Friday, July 31, 2009 6 comments ++[ CLICK TO COMMENT ]++

Shipping industry crashes into the rocks

(source: Image by AFP/Getty Images. Pictured: The cargo ship smashed to pieces just minutes after 31-strong crew were plucked to safety, By Daily Mail Reporter. Last updated at 9:36 AM on 12th October 2008)

One of the most volatile industries out there is the shipping industry. The transportation companies, in particular, are very volatile and only a few brave souls will ever invest in them. The stock price charts are volatile enough to scare off most investors.

Given the collapse in world trade, it shouldn't be surprising how badly the industry has been hit. The Economist has a story updating us on the present state of affairs:

World trade in general remains in its worst slump for generations, although it too is no longer falling. Two of the biggest shipping banks (RBS and HBOS) are in state-backed rehab. The parlous state of the world economy could mean more shipping companies following Eastwind Maritime, which went bankrupt in June. On July 28th Hapag-Lloyd, Germany’s largest container-shipping company, secured a €330m ($468m) bail-out from its shareholders while it seeks up to €1.75 billion to keep it from sinking altogether.

Worse, there is a huge supply of new ships on order and due off the slipways over the next four years. For bulk carriers alone, the backlog is equivalent to more than two-thirds of existing capacity.

Although the situation looks dire there are some green shoots that can be seen:

Analysts at ICAP Shipping Research in London shrug off the idea that there will be a glut, since shipments of cheap Australian coal and iron ore to China have for years been constrained by a lack of big ships. More giant bulk carriers will lower the prices of ores delivered to China and stimulate trade growth, they say.

The outlook for tankers is less clear because of the volatility of crude-oil prices. Rates recovered strongly in June, according to ICAP, partly because large vessels were in demand for storage, as oil companies waited for crude prices to strengthen... But lower demand will be offset by a scheme to phase out single-hull ships on environmental and safety grounds in European and North Atlantic waters. The decline in production from mature oilfields in the North Sea and Alaska also means that replacement supplies will have to be hauled longer distances by sea to the refineries of Europe and North America.

The part of the shipping industry headed for the choppiest waters is the container trade, which had steamed ahead gloriously since the mid-1970s. The forging of global supply chains in the past 20 years, the rise in merchandise trade and the emergence of China as the workshop of the world created growing demand. Vessels became gigantic, with the latest capable of carrying 15,000 standard containers. Now the box trade, as it is called, is in the midst of its first decline. AXS Alphaliner, an information service that tracks the trade, has estimated that some 15% of capacity will be idle by October.

Even though I post a ton of stuff seemingly unrelated to any viable investment idea I have, I think it is useful for amateur investors to expand their knowledge base and keep up with events. By glancing over an article like this, one may get a basic understanding of the business. Even if you don't invest in a shipping company, at least you'll learn, like I did, how the dynamics for container shipping companies is very different from the dry bulk carriers or the crude tankers. The time may come when one may consider investing in this industry. Mohnish Pabri made a killing investing in Frontline (FRO) when it was out of favour and a pure value stock, around 5 years ago. Shipping companies—or anything to do with China, emerging markets, trade, credit, or real estate—were overvalued hyper-growth stocks in the last few years but they may become value investments at some point.

Thursday, July 30, 2009 0 comments ++[ CLICK TO COMMENT ]++

Opinion: The failed running the failed

Banking was always considered very conservative and "clubby". Although novels and movies suggest bankers are the ultimate capitalists, nothing is further from the truth. Outsiders are never to be trusted, or so it is the opinion projected by bankers.

Sticking to their broken model, we get news from The New York Times that Lloyds Banking Group, the British banking giant bailed out by the British government, has appointed Winfried Bischoff as its chairperson. Bischoff, perhaps not surprising to the cynics, was a key player with Citigroup and a big proponent of mega-banking and keeping investment banks intermingled with commercial banks. Readers may recall that I am not a fan of investment banks, which I claim resemble casinos at times, and would prefer that they be kept separate from any commercial banking facility.

Bischoff seems to have become a chairperson only in late 2007 but seems to have been a big player in Citigroup's European operations. Here is the word from New York Times:

The Lloyds Banking Group named Winfried F. W. Bischoff as its chairman on Monday to succeed Victor Blank, who is retiring, Bloomberg News reported.

Mr. Bischoff, a former Citigroup chairman and an adviser to the British government, will take up the post on Sept. 15, Lloyds said.


