stock market rally alongside the economy. The market doesn't necessarily look ahead for major bear markets and crashes. In any case, Gary thinks the bottom may still be ahead.

I don't understand Gary's point about junk bonds. How could he say that the bondholders haven't anticipated the write-offs when the spread is 18%? I think junk bonds can still sell off further but most of it seems to be priced in. If anything, my feeling is that the junk bond market is looking far ahead into the future, more so than any other market.

Q: What is your target for the S&P?

Gary Shilling: I am on record with a target of 600 on the downside for the S&P 500, based on my forecast of $40 in operating earnings and a generous multiple of 15. I made that projection last November when the bottom-up analysts’ forecast was $83 and the top-down forecast was $62. They are closing in on me. We have another 25% decline to hit the bottom, which I expect in the later part of this year.

S&P 500 at 600 is pretty low but is a reasonable bearish call. Unlike some that mistakenly use trough earnings and trough P/Es to arrive at their estimates, Gary correctly uses trough earnings with normal P/Es (an alternative is to use peak earnings with trough P/Es.)

No one can predict the future and the S&P 500 may not hit 600 but it's a rough idea of what can happen.

Q: A year ago you offered 13 investment strategies for 2008, and in hindsight they were very prescient. Can you discuss some of the strategies you are recommending for 2009?

Every year, in the January issue of our Insight publication, we offer our investment strategies. Last year, 13 out of 13 worked well. Probably a lot of luck was involved, but someone in my office calculated the odds of batting 13 out of 13, and it was one out of 8,192, so it is more than just dumb luck. We updated this in January. A number of our ideas from a year ago are pretty well exploited. For example, investors can no longer profit from the collapse in the subprime market or from the decline in Treasury bond yields. Thirty-year Treasury bonds have been one of my favorite asset classes since 1981 when yields were 14.1%. Yields went to 2.6% at the end of last year, and investors in this asset class, which is supposedly only suitable for conservative investors, earned a 42.5% total return. That is over. Another fully exploited asset class is junk bonds, as charge-offs haven’t leaped but spreads have.

Stocks are going down, but I am still bullish on the dollar – it is the best of a bad lot...

I am cautiously recommending high-grade municipal and corporate bonds. They have rallied nicely since the beginning of the year, but downgrades – not defaults – are a tricky problem there.

There will be downward pressure on homebuilding and housing-related stocks, consumer discretionary stocks, commodities, and emerging market debt and equity.

I really don't understand Gary Shilling's view on junk bonds. He says one can't profit from it but what am I missing? It seems now is better than the last few years? Or is he talking about short selling junk bonds?

Q: What is your personal asset allocation, at an asset class level?

The best way to answer that is to look at how we run our portfolios, which is on the basis of strategies.

We are long the dollar, short stocks, and long Treasury bonds. A lot of these are the same trade. Last year only three asset classes went up: Treasury bonds, gold, and the Yen. Everything else went down. There is so much hot money that it ends up on same side of every trade at the same time. Investors bail out of bad ideas at the same time to preserve capital.

Q: What about gold?

I am agnostic on gold.

Gary is agnostic on gold but not me. I'm bearish and am maintaining my view from earlier this year of a potential short of gold. We haven't seen the speculative blow-off in gold yet and I'm still waiting for it to hit $1500, at which point it is worth considering a short. Similar to oil last year, it's possible that gold will skyrocket on erroneous views of hyperinflation at the first signs of high inflation.

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US GDP contracts 6.1% (annualized) in 1st quarter

Shouldn't be a surprise to anyone, although it seems slightly worse than consensus expecation, but US GDP contracted by 6.1% (annualized rate) in the 1st quarter of 2009:

Real gross domestic product -- the inflation-adjusted, seasonally adjusted value of all goods and services produced in the United States -- fell at a 6.1% annualized rate in the first quarter, nearly matching the 6.3% decline in the fourth quarter of 2008. Read the full report.

The two-quarter contraction is the worst in more than 50 years. Since the 1947, the economy had never contracted by more than 4% for two consecutive quarters. With a 0.5% drop in the third quarter of 2008, it's the first time the economy has contracted for three consecutive quarters since 1975.

In the past four quarters, the economy has fallen 2.6%, the biggest year-over-year decline since 1982.

The big story for the first quarter was in the business sector, where firms halted new investments, and shed workers and inventories at a dizzying pace to bring down production and stockpiles to match the lower demand from U.S. and foreign markets.

"The traditional patterns of a business cycle are emerging," wrote John Silvia, chief economist for Wachovia. "After a sharp decline in demand in the fourth quarter we are now witnessing the inventory correction. Ahead is rising demand and recovery at a slower, but still positive, pace."

Sharp contraction in 4Q08 and 1Q09 was a given; the question is whether 3Q09 and 4Q09 will see strong recovery or not. The stock market is betting on strong recovery in the 2nd half of 2009. The Federal Reserve also forecasts strong growth in the latter part of the year. For long-term investors, the decision is to figure out what normalized profits really are.

Tuesday, April 28, 2009 0 comments ++[ CLICK TO COMMENT ]++

If you are a contrarian and believe in re-flation, worth considering natural gas

I'm mildly bearish on commodities and don't really believe in the re-flation scenario, which is pinned on strong economic growth. But if you disagree with those views, and I suspect many readers are :), you may want to do some homework on natural gas. Strictly from a contrarian point of view, it is starting to look attractive. As you can see in the chart below from, its price has declined quite a bit and is possibly on its way to a decade low.

Without looking at fundamentals and strictly looking at that chart, it is probable that natural gas can fall another 40% to, say, $2. This was the price back in 1999 and 2001-2002. If you assume that fundamentals, either on the production or demand side, hadn't changed much and value of the US$ hasn't changed much, it wouldn't be unreasonable to expect prices to go back to the lows set a decade ago.

Has the Fundamentals Changed?

I don't follow the natgas market but did read up on it several years ago (when I was actually bullish on commodities and shortly owned a coal-bed methane play.) The fundamentals for natgas is probably slightly bearish right now. Here is my thinking, without doing much research.