Mr. Bischoff, 68, became chairman of Citigroup in December 2007. He joined Citigroup in 2000 after its acquisition of the investment banking unit of Schroders, based in London. Mr. Bischoff had been chairman of Schroders and then became chairman of Citigroup’s European business. Mr. Daniels, who became Lloyds’s chief executive in 2003, spent 25 years at Citigroup and joined Lloyds in 2001 as head of its retail operations.

Mr. Bischoff and the chancellor of the Exchequer, Alistair Darling, co-chaired a financial services panel that produced a report in May favoring “broad-based banking” models and rejecting the separation of retail and investment banking.

Mr. Bischoff will receive an annual fee of £700,000, the bank said. He will not be eligible to participate in the bank’s bonus plan, Lloyds added.

I have no idea if Winfried Bischoff played any big role in Citigroup's dubious adventures in SIV-land or CDO-land, but I wonder if Bischoff will be spearheading Citigroup's next grand adventure, trying to grab as much investment banking market share as possible—at any cost. Maybe Citigroup can finance all the hedge funds fleeing to New York. The only uncertainty in all this is whether American taxpayers will be as kind the second time around.


Shareholder activism in Japan... or lack there of

One of the reasons Japanese stocks are dangerous is because companies are not shareholder-friendly. I consider myself as an OPMI (outside passive minority investor) so I don't expect to influence any company. Nevertheless, I expect the larger shareholders to push for changes if things get really dire. In Japan, that just doesn't happen. Because of this, you should apply a discount to Japanese stocks.

(Note: Poor corporate governance does not apply to some large, internationally-focused, companies such as Toyota or Sony. These companies are operated more like American companies, with more independent board of directors and/or outside management, better capital allocation decisions, and so on.)

Bloomberg has an in-depth story summarizing the current state of affairs in Japan. It profiles hedge fund TCI—you may recognize it in numerous stories in The Economist—and its difficulty carrying out changes. Who knows if TCI are the "good guys" or were simply out to make a quick buck that is detrimental in the long run. Regardless of what one thinks, the point about Japanese companies stands. If you have an interest in Japan, the story is worth reading to get a feel for the investment environment over there.

I hope Bloomberg doesn't mind me quoting a big chunk. I don't really have much to add*... I have beaten this issue to death...

“Sadly, Japan has been a value trap for many years,” says James Rosenwald, co-founder of Los Angeles-based Dalton Investments LLC, which controls more than $1 billion in assets, with 40 percent of its holdings invested in Japan. “That means the shares are amazingly cheap for an extended period of time without managements unlocking obvious value, such as companies with huge cash balances and no debt that have no intention of raising dividends or conducting share buybacks.”

Japanese managers are accustomed to investors who are both local and passive. These so-called stable shareholders -- financial institutions such as banks and insurance companies that buy stakes for the long term -- account for about 30 percent of all holdings in Japan’s $3.4 trillion equities market, according to the Tokyo Stock Exchange.

Threatened Japanese companies have deployed “poison pill” defense rules that can dilute the value of shares held by activist investors -- moves that have been backed by local courts.

Tradition has also helped thwart agitators. Annual general meetings, often the stage for shareholder showdowns in the U.S., are treated as a formality in Japan. This year, half of all Japanese AGMs were held on the last Friday in June. As recently as 1995, 96 percent of Japanese companies held their AGMs on the same day.


Western investors who try to impose their own will in Japan can run into boards made up mostly of company executives. Those with outside directors often hire them from companies that already have commercial relationships with the business.

Japan’s publicly traded companies aren’t required by law to hire independent board members, and managerial oversight is left to auditors appointed by the businesses themselves, according to Hiroaki Niihara, an official at the Ministry of Economy, Trade and Industry who has tracked governance issues.

In June, METI recommended that public companies have at least one independent director or hire an independent auditor. The ministry said those that don’t hire outside directors should compile a report on steps they’re taking to boost accountability, such as hiring an outside panel of advisers. The absence of a requirement for independent directors disappoints some overseas investors.


There is no Japanese equivalent of the Sarbanes-Oxley Act, the U.S. law passed in 2002 after Enron Corp. and WorldCom Inc. imploded following accounting scandals. Sarbox, as it is commonly known, requires companies to have a majority of independent board members who must regularly review financial controls on investment risks.

About 80 percent of directors at U.S. firms are outsiders, compared with about 9 percent in Japan, according to data compiled by METI. Yet those Sarbox provisions weren’t enough to prevent the current financial meltdown, says Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware.

“Sarbanes-Oxley was not successful insofar as reducing risk,” he says. “It led to bureaucratic risk analysis, which ultimately failed.”