Historically, and still to a large degree, natgas has been a localized market. What drives prices in America is almost entirely the North American economy (this is not the case with oil.) I am quite bearish on the economy even though we may have seen the worst already. Although the total North American GDP is higher now than a decade ago, one can't blindly assume this means higher prices since efficiency may have improved as well. Demand may also have changed. For instance, natural gas was somewhat popular as an energy source for power plants in the late 90's but nowadays very few seem to favour natgas for electric power plants. You can see the localized nature of natgas by noticing how you have wild price swings (unlike oil.) A lot of that is driven by localized weather—such as hurricanes.

Natgas also seems to have a major bearish event that didn't exist a few years ago. Although a still small component, America is starting to import quite a bit of LNG (liquified natgas). The following Bloomberg article provides some details:

“Oversupply is all but certain to persist in the near term, with liquefied natural gas imports starting to ramp up in addition to still-robust domestic production growth year over year,” Biliana Pehlivanova, an energy analyst at Barclays Capital in New York, said in a note today.

Imports of LNG may rise to 480 billion cubic feet this year, up 36 percent from last year’s 352 billion, as global demand for the fuel declines and output from the Middle East and Asia enters the market, the Energy Department said on April 14. The estimate was 26 percent higher than a March forecast.

LNG is gas that is cooled to a liquid for transport by ship to markets not connected by pipelines. The fuel is received at import terminals and converted back to a gaseous form so it can be piped to users.

April imports of LNG are averaging 1.3 billion cubic feet a day, or 44 percent more than the same month a year earlier, David Pursell, a managing director at Tudor Pickering Holt & Co. LLC in Houston, said in a report today.

Imports were 25 percent higher in the first quarter of the year compared with the same period in 2008, he said.

This LNG source is not going to decline easily. I have to do research to confirm this but I belive the cost of production in foreign regions (like the Middle East or Russia) is far lower than in North America, for the most part. If you are investing in natgas for macro reasons, you better make sure that the LNG imports don't cause oversupply for years. Natgas does not have a cartel like OPEC putting a floor under the price. It will come down to marginal cost of production.

Still Worth Considering

The environment right now is different from when I was investing back in 2005. Back then, demand was growing strongly and prices were going up. Hence many of the natgas producers were expensive. Right now, in contrast, the market is distressed. Many natgas producers are cheap and some are on the verge of bankruptcy.

It is probably safer to invest in natgas companies now than at any point since 2001. I think if someone can do their homework and pick a few companies at low valuations, it may work out. If you believe in strong economic growth then this industry seems attractive and is probably safer than it seems. I personally am concerned about economic growth and hence perceive natgas as risky so I'm staying away. But I am keeping my eyes open, in case I'm wrong, and may change my mind. A natgas producer may be a good investment coming out of a severe recession.

I have to do research since things have changed over the years but, if interested, one should consider the full spectrum from the largest to the smallest producer. If I'm not mistaken, the lagest natgas producer is ConocoPhillips but that's not a pure play. The largest independent pure play is Encana if I'm not mistaken. Others such as Apache are also worth considering. Chesapeake is another major player that is distressed. When I was investing there were countless juniors but many may have gone bankrupt or dissapeared (mergers & acquisitions) now. Contrary to what many believe, if you are superbullish on a commodity, you should consider high-cost producers. These are typically companies involved in unconventional sources such as coal-bed methane or shale gas.


Well, looks like we don't need to wait until May 4th for bank results

I thought there would be lot of suspense until the week of May 4th, when the bank stress test results are to be revealed, but it seems the media has killed the suspense. The Wall Street Journal is reporting that Bank of America and Citigroup have been told to raise capital (don't have access to original article so here is a summary from Calculated Risk.) Both banks are supposedly in the process of responding with rebuttals. It's not clear if other potentially distressed banks, such as Wells Fargo, Fifth Third Bankcorp, and others, have also been told to raise capital.

By not nationalizing banks—admittedly very difficult to do this in America since conservatives tend to be completely against it and it seems to run somewhat against American character—I wonder if the Obama administration is going to end up zombifying all the other distressed banks as well. If the government gains sizeable ownership, which it will if preferred shares are converted to common or if it purchases a lot more common shares, and chooses not to break up these megabanks, it will likely hurt private banks. It will be very difficult for private banks to compete against government banks (particularly if the govt cuts off cheap funding to the private banks while providing cheap financing to the govt banks--although no indication that this will occur any time soon.)

Another major reason the government is reluctant to seize the banks is because it will cause massive losses for bondholders. The government is trying to avoid the Lehman outcome. John Hussman has favoured the alternative—to let bondholders take losses, as they would in a true free market— and he points out what he thinks is really happening with the current approach:

As a result [of forcing Bank of America to Merrill Lynch even though the CEO wanted to back out], instead of Merrill Lynch's bondholders taking a loss on their bonds, or swapping their debt for BofA equity, those bondholders will now be made whole for all of the losses that Merrill incurred, with 100% principal and interest, right alongside of the bondholders of BofA that are being protected. That's what these bureaucrats want during their stint in government service, that's how they advise our elected officials, and then their revolving door takes them right back to Wall Street. This thing is run by investment bankers and corporate bondholders for the benefit of investment bankers and corporate bondholders.

Of course some would argue that Hussman is downplaying the systematic risks. They would argue that these banks are too-large-to-fail and hence letting their bondholders take haircuts will send ripples all acros the world.

The way I look at it, there is no "right" answer in this situation. The difficulty in the solution is to allocate the losses to various parties. The government can't save anything here; the losses are real and you can't turn back the clock. So, do most of the losses accrue to bondholders (Hussman's preference)? Or do they accrue to taxpayers (Bush administration solution last year)? Or does it accrue to competitors and bank customers (Obama solution right now)?

As I speculated above, the current Obama strategy will likely lead to zombification of select banks. You will prevent the bond market from locking up and save bondholders, while also seemingly saving taxpayers (for the most part.) But, like Japan, keeping these banks alive will suck up capital from other parts of the economy. Competitor banks on strong footing may suffer; customers of banks may see poor service and high costs (generally the case with government-run operations.)

Regardless of whether the government follows the current zombification strategy or the nationalization strategy, I think it will be difficult for the government to exit their ownership. Some, such as Nouriel Roubini and Paul Krugman, are advocating a quick-nationalization-and-subsequent-privatization, as was done in Sweden, but I think it will be difficult for the government to exit easily here. The current American problem seems much greater in scope and complexity than, what little I understand of, the Swedish situation.

In summary, it looks like the regulators have threatened some banks already. It remains to be seen what the final oucome will be. There is no perfect "right" answer and it all comes down to who is going to take the losses. When someone defaults on a $600,000 home that is only worth $300,000, who will cover the loss? I have my own personal opinion of what seems best but, as investors, we should prepare for all scenarios. Given the behaviour of the stock market in the last few days, it is possible that a lot of the negativity is already incorporated into stock prices.

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Monday, April 27, 2009 0 comments ++[ CLICK TO COMMENT ]++

Articles to Peruse

Some articles to increase your knowledge... maybe :) ...

  • (Recommended) The case for deflation (Van R. Hoisington and Lacy H. Hunt; via Mish's Global Econommic Trend Analysis): The link to the original article doesn't seem to work consistently :( but do read the original article mentioned by Mike Shedlock, along with his response. Since you will see very few deflationists, you may want to read this article, even if you are an inflationist or a neutral, to see why the deflationists believe what they do.
  • Profile of several workers laid off (Report On Business magazine by The Globe & Mail): Some depressing stories of people in wide spectrum of industries and positions losing their jobs. One of the sad things about losing a job, and capitalism in general, is that the layoffs can be indiscriminate. Some like to think that the worst workers or the overpaid or those willing to leave are the ones to go, but reality is that almost anyone's job can be lost.
  • Tampa Bay Lightning and the difficulty faced by sports teams (Report On Business magazine by The Globe & Mail): Sports teams are glamour investments that rarely ever work out. This article illustrates the problems for NHL's Tampa Bay Lightning, which seems to have gone from a mild success story to a distressed team. If one of you happen to be a multi-millionaire and thinking of buying a team, consider the downside first ;)
  • Portfolio magazine dies a quick death (Portfolio): Portfolio magazine, which some may recognize as the former home of blogger Felix Salmon, shut down today. I never followed the magazine nor subscribed to it—I did read a bunch of my brother's magazines—but it did have a few spectacular articles on the financial meltdown. Perhaps the most memorable for me was Michael Lewis article on the end of modern Wall Street. I think one of the flaws with Portfolio was that it was a high-end magazine, targetted at executives, investment bankers, and other, what an average person would consider as, jet-setting crowd. That is a market that is probably tough to crack. Given their targetting of high income citizens and corporate workers, they probably should have charged a lot more money or somehow generated more revenue from those readers. (The positioning issue also reminds me of the business section of The Globe & Mail newspaper in Canada. The business section in G&M targets upper-middle-class or higher. Many ads, for instance, are high end jewellery stores, high end cars, and so forth. Perhaps it makes some sense because some who work in the financial industry have high incomes. Nevertheless, I can see it going bust really quickly, not that all newspapers aren't struggling, because it will continuously struggle to attract the mainstream investors, casual readers, and the like.)
  • Avner Mandleman predicts the first electric car to be from China (The Globe & Mail): Avner Mandleman is quite contrarian and often presents unusual, pie-in-the-sky, ideas. In this article, he predicts that China will build the first revolutionary electric car, perhaps by BYD or some company like that. He presents a bunch of reasons why that is likely to be the case. I don't think some of his reasons are significant but I do feel that electric cars will have a tough time in the developed world. The main reason—Mandelman also mentions a similar reason—is because Big Oil and Big Auto will crush any attempts. Imagine the impact on ExxonMobil if a viable electric car was produced; or imagine what would happen to GM or the huge parts supplier base. Having said this, there is negative reason, not mentioned by Avner Mandleman, why China will have difficulties. And that has to do with its electric power-producing capability. China has serious problems as is, with normal electricity usage, and with countless coal and nuclear power plans being built. It will not be easy to build enough power plants to handle the massive needs of electric cars.
  • Newbie overview of the bank liquidity vs insolvency problem - Part I - Part II (Calculated Risk): I mentioned a primer by Bronte Capital Blog during the weekend, and now Calculated Risk has a basic overview of the situation.
  • China & its cheap mobile phone knockoffs (New York Times): Chinese fake goods is an issue that has been discussed countless times; but this time it has to do with mobile phones. The technology is so good and the costs are so low; that a fake counterfeiter can produce a mobile phone better than Apple with more features for a lower cost. It remains to be seen whether counterfeiters win (and hence patents, intellectual property rights, etc) weaken; or if the governments wil crack down on these companies.
  • (Recommended) Brief summary of John Paulson interviews (various original sources; mention by GuruFocus): Very brief but covers his investing strategy and portfolio allocation style... and it has some comments about risk arbitrage as well.

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Sign of the times: some banks exiting proprietary trading

Not surprisingly, TD and CIBC, two major banks in Canada, are shrinking or shutting down their proprietary trading divisions:

As international policymakers prepare to force banks to reduce risky trading activity and embrace a more balanced business model, TD and CIBC are taking the leap on their own.

TD's Mr. Clark says his bank is going to give up the industry-wide practice of placing casino-like bets with the bank's own capital. The 61-year-old's decision to halt this profitable-but-risky activity -- known as proprietary trading--makes TD one of only two big banks in the world to make such an explicit pledge, along with Germany's Deutsche Bank.

Mr. Clark says the "wholesale" side of his bank, which advises institutional clients and handles market trades, should not behave like "a hedge fund in disguise."

He wants to stick to activity that produces economic value as the core of new banking model that is emerging from the financial crisis

"Our simple test is to ask: Would the Gross National Product of Canada go down if we eliminated our wholesale activity?" he says.

Unfortnately there may be some job losses for the traders but maybe they can find jobs in standalone firms or in the shadow banking system. I have never owned bank shares but I am not a fan of proprietary trading. I, like many sceptics, view it more akin to gambling with the house's money. When times are good they post high profits; but when times are bad, they can seriously hurt banks.

The impact of a shift away from trading will likely reduce future profitability.


Does Ken Lewis and Bank of America have a way out?