By not tightening corporate governance rules, Japan may risk losing out on the foreign capital that could help drive the country’s economy out of the doldrums, says Atsushi Saito, president of Tokyo Stock Exchange Group Inc.

“The biggest challenge for the exchange is to win back investors at home and abroad, as the global credit crisis made them risk averse,” Saito says. “Implementing a clear corporate governance standard would be the best stimulus measure to boost stock prices.”


* The story says, "Japan’s gross domestic product grew by an average of 8.4 percent annually from 1955 to 1975," which I never knew. I always knew that Japan grew strongly but didn't think it was that high. I had been skeptical of countries like China and India because they have very high growth rates (7% to 10% real) but, given Japan's performance for 20 years, maybe I am being too critical. I still think China's 10% is way too high but maybe 5% to 7% is sustainable. After the super-high-growth period, Japan slowed down to around 5% in the 70's and 80's, and, of course, down to around 1% in the 90's and 2000's.


Newbie thoughts: Know your circle of competence

I'm going to start two new series for those who started out investing in the last few years. The series will be called Newbie Thoughts and Newbie Mistakes. I will randomly write up on issues that others may find useful. They will range from mundane, simple, ideas to interesting ones. Vetern investors may find them lame and may want to skip over the posts. Also, one should take my comments to be the equivalent of the 'blind leading the blind' because, quite frankly, I'm a newbie too :)

Know Your Circle Of Competence

Once you start investing for real, one of the important things is to know, what Warren Buffett coined as, your circle of competence. Just like in other aspects of life, everyone will have their strengths and weaknesses when it comes to investing.

It is very difficult for those who just started investing—say less than 5 years experience*—to say what is one's circle of competence is. After only trying many different strategies will we know if we are cut out for it or not. Furthermore, we will learn new things as we gain experience and this will expand our circle.

There is some benefit in thinking about your circle of competence, or at least what you think it is. In addition, one may want to think about how to improve your circle.

Even if it looks like a basic thing, you should probably write down what you think your circle of competence may be, and areas that you feel you are strong in and others where you are weak. Once you have such a list, you can set a goal to improve an area or, conversely, automatically ignore potential investments in areas you have no competitive advantage, even if you are attracted to it. For example, let's say you run into a seemingly attractive risk arbitrage opportunity but you feel that you are not cut out for it. Well, even if you are attracted to the opportunity—everyone else may tempt you by saying it's great and a surefire way to make money—you may want to ignore it. Or say you are not very good with sovereign bonds and run across articles or opinion pieces suggesting that Mexican bonds are good. Well, you may decide to improve the knowledge in this area and try to bring that area within your circle of competence. Whether you actually succeed in bringing it within your circle of competence depends on the person but at least you have a plan.

Here is how I perceive myself right now, along with notes on why I feel the way I do. Just because I say something is within my circle of competence and is "strong" does not mean that I'm good at it—all it means is that I feel comfortable and am willing to tackle it.

Center of the circle of competence (strong)

  • Commodities: I haven't taken a long position in any commodity companies lately but I did a lot of research when I first started investing so I think I'm ok on this front.
  • Contrarian opportunities: I feel this is a core strength of mine. Although the record is questionable so far, I have no fear wading into distressed situations or beaten down stocks.
  • General macro: Can't say I have profitted much off this but I do have an interest in general macroeconomic stuff so I feel I'm a bit more knowledgeable than many others I see on the blogsphere. Except for some early profits based on a commodity thesis, I can't say I profitted much from macro. However, I do think it helped me avoid losses.
  • International investing: I'm not really good at this and haven't done much of it yet but unlike many others, I'm pretty comfortable investigating overseas markets. Although one does not need to leave a major market like the US to find good opportunities, there are some advantages to investing overseas. If I'm still an active investor in the future—if I conclude that I'm not cut out for investing, I'm going to be a passive investor—I suspect I will invest mainly outside Canada and USA. You can invest in ETFs and mutual funds but stockpickers should really go for individual securities.
  • Risk arbitrage: I don't think one can really be much of an expert in this field. Put another way, it's hard to develop a competitive advantage over others. At best, you will just be good and avoid many blow-ups.