Ignoring the swine flu issue, which may or may not turn into anything serious in the end, one of the big scandals brewing in the background is the coercion by the government of Ken Lewis and Bank of America to act against their own shareholders in the buyout of Merrill Lynch. Basically, if Ken Lewis is to be believed, Bank of America was prevented from backing out of the Merill Lynch deal in order to save the country's banking system, at the expense of Bank of America shareholders. This is a serious issue that goes all the way to the highest levels of government. In particular, Henry Paulson, Ben Bernanke, and since he was the president overseeing the Treasury, George Bush, seem to have engaged in some dubious behaviour. It is also possible that Timothy Geithner may be involved in this somehow, since he was the head of the New York Federal Reserve at the time, but that is uncertain right now. Henry Paulson has shifted the blame to the Federal Reserve; and the Federal Reserve has denied that it asked Bank of America to break securities laws.

The only thing that might keep this issue from blowing out of control is the fact that the questionable actions occurred under the prior Bush administration and hence the Republicans may not want to escalate the issue (Democrats likely have no incentive in turning this into a big battle.) Regardless of what either party does, a lot will depend on the shareholder lawsuits and any SEC ruling.

In the mean time, let's look at what New York Times' Deal Professor says. In this case, the opinion is given by Peter Henning, a law professor at Wayne State Law School. Let me excerpt some of his comments:

The antifraud provisions of the Securities Exchange Act of 1934, Sections 10(b) and 14(a), prohibit misstatements or omissions of material facts in connection with the solicitation of proxies from shareholders and in public statements made by a company. A company has a duty to ensure that shareholders have truthful information, and if a prior disclosure is no longer correct or complete, then additional information must be disclosed to ensure the market is not operating on false data.


When the government tells you not to disclose information, however, the analysis may be different. In the criminal law, there is a defense that the federal courts now recognize called “entrapment by estoppel” that might be a means for Mr. Lewis and Bank of America to avoid liability in the securities suits and in connection with the Securities and Exchange Commission’s investigation of its disclosures.


The usual defense of entrapment arises when a defendant claims a government agent enticed him into engaging in criminal conduct that the person was not otherwise disposed to commit. For example, a drug addict cooperating with the police repeatedly cajoles an old friend into furnishing drugs, finally wearing the person down and then having him arrested once he succumbs to the requests. In such a case, the defendant can be acquitted because of entrapment. There is something unsavory about the government creating a crime that otherwise would not have occurred.

Entrapment by estoppel is a more recent development in the criminal law that concerns the increase in government regulation and licensing. There are four basic elements of the defense: (1) that a government official told the person the act was legal; (2) the person relied on that advice; (3) the reliance was reasonable; and (4) given the reasonable reliance, prosecution would be unfair.

The doctrine is most often asserted in gun possession cases in which the defendant claims that a dealer or other authorized seller said it was permissible to buy the weapon and later the person is arrested because of some condition, like a previous conviction, that makes it illegal to possess the weapon. Unlike regular entrapment, this defense is based on reasonable reliance on a statement by someone acting on behalf of the government approving conduct that turns out to be criminal.

The first and third elements of the entrapment by estoppel defense are the key. It is not Mr. Lewis’s interpretation of what the government officials said that counts, but whether he was told that Bank of America should not make any disclosure and that the conduct would be legal. This may be a matter of nuance, and already a Federal Reserve spokeswoman denied that the Fed told Bank of America that it should not make any disclosures otherwise required by law.

Even if Mr. Paulson and Mr. Bernanke told Mr. Lewis not to disclose the information, the obligations of the federal securities laws on disclosing material information are clear, so it is arguable whether reliance on their direction about what to disclose was reasonable. It may be important to learn what Bank of America’s lawyers said about the issue to determine whether any reliance was reasonable.

IANAL (I am not a lawyer) and my impression is that legal cases dependent on various interpretations so who knows how correct this legal scholar's opinion is. In any case, as if we didn't have enough problems with the banking sector, this Bank of America controversy is going to lurk in the background. The real concern will materialize if criminal charges are laid against Ken Lewis. I think it would make a mockery of government and the banking regulators if Ken Lewis is jailed for following government orders.

Well, whatever one thinks of John Thain, he certainly did his shareholders a huge favour. It looks like he managed to sell Merrill Lynch at a big premium when in fact it seems to have been nothing more than an insolvent firm. It borders on the unethical and was a total disaster for Bank of America, but Thain bailed out the Merrill Lynch shareholders. I was critical of his high compensation and I still am, but certainly saved his shareholders tens of billions of dollars.

Sunday, April 26, 2009 0 comments ++[ CLICK TO COMMENT ]++

A Black Swan just flew into view: the swine flu

Diagram of the Flu Virus

Too early to tell but the swine flu that has started spreading throughout North America can supposedly turn into a major pandemic. So far, the incidence of death and infection rate does not seem too terrible but it's something to keep an eye on. In addition to loss of lives and health issues, this is going to cause sizeable economic losses, particularly for Mexico (and its tourist industry.)


Sunday Spectacle VI

Was an American Icon...

Saturday, April 25, 2009 0 comments ++[ CLICK TO COMMENT ]++

Some articles for the week ending April 25 of 2009

Some articles, in no particular order, that may be of interest...

  • Current recession close to being the worst since the 60's (The New York Times): According to some indicators, our the recession in the US is on par to be one of the worst since the 60's. The question is, will it linger on? (Further comment below)
  • Andrew Mickey interview with John Calamos, a convertible bond investor (Q1 Publishing; via SeekingAlpha): I don't know the track record of either of these guys but I ran across this insightful interview regarding convertible bonds. As I have remarked before, convertible bonds are arguably the ultimate security for distressed investment. They generally give you the upside of equity and the downside of bonds. Unfortunately many companies haven't issued them in the last decade (possibly because financing cost of straight bonds was really low in the last 5 years; and it leaves them open for hedge funds to aggresively short-sell shares while owning the convertibles.)
  • Liquidity vs solvency for the banks (Bronte Capital): A rundown of the differences between liquidity problems and solvency problems faced by banks.
  • (Recommended) Seth Klarman partnership letters (Noise Free Investing): Thanks to GuruFocus for bringing to my attention to the posting by Noise Free Investing of Seth Klarman's partnership letters from the 90's. I don't know much about Seth Klarman and I don't really follow him—it's virtually impossible to know what he is investing in and why—but I'll see if I can get some insights from him. One of the things about value investing—this may be why Buffett never wrote a book—is that the core principles are so "obvious" that I find little to learn after a while. You can continuously read and learn about financial statement analysis or accounting but that may or may not help investing. Anyway, I'm more macro-oriented so I tend to read a lot more articles and books on macro stuff (as you can tell by reading this list of articles.)
  • John Mauldin's view of the investing world (Part 1 & Part 2—may require e-mail sign-up but you can access it free here (part 1) and here (part2) ) (Thoughts From the Frontline): John Mauldin presents his views on what caused the financial meltdown and what he sees in the future. I don't agree with some of his econopolitical views—he is very hypocritical when he says that tax re-distribution, not mention carbon taxes or increased government spending is bad, while advocating huge sums being thrown at failed and possibly insolvent financial firms—but conservatives are in a tough bind right now. Unfettered capitalism has come unglued and their strong support for the Bush administration policies in the last 8 years has been a complete disaster (and I'm not talking about political issues but the economic ones.) (Further comment below)
  • Inflation vs Deflation vs Stagflation (BusinessWeek): "Will the real 'flation please stand up?" asks Businessweek. A quick and simple summary of the three bearish economic scenarios. (Further comment below)
  • Women gain influence in Iceland (Spiegel Online, through BusinessWeek): Perhaps it's fitting; women are gaining greater influence in Iceland, with the possibility of the first female PM being elected soon.
  • Japan and its "communist" island of Hime (New York Times; thanks to Naked Capitalism for original mention): To the horror of most conservatives everywhere, liberals always have a soft spot for socialist ideals—I think this is because most liberals value egalitarianism. However, ignoring the economic side and simply looking at the political side, you can see in this article why almost all socialist-like systems have turned into disasters with essentially monsters ending up as leaders. Reading this article, you can see, in a subtle manner, how Hime became totalitarian day by day. For instance, the fact that the same family has held the mayor position for 49 years shows the flaws of the system. Perhaps this family is virtuous and great but what happens after them? All it takes is one Stalin, who obviously would not seem evil initially, to become mayor and it's all over! Almost any country can collapse if a corrupt and evil leader takes over. So, I say we should be short selling Hime ;) (The emphasis on liberties by America, particularly it's political apparatus and The Constitution, is what separates America (and a few others like it) from shooting stars like China, India, Russia, Vietnam, Brazil, United Arab Emirates, and so on. Investors may make more money in the latter countries but it will likely prove unsustainable in the long run. It is extremely difficult for a single party to rule America for a long time.)

Will this be the Worst Recession Since the War?

A New York Times article by Floyd Norris compares the current recession against those since the 60's using the coincident indicator. The following graphic summarizes the current state:

The question is will this be the worst? Generally the recession that started in 1973 is considered as the worst in the last few decades.

According to the graphic, the current recession is already the worst (since the 60's) based on employment and industrial production. It is possible that this may turn out to be the worst in terms of manufacturing and trade sales but I'm not sure if personal income will decline as much as in 1973-1975.

What is different about now, compared to all the other ones shown, is that we are genuinely facing a deflationary bust. Barring some hyperinflationists who dismiss deflation, we are in one of the rare periods where deflationary forces are stronger than the inflationary ones. In contrast, the two other severe recessions, 1973-1975 and 1981-1982, involved inflationary pressures. Right now, I personally don't think there is much inflationary pressure. In contrast, we have deflationary pressure all over the place—such as potential overcapacity in China; continuously available cheap labour force in developing countries; potentially still-unaccounted-for losses in commerical real estate, credit card loans, CLOs, corporate bonds; and so on. As a reminder, The Economist made the following comment about deflation this week:

The threat of deflation remains. German producer prices fell more quickly than expected in March. And the retail-price index in Britain fell by 0.4% year on year in March, its first drop since 1960.

Sure, the contraction in Britain, or the collaspe in Germany, or even in America, may be temporary. But it may also turn into something that lasts longer than the consensus expects.

I don't think many of us, either as citizens, investors, workers, management, or politicans, really know how to handle deflationary threats. That is what makes this episode more challenging in my eyes. This is also what makes the present investing world totally different from most of history.

The consensus—certainly in the last few months—and probably most readers of this blog probably don't share my concern for deflation. I suspect many are more worried about inflation. Even if that were the case, I do recommend that you keep an eye on deflation and perhaps read up on the Great Depression or Japan.

The Three Bears: Inflation, Deflation, and Stagflation

BusinessWeek has a very basic overview of the three bearish scenarios that can decimate investors' portfolios. There isn't much in the article but, since I lean more towards deflation, I found it interesting that Gary Shilling suggests that technology is an attractive area. This is the first time I have heard him say that (usually he suggests the long bond or cash.)

Although not as knowledgeable as Gary, I have also felt, for other reasons, that technology may be a good sector for the next decade. There are some obvious contrarian reasons for considering tech—such as the fact that many companies have been in a long bear market and have gone nowhere in the post-bubble period—but I also feel that many technology companies may handle deflationary periods better since they tend to operate in industries where end-user prices are continuously falling. Yet, I never considered what Gary has suggested here as a bullish reason for technology i.e. companies will consider technology purchases to increase productivity in a world where deflationary forces persist.

Gary's view makes a lot of sense, assuming we do end up in a slumping world with bouts of deflation everywhere. My, admittedly distant and ill-informed, impression of Japan, a country that is the classic case of modern deflation, is that it has endorsed technology in the last two decades to a greater degree than one would expect. Partly this is due to their culture; and partly it's because of their aging population. However, it is possible that it may also be driven by deflation. (Japanese stocks (even technology companies) haven't done too well but I believe that is due to poor corporate goverance, poor government policy, and severe overvaluation of stocks in the late 80's.)

Of course, even if one is bullish on tech, figuring out which companies actually improve productivity versus ones that don't, will not be easy. Gary Shilling mentioned semiconductors but that's an ugly industry with overcapacity and low profit margins. I'm thinking that the ideal one would be something that provides a tool or a service that clearly lowers the costs of the end product or of doing business. Anyway, this is a macro thesis for me to investigate and I'll keep everyone posted.