Boundary of my circle of competence (weak)

  • Technology: I want to develop my skills in this sector. Tech is sort of like consumer goods in the 30's to 60's so it's important for the future. My goal is to significantly improve my knowledge and understanding of this sector. I am already a geeky guy of sorts (in terms of tech products or whatever) but I really don't have a good grasp in terms of investing.
  • Bonds: Know very little, although I have studied them a bit in the last year. I think it is useful to develop some knowledge about bonds. Even if it doesn't help you right now (it may not since we may be entering a multi-decade bear market in them,) it can help you later on in life, perhaps closer to retirement. After looking more at bonds lately, I think I improved my understanding of stocks. It's sort of insightful to look at stocks as a zero coupon super-long-term bond with a yield.
  • Fundamental analysis: Bottom-up analysis is quite weak. I may never become a good fundamental analyst because I find it boring and hated accounting whenever I studied it in school :) But I hope to improve my ability to value stuff. I don't think I will ever be as quantitative as someone like Benjamin Graham but, hopefully, with a mix of qualitative, macro-oriented, insight, and reasonable estimate of valuations, I'll get it right.
  • Taxes: My portfolio is small and I'm near the bottom tax bracket so taxes aren't a big deal right now. At some point, I have to improve my understanding. This also means that companies that make a living by manipulating the tax laws to their advantages are confusing to me.

Areas outside my circle of competence (avoid)

  • Anything to do with biology/health/etc (healthcare, biotech, pharmaceuticals, etc): Of the core sciences, I hated biology more than any other subject in High School :) I am not interested in the field, don't follow it, and, quite frankly, just don't understand it. I automatically rule out any company in these fields.
  • Derivatives: I actually took courses on derivatives in University but I'll probably never use them. I actually invested in warrants before and, although it produced profits (in fact my all-time highest profit on any investment), I think it was a mistake—I was gambling and I never knew it at that time. There are many reasons for avoiding derivatives (options, warrants, futures, swaps, etc.) The obvious reason is their complexity. Even if one understands how to value them, I believe some of the commonly used formulas are flawed and you may be nothing more than an alchemist because chemistry wasn't developed yet. Futhermore, it's not clear to me what advantages small investors have over the professionals when it comes to derivatives. But the #1 reason to avoid derivatives is because they are a zero-sum game. You can still do OK in common stock investing (which is not zero-sum) even if you are not in the top 10% or 20% of investors. But that is not the case for zero-sum games. Those in the 10% in a zero-sum game will likely wipe out all the others and take all the profits. Think about a gambling game where someone else on the table is clearly the best. Do you think you will end up with any money? (some may disagree with my criticism but I have a post coming up on this.)
  • High growth stocks: I looked at growth stocks when I first started investing and quickly came to the conclusion that I'm not cut out for them. I never would have predicted that Apple would skyrocket so much. Perhaps the best example is Google's IPO. I actually thought Google was overvalued at its IPO price. Well, we all know how that turned out (I always remember the Google case because Bill Miller said it was cheap and I couldn't figure out what the hell he was talking about. I actually thought it was one of Miller's mistakes but, lo and behold, it was a correct call, while his bets (much later on) in financials was a mistake.) Clearly goes to show that I can't value growth stocks properly. I try to avoid them. An example of something I avoid right now, even though I am attracted to it, is Mastercard and Visa. These two stocks have very high growth potential but they are outside my circle of competence. (Do note that any investing involves a growth element but I'm talking about situations where growth is the key factor.)
  • Real estate: I am talking about either physical real estate (can't afford them) or companies that deal with real estate (such as REITs). I have spent some time looking at them but I have a feeling that this is beyond me. I just don't understand how to value them. For instance, I was looking at Japanese REITs and I get the feeling that it just doesn't click with me.

I'm sure I'm missing a lot but it's just the beginning. Everyone should probably think about where their strengths and weaknesses may lie...


* Like with any non-investing task, experience does not simply refer to the number of years. The amount of effort and knowledge gained in those years matters a great deal. Someone who has a high opportunity cost of investing—say one with a high paying job, or has kids to take care of, or has to spend a lot of time on relationships, or has a rich social life, or is in school—may be spending far less time than some guy who has a lame job, lives in the middle of the Arctic, and has nothing else to do ;) There are people who have been investing for 15 years but have less knowledge and expertise than some bloggers I read, who have only been investing for 3 or 4 years.

Wednesday, July 29, 2009 6 comments ++[ CLICK TO COMMENT ]++

The price you pay for emerging markets

Jason Zweig writes the weekly Intelligent Investor column for The Wall Street Journal. I don't subscribe to the WSJ but this column seems to be freely accessible on the web every week. Sometimes the articles are good; sometimes they are not. For someone who is a fan of Benjamin Graham, he writes a lot of articles that are more suited for passive investors than stockpickers. Nevertheless, sometimes the articles are pretty good, like last week's.