Some Thoughts on Mauldin's Essays

I agree with some of what Mauldin is saying but disagree with others. I share Mauldin's view that, contraray to the Austrian Economists' desire, 20%+ unemployment is far worse than 10% for a few years. Nevertheless, I think Mauldin is too critical of liberal policies while ignoring hundreads of billions thrown at the failing financial firms. This shouldn't be surprising, though, since Mauldin makes a living off hedge funds, institutional investors, and others who are dependent on these failing financial firms.

I think most of his description of what happened is correct. His description of the collapse of credit is how I, who isn't an economist, look at the world as well. This is also why I lean towards deflation more than inflation.

But although I have been critical of mark-to-market accounting, I think he puts too much emphasis on it. Some of the key implications, such as the impact of reduced consumption in USA on the rest of the world, is also not covered.

I am less concerned about inflation than Mauldin. However, there is a risk of high inflation if government chooses to pursue it. Mauldin suggests that the Democrats may replace Bernanke with someone who is more left-leaning and less of a fiscal conservative. That is a definite possibility that might shift the environment towards inflation. Recently it has also emerged that Ben Bernanke has made some questionable judgements in the Bank of America buyout of Merrill Lynch. He might be shown the door if this turns into a huge crisis and Obama isn't able to control it. It's too early but this could very well turn into a huge scandal. Henry Paulson seems to have shifted the blame onto Bernanke. I have been supportive of Bernanke in the past and think he is the ideal person to handle the current situation so I hope he is allowed to finish the job. Timothy Geithner may also come under attack if the Bank of America crisis isn't contained since he may have played a role at the New York Federal Reserve. The problem here is that the Federal Reserve and the US Treasury asked Ken Lewis, CEO of Bank of America, to do something to the save the country while hurting his own shareholders. It's not clear who is telling the truth but it seems to me that Ken Lewis almost bankrupted his $100+ billion company in order to follow orders from the Federal Reserve. It appears that Ken Lewis may have done something illegal by not disclosing material changes to shareholders. Whether this turns into a huge crisis will depend on what the SEC says and how the courts will rule on the likely shareholder lawsuits that will be filed. Interestingly, all this started with New York Attorney General, Andrew Cuomo, probing an unrelated issue relating to Merrill Lynch bonus payments, and it seems to have opened up a can of worms.

Going back to Mauldin, he thinks that Irving Fisher will win out in the end but my feeling—a possibly biased view :)— is that Keynes will probably win out. I have a feeling that theories and solutions of someone like Robert Shiller, who follows in the tradition of Keynes to some degree, will become the staple for the next few decades. In particular, Shiller's view of irrational behaviour driven by 'animal spirits', a concept originally popularized by Keynes, will likely gain great influence in economics. I suspect that psychology will be incorporated into mainstream economics that is taught and practiced. In the grand scheme of things, this makes a lot of sense to me because economics is a social science and hence shares more with psychology than the hard sciences or mathematics.

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Friday, April 24, 2009 0 comments ++[ CLICK TO COMMENT ]++

William Ackman -- The Man Who Stood In Front of the MBIA Train

(source: Portfolio)

I have trouble saying 'MBA' without saying 'MBIA'
— William Ackman

I have the same problem as William Ackman when it comes to MBIA. I get it mixed up with MBA and, unlike Ackman, I also get it mixed up with MBNA. In The Optimist, Jesse Eisinger of Portfolio magazine presents an in-depth profile of William Ackman. For those not familiar, William Ackman is a hedge fund manager whose reputation for activist investing has risen rapidly in the last few years. This article has been making the rounds on the blogs but I thought I would highlight it in a separate post. It is only fitting given how I had mentioned some negative things about him in the past.

Long time readers of this blog may recall how I have been critical of William Ackman over the years. Part of it possibly arises due to opposite bets on the fate of the monoline bond insurers; but most of it is probably because he is not the type of investor that I hold in high regard. I'll bet if we were in the same room, our personalities will conflict. William Ackman is adament and persistent like me. But he is very arrogant, unlike me. I also think he is primarily a good salesperson. This is not to say that he doesn't do his homework but there is a lot of showmanship to his game, and this doesn't sit well with me.

Having said all that, I do think, as I remarked in my Turtle Awards post early this year, we need more people like him. He is an activist investor and he does push companies to make changes. Whether those changes are good or bad is another story, but at least he is doing something.

I also respect his major contrarian bet against the monolines. It was a spectacular call and possibly one of the best contrarian bets in the last 30 years. He basically shorted (through CDS) a AAA-rated company that everyone—regulators, rating agencies, counterparties, customers, investors—thought had a super-strong balance sheet. This was, back then, the equivalent to shorting the highest quality, safest, and dominant player in an industry with practically no visible problem.

I think Carl Icahan's mantle has been passed to William Ackman...but Ackman needs to lay off his super-high-leverage bets, usually using options or swaps. It has completely blown up with Target, and he also has swaps on Borders if I'm not mistaken, which likely will also blow up, if it already hasn't. Ironically, Ackman may have correctly pointed out the flaws of high leverage used by monolines, but he also got burned using leverage with Target, Borders, and other investments. Nevertheless, he posted (roughly) an impressive -12% last year with his main funds.


Tangible common equity ratio for major American banks

Yesterday I mentioned the risk to Wells Fargo shareholders from regulators and shown below is a table listing TCE (tangible common equity) for major American banks (the table is from OptionARMageddon and I can't vouch for the accuracy of it. The source is a bearish site so it likely has a bearish slant.)

As you can see, if you went with this simple TCE calculation, Wells Fargo and Citigroup are at the bottom and at risk of requiring capital injections probably on the order of $15 billion (if 3% TCE is required.) Additional capital may be in the form of new equity or conversion of prefered shares. Wells Fargo's market cap is $88 billion so you are looking at slightly less than 20% of market cap. But that's all assuming a simplistic TCE calculation without considering the supposed superior underwriting and risk evaluation skills of Wells Fargo.

From the table, you can also see how simplistic ratios are misleading. For instance, Bank of NY Mellon seems to be near the bottom of the pack, and seems risky based on the TCE measure. However, my impression, from what little I know of it, is that Bank of NY Mellon is more of a custodial bank and probably doesn't own bad mortgage/credit card/etc assets like others on this list. I could be wrong but my impression is that it is safer than any other bank on this list.

Thursday, April 23, 2009 2 comments ++[ CLICK TO COMMENT ]++

Opinion: Warren Buffett has a problem with Wells Fargo

This is going to be a provocative post and I have to admit it isn't based on anything solid. Nevertheless, I have a feeling that Wells Fargo is in trouble with the regulators. Before I say anything, I should note that I know very little about Wells Fargo or banking in general. My impression, for what it's worth, is that Wells Fargo is far better off than possibly all the other American megabanks. But that may not be enough in these times...

No, Wells Fargo is not going bankrupt. Buffett also probably won't lose real money in the long run. But Wells Fargo is not what it seems.

It seems quite rare, and out of character, for Warren Buffett to take a public stand defending Wells Fargo all of a sudden. What I am referring to is his Fortune interview conducted a month ago but only published a few days ago. Although Buffett has been making himself available to media in the last few years, this Fortune piece seems like it was directed at the regulators and the public.

What Buffett says in the interview about earnings power being of utmost importance is true; but, at the same time, it seems like an attempt to patch up Wells Fargo's balance sheet. The problem, as this Bloomberg article speculates, is that Wells Fargo's tangible common equity is negative. As the same Bloomberg article implies, regulators seem to favour measuring banks using tangible common equity now (supposedly because Tier 1 capital has been losing credibility.) If tangible common equity ends up being used by regulators, Wells Fargo may have to dilute its shareholders quite a bit.

Now you can see why Wells Fargo Chairman Dick Kovacevich was against the stress test and was attacking the regulators last month. The only hope of Wells Fargo is that the regulators somehow capture its supposed superior underwriting and risk evaluation skills.

Buffett is arguing Wells Fargo can earn its way back but how lax will the regulators be? The results of the stress test will be revealed on May 4th.

Wednesday, April 22, 2009 0 comments ++[ CLICK TO COMMENT ]++

Bear case for commodities

I am not a huge fan of relying on opinion pieces from Wall Street analysts--in this case an analyst from Morgan Stanley--but I felt the following Newsweek article summarizes many of the reasons I am staying squarely away from commodities. My impression is that most readers of this blog, as well as the market itself, is still bullish on commodities. One just needs to look at the futures curve to see how the market is betting.

The article If It’s in the Ground, It Can Only Go Down by Ruchir Sharma for Newsweek was pointed out to me by Naked Capitalism, which in turn relied on Metal Miner. I recommend it to anyone interested in commodities; even if you are bullish, it's worth reading the bearish case. Here is an excerpt of it:

As playwright Arthur Miller once observed, "An era can be said to end when its basic illusions are exhausted." And most of the illusions that defined the late global economic boom—the notion that global growth had moved to a permanently higher plane and housing prices from Miami to Mumbai would rise indefinitely—are now indeed exhausted. Yet one idea still has the power to capture imaginations and markets: it is that commodities like oil, copper, grains and gold are all destined to rise over time. Lots of smart people believe that last year's swoon in commodities prices represented a short pause in a long-term bull market.


At some point, of course, commodities will spike again, but only temporarily. To date, the centuries-old slide in prices has been marked by long bear markets and short bull runs. Data from CSFB shows that the average bull market in oil has lasted from four to nine years, and the average bear market from 11 to 27 years. The bull market that ended last summer saw prices rise tenfold over nine years, mirroring the duration and magnitude of the previous bull market, which ended in 1979. That was followed by a bear market that lasted 20 years. If history is any guide, we're only at the beginning of another long one.

The problem with a bullish bet on commodities right now is that it requires (i) strong economic recovery, and/or (ii) the fundamentals of the world to have permanently changed. (One can also bet due to an expectation of a strong decline in purchasing power but there are better ways to achieve that--such as betting on gold or foreign currencies or shorting bonds.)

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Bank stress test results may be revealed on May 4th

Saw the story first at Calculated Risk... Bloomberg is reporting that the US government is planning to reveal the results of the bank stress tests on May 4th:

The Obama administration may direct banks that are judged to be short of capital after stress tests to disclose how they are going to get additional funds when the government reveals the results on May 4, according to a person familiar with the matter.

The government would release a bank-by-bank assessment, while the lenders would say how they plan to shore up their finances, said the person, who spoke on condition of anonymity because a decision hasn’t been made.


The Treasury and banking regulators are still working out the final details of how to reveal the test results and plans could change, said the person. Generally, the regulators favor less disclosure because bank exam data is confidential, while the Treasury advocates releasing more details.


Regulators conducting the stress tests are increasingly focusing on the quality of loans banks made after finding wide variations in underwriting standards, a regulatory official said on April 20. They concluded that banks’ lending practices need to be given as much weight as macroeconomic scenarios in determining the health of each bank, the person said.

May 4th is going to be a big day. The banks that don't pass the tests will probably get killed. I don't think the failing banks will be able to raise capital, unless it is backed by the government or something. Even then, I can't see anyone wanting to invest in equity given the risk of future losses (unaccounted for by the stress test.)

Initial leaks--one has to assume these are strategic leaks by the government--seemed to suggest that the stress was to use a mild assumptions. This would have meant that nearly all the banks may have passed. Later on, the government, through media leaks, seemed to indicate that they will be using more stringent tests. In this latter scenario, it is possible that some major banks won't pass or will barely pass.

The stock market will probably struggle in the short term, after the results are announced, given how most of the insolvency concern surrounds the megabanks and they are the ones with the largest weight in the stock indexes (although their weight has declined significantly over the last 2 years.) However, I believe that transparency will help in the long run.

My confidence in my understanding of the banking situation has deteriorated. Although I never invested in any bank, I have been completely wrong with my early views. For instance, I never realized how bad Merrill Lynch was, and hence underestimated the severe damaged it caused Bank of America; or how bad Wells Fargo may be if the bears are to be believed. My initial view was the banks were facing liquidity problems but I think Nouriel Roubini (and others) are correct in saying that we are looking at insolvency. Not every bank is insolvent but major ones are insolvent enough to cause serious problems. John Hampton at Bronte Capital has suggested that American banks, as opposed to say British ones, can earn their way back but I don't share that view anymore. The potential losses look so large--it's incomprehensible to me anymore--that it could take 10 to 20 years to cover their losses and pay out reasonable dividends to shareholders (otherwise the banks are near worthless, no?) To make matters worse, there is a possibility that we have seen the end of financial revolution and financial profits will contract going forward. If it took, say, 8 years for an insolvent bank from the S&L crisis to earn its way back, now it might take 15 years.