In Under the 'Emerging' Curtain, Jason Zweig tackles emerging markets. More specifically, he quotes some study by Elroy Dimson that shows that fast growing emerging markets produced less profits for investors than slower growing ones. This isn't really news to me—it's like growth stocks versus value stocks—but some may find it surprising (as usual, bolds are by me):

Based on decades of data from 53 countries, Prof. Dimson has found that the economies with the highest growth produce the lowest stock returns -- by an immense margin. Stocks in countries with the highest economic growth have earned an annual average return of 6%; those in the slowest-growing nations have gained an average of 12% annually.

That isn't a typo. Over the long run, stocks in the world's hottest economies have performed half as well as those in the coldest. When Prof. Dimson presented these findings recently in a guest lecture at a Yale University finance program, "a couple of people just about fell off their chairs," he says. "They couldn't believe it."

But, if you think about this puzzle for a few moments, it's no longer very puzzling. In stock markets, as elsewhere in life, value depends on both quality and price. When you buy into emerging markets, you get better economic growth -- but, at least for now, you don't get in at a better price.


"The logical fallacy is the same one investors fell into with Internet stocks a decade ago," says finance professor Jay Ritter of the University of Florida. "Rapid technological change doesn't necessarily mean that the owners of capital will get the benefits. Neither does rapid economic growth."

High growth draws out new companies that absorb capital, bid up the cost of labor and drive down the prices of goods and services. That is good news for local workers and global consumers, but it is ultimately bad news for investors. Last year, at least six of the world's 10 largest initial public offerings of stock were in emerging markets. Through June 30, Asia, Latin America, the Mideast and Africa have accounted for 69% of the dollar value of all IPOs world-wide. Growth in those economies will now be spread more thinly across dozens of more companies owned by multitudes of new investors.

If you are top-down, like Jeremy Grantham, or driven by some macro thesis, like Jim Rogers, then it doesn't matter if you invest in high growth countries or not. But if you are simply doing it because the economic growth is forecast to be high, be careful...


Is China going to face serious problems within a few quarters?

Deciphering the strength of the Chinese economy will also play a major role in formulating our view of any future relative strength of emerging. My colleague, Edward Chancellor, strongly suspects that the Chinese economy is dangerously unbalanced and very likely to come unhinged in the next few quarters, surprising the pants off investors.

— Jeremy Grantham, July 2009 GMO Quarterly Letter

Edward Chancellor, assuming it's the same person, is the author of Devil Take the Hindemost so he knows his stuff—at least when it comes to history. Is there really a risk that China may face serious problems within a few quarters?

The important point, as Grantham suggests, is that this will be a big negative surprise for the markets. The most at risk, as usual, as those overloading on cyclicals (such as commodity businesses or capital goods companies.)

Although some seem to follow China by observing its stock market, that is totally meaningless as far as I'm concerned. The stock market in China is close to early 1900's, or late 1800's, NYSE and resembles a casino more than anything. To see how much of a joke the American stock exchanges were at that time, recall how "serious investors" only invested in bonds during that era. The insiders and wealthy owners manipulated the markets so much that the outsider had little chance. There was nothing like modern insider trading laws and, well, outsiders "invested" on rumours more than anything. Similarly, Chinese markets right now are like that. Most of the listed companies are government-owned with limited float, poor transparency and spread of information, and shareholder rights are well, um, still being developed. You'll see a lot of people investing based on rumours of what the government may or may not do.

The proper thing to observe in China is their economy. Although stock markets aren't correlated very much with economies, I believe the correlation is really high in the case of foreign markets and the Chinese economy. A lot of market participants are betting on high Chinese growth so stock markets in America are influenced by that. Even politicians in developed countries are pinning their hope on countries like China and India these days so all this is widely believed and priced in.

Even if you don't believe in the bear case, you should at least spend some time thinking about whether you are vulnerable if the bears are right. I have been bearish on China (and others like India and Russia too) so I have never contemplated any investment that is tied to those countries (this meant forgoing huge profit opportunities in the last few years.) Yet, recently, I started looking at Japanese stocks and I have started to wonder what will happen to Japan if China faces problems. I have decided to be very cautious about any Japanese investment until I am confident with China.

Tuesday, July 28, 2009 3 comments ++[ CLICK TO COMMENT ]++

Ambac very close to being seized by the regulator

Ambac warned of huge losses, before it hosts an earnings call on August 5th. MarketWatch reports:

Ambac Financial Group shares dropped 13% Tuesday after the bond insurer said it's likely to lose about $1.3 billion and will stop paying interest and dividends on some securities.

Additionally, the company said that its Ambac Assurance unit has asked regulators for permission to release a big chunk of rainy-day money known as contingency reserves. Without that, the unit would have negative statutory capital of more than $1 billion.


Ambac said its Ambac Assurance unit expects to report estimated statutory impairment losses on credit derivatives jumped $1.6 billion to roughly $4.9 billion during the second quarter. The unit will also incur about $800 million in statutory loss and loss expenses in the period, the company added.

The increase in impairment losses were driven by problems with the guarantees that Ambac Assurance sold on CDOs that held asset-backed securities. One problem was that the underlying assets in the CDOs continued to deteriorate in the period, Ambac explained.

The $800 million in loss and loss expenses were mainly triggered by deteriorating second-lien and Alt-A mortgage-backed securities that Ambac Assurance guaranteed.

The impairments include two deals in which Ambac counterparties agreed to tear up CDO guarantees they bought from the insurer in return for $750 million in cash.

The impairment losses reduce Ambac's statutory capital and surplus, which comprises a cushion of extra assets that insurers have to keep for state regulatory purposes.

At the end of March, Ambac Assurance had $372.8 million in statutory capital and surplus. With the $1.6 billion in extra impairments from the second quarter, the unit would have negative statutory capital and surplus of more than $1 billion.

Ambac Assurance has appealed to Wisconsin State Insurance Commissioner Sean Dilweg to let it release a substantial part of its contingency reserves, which totaled $1.95 billion at the end of March. That would top off the unit's statutory capital and surplus.

Ambac noted that it can't say for sure whether the regulator will allow the release. A spokeswoman for Dilweg didn't immediately respond to a request for comment.

CreditSights' Di Carlo said Ambac Assurance will likely be granted regulatory approval to release contingency reserves. However, the analyst still expects capital levels to continue to deteriorate.

In related news, S&P cut Ambac Assurance deep into junk, from BBB to CC.

No hope, really. There was a remote chance of survival solely on the CDO losses but once HELOCs and Alt-As started posting huge losses, it was pretty much over... worst investment of my life. Oh well...


Are bubbles building in China?

Honestly, it's difficult to say what is happenning in China. Usually it's hard to discern the reality for any developing (or undeveloped) country but it's even more confusing given how China runs a totalitarian state and there is only one media (technically, they do permit other sources but they are tightly controlled.)

The big question being raised these days is whether China's stimulus programs are setting the stage for massive bubble formation. China is spending around 25% of GDP to stem the credit bust and the subsequent collapse in world trade. Bears like me already think there may be bubbles in fixed-assets like real estate, factories, malls, and so forth. But even if you didn't believe bubbles exist now, are they being created?

Vitaliy Katnelson recently wrote an article for Foreign Policy painting a negative picture that some of you may find interesting. Admittedly, Vitaliy has been bearish on China for a while and been completely wrong (like me) so don't blindly make any investment decisions based on that.

I also ran across an article in The Globe & Mail questioning the situation:

Loan growth exploded in the first six months, totalling a record 7.4 trillion yuan. That's nearly a quarter of China's gross domestic product and well in excess of the government's own projected quota of five trillion yuan for the entire year.

There is little doubt much of this cash has found its way into booming urban property markets and red-hot equities. The Chinese stock market has soared 88 per cent so far this year. On Monday, when Sichuan Expressway Co. became the first new listing on the Shanghai Stock Exchange's main board in almost a year, trading was so frenzied that officials had to twice call halts [the stock rose 203% on the first day—did the investment bankers misprice the stock or is it a mania?].

In Beijing, house prices soared an average of 27 per cent in the first six months of the year, and Hong Kong property loans are at their highest level on record.

Analysts estimate that at least a third of all new bank lending is being funnelled into stocks or real estate speculation. Another third is going just to keep struggling businesses running day to day in a tough economy, rather than for infrastructure or other economic improvements.

Who knows if the analysts are right but going with their estimates... spending 1/3 propping up failing businesses is neither very capitalist nor is it benefitial in the long run. But I can live with that. At least it is creating jobs. But the real worry is the 1/3 going into stocks and real estate.

One thing that is working in China's favour is the fact that their reserves are very large (something like $2 trillion). Most of the banks are owned by the government so any loan losses will accrue to the government and can probably be absorbed by the government. So I am not so concerned about the losses per se.

Instead, my worry is that bubbles distort the free market, not that it ever is free anywhere, and provides incorrect signals to consumers and businesses. Investors are also vulnerable but I don't care about them*.