Having said all that, if you are a contrarian and have a good sense of losses and future profitability then financial stocks are worth investigating.

Tuesday, April 21, 2009 0 comments ++[ CLICK TO COMMENT ]++

Flashback... Interviews with Shloss and Klarman

I don't know if it's just me but I am seeing quite a number of amateur-oriented investment blogs start up in the last year. Several of them seem to be focused on value investing and tend to cover material that are useful for newbies like me. I don't know if it's just the rising popularity of blogging or if it's someone trying to take out their misery on the written ink ;) but I hope the bloggers continue doing what they are doing...

Older investors or those with good historical research skills may have seen the following two articles before but it's the first time I have encountered them and thought others may find it interesting. The two interviews come from a new blog I ran across, Mr. Market Blog.

The first is an interview with Seth Klarman conducted by Fortune in 1990. From the article, you can get a sense of the type of investments he was investing in when he started out. I don't really follow Klarman--not my style and virtually impossible to know what he is doing or why he is doing it--but many others hold him in high regard.

The other article is Barron's interview with Walter Schloss, back in 1985. For those not familiar, Schloss is an honourary member of the Superinvestors of Graham & Doddsville :) He is one of the best value investors in the last 50 years. But since he ran a small portfolio and stayed away from the spotlight, he won't be considered as successful as other investors such as Jim Cramer, George Soros, or Edward Lampert. However, in my eyes, he is a more successful investor than any of them (except possibly George Soros) and his techniques are more applicable to small investors than the other three mentioned here, or the countless other successful investors cited in the media. Schloss is more of a pure value investor--one that focuses on bottom-up analysis, balance sheets, and generally attempts to buy something below book value or maybe NCAV--and anyone following pure value investing may find the interview insightful. (I'm not a pure value investor and am more interested in trying to find growth (or contrarian turnaround situations.) But I do wonder if Shloss' investing strategy, which basically started going out of favour in the 60's, will make a comeback. If the economic slump is prolonged, it is possible that this style is safer.)

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Monday, April 20, 2009 1 comments ++[ CLICK TO COMMENT ]++

Historical junk bond default rates

Felix Salmon, who now blogs for Reuters, managed to get some information on junk bonds (aka high-yield bonds, aka speculative-grade bonds). Since my interest, if I were to invest any bonds, is with junk bonds, I have always been interested in historical default rates. The following chart (from Moody's I believe) plots defaults on junk bonds since 1920:

Moody's is projecting defaults that are on par with the rates during the Great Depression. In the worst case, the default rates are supposed to exceed those during the 30's. However, the business environment is radically different now. The junk bond market only took off in the 80's. Furthermore, there is higher corporate leverage now than in the 30's. So, high defaults don't necessarily mean that we are looking at a depression.

What does all this mean for bond investors? Well, here is how I look at it. The yields on junk bonds are high (15% to 20% or so) but the risk of default is extremely high as well. I don't really think one can say the market is necessarily mispricing these bonds (unless you think defaults will end up being much lower.) It may be the case that some specific bonds are mispriced but the market as a whole is not necessarily cheap.

My impression of junk bonds is similar to the stock market as a whole. That is, valuations are lower than at any point in the last 20+ years but that doesn't mean it is very cheap. The P/E ratio for the stock market may look low, and the yield for junk bonds may look high, but this is not exactly cheap if you have some concern about defaults, losses, contracting profit margins, and so forth. You can go and invest in, say, HYG, the junk bond ETF from iShares yielding about 15%, and may still lose money.

Sunday, April 19, 2009 0 comments ++[ CLICK TO COMMENT ]++

Sunday Spectacle V

(source: Bloom or bust? By Barrie McKenna, The Globe and Mail, April 17, 2009)

Saturday, April 18, 2009 2 comments ++[ CLICK TO COMMENT ]++

Quick look at BYD (HK: 1211)

BYD (HK: 1211) is one of Buffett's most interesting picks in several years (for those that never saw my prior post, you might want to read this Fortune article that was brought to my attention by Infectious Greed.) Interesting doesn't mean "best" but it does mean something "different". What follows is a quick look of BYD...

Stock Price Chart

You can access BYD's English investor relations page here.

The chart above plots the share price on the Hong Kong exchange of BYD (the H shares), along with volume, P/E ratio and dividend yield. These numbers are not always reliable but I like to quickly look at them, if available.

Needless to say, it has been a wild ride for BYD shareholders in the last two years. I haven't looked into the reasons for the severe sell-off. Buffett is thought to have offered HK$8 for 10% stake in the company (roughly 50% of the Hong Kong float.) Government approval seems to be taking a while and it's not clear if the Chinese government will block Buffett's investment.

As is usually the case with Buffett's investments, shares have rallied a lot since then. So anyone interested in this should probably wait for a better price.

Basic Financials

Yahoo Finance (English translation using Google Translate) lists the following information (note that Yahoo Finance can be wrong and one should really check against official documents if they are interested in this company):

Market value: HK$ 10.42B (approx US$ 1.4B)
P/E (ttm): 21.84
Price/book value: 2.72
Long-term debt/equity: 42.46%

Net profit margin in the last few years: 8% to 9% (not sure if this is a cyclical peak)
ROE in the last few years: 7% to 9%

The stock has rallied 125% since Buffett's annoucement so the valuation does not appear cheap. But it comes down to whether one values this as a growth company or a cyclical. If you considered this as a cyclical, nothing really stands out. But I am sure that Buffett's investment, which seems to have been influenced by Charlie Munger, is more of a bet on growth, particularly the electric battery potential. Growth potential is very large but one needs to dig into the company and see the details.

I personally don't have much interest in this company. But if the founder, Wang Chuan-Fu, is indeed a cross between Thomas Edison and Jack Welch--hopefully more of the former ;)--then BYD is worth considering. Charlie Munger, as Buffett says in the Fortune article, is rarely ever bullish on anything or anyone. Yet, Munger seems impressed with Wang Chuan-Fu.