* Sounds weird but I usually don't care what happens to the so-called 'capitalists', which includes me as an investor, because it's our job to price things properly and if it blows up, well, that's our problem. This is why it's so painful for me to see those who made mistakes be rewarded so lavishly. In fact, many executives who ran American banks into the ground are still at the firms (CEOs may be gone but many don't realize how the chief risk officers are still around.) Even worse are the incompetent board of directors, who didn't know what they were doing the first time, still around the second time, hoping to fix problems they clearly know little about. Even companies I am a shareholder of, like Ambac, should replace its entire board because they were all incompetent (there have been some minor changes.)


Are long-short strategies and market neutral strategies the way to go?

If someone is looking for an answer, let me say straight up that I don't have a testable answer. There isn't much public data available on long-short or market-neutral strategies; someone in the shadow world (i.e. hedge funds) would know a lot more and have more concrete data.

In a post I made earlier in the year suggesting that value investing may underperform if we end up in a scenario like the Great Depression but it may do ok if we end up like Japan—to confuse everyone, I'm not even sure how true that is and I wonder about Montier's suggestions—reader R. Soul suggests that long-short equity funds should do well in an environment like the Great Depression. I would throw in market-neutral strategies into the discussion as well. How good are those strategies?

Benjamin Graham ran something close to a long-short fund with a long bias in the late 1920's/early 1930's. He got wiped out during the Great Depression because he was net long and used leverage. Graham supposedly had $2.5 million long with $2.5m short, but he also had $4.5m unhedged with $2m debt. Even though Graham probably wouldn't be considered as running a pure long-short fund, he, nevertheless, provides an example of how it may not work if you make mistakes (in the case of Graham, he was too long and indebted.)

There may be some academic work on the performance of long-short and market-neutral funds during the Great Depression but I am not aware of any. So, let's take a short cut and see how such strategies have fared during the current crash.

Modern Long-Short & Market-Neutral Performance

I don't know much about hedge funds and the best indexes to analyze. Perhaps the Credit Suisse Tremont hedge fund indexes are the most widely accepted—I seem them referred in news stories—but it is not freely available (you either need to register or pay for it.) Instead, let's look at two freely available indexes: Eurekahedge Hedge Fund Indices and Dow Jones Hedge Fund Indexes.

Reader R. Soul mentioned long-short but I think market-neutral is also somewhat similar and worth considering. There are different definitions of what these strategies entail but here is what Dow Jones says of the two strategies (I am quoting from the latest fact sheet: here and here):

Dow Jones Hedge Fund Indexes

Equity Long/Short
Seeks to add value by generating returns from undervalued long positions and overvalued short positions. Besides using individual short positions to enhance returns, shorting exchange-traded futures and options is also used as a means for hedging market risk. The Equity Long/Short Benchmark has a positive long exposure to the equity market, which can produce potentially greater return and consequently more risk.

Equity Market Neutral
Seeks to add value by capitalizing on differences in the “fair” and current relative valuations among stocks. The strategy buys stocks that are currently undervalued and sells stocks that currently overvalued, while maintaining a zero net exposure to the broad market, i.e., portfolio beta is zero, and consequently portfolio performance is uncorrelated to moves in the broad equity market. But moves towards “fair” values of the stocks held in the portfolio may generate returns.

Basically the long-short strategy buys undervalued stocks and sells short overvalued stocks, and has a slightly net long tilt. The market-neutral strategy buys undervalued stocks and sells overvalued stocks but maintains neutral exposure. You may have your own definition of what these strategies entail and other index providers may define them differently but the concept won't change.

The following graphic shows the performance of these two styles using Dow Jones Indexes in the last few years. I highlighted the last three years, as well as the YTD figures for this year.

There are a couple of things to note.

Both strategies performed well in the last couple of years (bottom table). Last year, the long-short posted -18.41% while market neutral posted -8.33%. This compares favourably to -37% for S&P 500 and -42.5% for Dow Jones Global. If we look at EurekaHedge's long/short index (pick long/short from the chart), it posted -20.30% (it doesn't have a market-neutral index.)

However, both strategies underperform in prior years (although long/short did ok in 2007). Even if you were bearish in 2007, you would have underperformed the broad markets.

It gets interesting if we start looking at the current year. Long-short is posting a gain of +1.92% so far, while market-neutral has returned -3.34% YTD. Both of these are worse than the broad markets so far.

So, based on these limited data points, it seems that if we get a few more years like 2008—this would resemble the early Great Depression period—then these two strategies will outperform. But if we get a typical bear market, with rallies in-between collapses (like 2009, so far), these strategies may underperform.

Not Sold On Them

I think it is reasonable to expect these strategies to outperform if we get precipitous declines, such as the 1929 to 1932 period. So R. Soul is right. But the real question is how they will perform if we get a long bear market like Japan? This is important to me because I think we are unlikely to see anything like the Great Depression; indeed, I am expecting something more like Japan (but it won't be as bad because stocks weren't as overvalued.)

The answer, it appears, is that these strategies don't look so good if we get a Japan-style decline—protracted; rallies and sell-offs; slow. In fact, if we mark the top as being 2000, we are already experiencing something like Japan. We have had huge rallies and collapses and it has taken many years—9 years so far. The collapse isn't as bad as Japan but that's partly because the Japanese market was way more overvalued.

So, my view is that, unless you were really good with these stratgies and consider it as your core investing strategy*, I don't think these strategies will help unless we get a replay of 1929-1932. If there is ever a rally, these strategies will underperform, just like how short-sellers, who were geniuses last year, are getting decimated this year. It's probably very difficult to time things properly so that you are long-short when the market is collapsing but long-only when the market is rallying.


* When I refer to long-short or market-neutral being your core strategy, I'm referring to people like John Hussman and David Einhorn. Although they don't fit the definition exactly, both of these guys use strategies that involve a lot of short selling and/or taking bearish bets using derivatives (eg. buying put options, selling call options, etc.) Although Hussman's main fund isn't truly a market-neutral fund, it is probably the best approximation for someone who doesn't run a hedge fund; Einhorn is generally very long but he resembles a long-short fund (Einhorn may also be classified as an activist investor to some degree.) These guys use these strategies all the time, even during bull markets, and aren't necessarily driven by the market. In contrast, if you or me only use these strategies only during severe bear markets, it's a totally different matter. We are timing the strategies and may not have built up much skill.

Monday, July 27, 2009 4 comments ++[ CLICK TO COMMENT ]++

Opinion: Unregulated derivatives pose a grave threat to America

This was going to be a quick article referencing a story about how derivatives are concentrated in a few banks in America. Well, it turned into an opinion piece...

Once upon a time in America, there were thousands of banks and assets were distributed more widely across those banks.

Well, unlike countries like Canada, there are still thousands of banks in America but the assets are concentrated in a few major banks. My understanding is that the so-called "New York banks" had sizeable assets a hundread years ago but that pales in comparison to the present situation.

This basic history lesson, admittedly from someone who is neither a historian nor an expert on banking, is important in light of the following story.

Naked Capitalism pointed me to a story from CFO magazine about the concentration of financial derivatives in America:

Members of Congress probing threats to the global financial system — especially the threat of concentration of risk — will have a lot to ponder in newly mandated disclosures highlighted by a Fitch Ratings report issued last week. While derivatives use among U.S. companies is widespread, an "overwhelming majority of the exposure is concentrated among financial institutions," according to the rating agency's review of first-quarter financials.

Concentrated, in fact, among a mere handful of financial-services giants. About 80% of the derivative assets and liabilities carried on the balance sheets of 100 companies reviewed by Fitch were held by five banks: JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley. Those five banks also account for more than 96% of the companies' exposure to credit derivatives.

This is important because if these go down, the whole American banking system will be under threat. Even more of a concern is the following:

About 52% of the companies reviewed disclosed there were credit-risk-related contingent features in their derivative positions. Such features require a company to post collateral or settle outstanding derivative liabilities if there's a downgrade of the company's credit rating.

A mistake is a mistake, and losses will have to be borne by someone. But what separates an AIG from an Ambac—for thost familiar, both insured mortgage bonds and are sitting on potential losses of hundread of billions of dollars—is that AIG had to post collateral upon rating downgrades. The fact that some 50% of the reviewed companies say they would have to do this is kind of worrisome. However, it's not clear what percentage of their derivatives transactions require this and I'm not sure how many of them are banks.

Concentration You Say?

I always knew that nearly all the derivatives in America were written by a few banks (recall how in the Turtle Awards post I said Jamie Diamond is one of the top executives in America but given how JP Morgan has the highest nominal exposure to derivatives, it's too soon to say how good he is.) Although I don't have details about the 100 companies reviewed by Fitch (i.e. I don't know if they are leaving out key players), I'm surprised that 80% lies with 5 banks.

I am not too knowledgeable about derivatives and I may be perceiving the risk to be greater than it is, but I just wonder. A lot of the derivatives seem to be pertain to interest rates, and such derivatives are thought to be safe. But then again, soverign bonds were thought to be safe 10 years ago until LTCM found out the hard way; and pooled mortgage bonds were thought to be safe, until everyone owning them started blowing up two years ago.

We Can't Rely On the Zero-Sum View

The good thing about derivatives is that it is a zero-sum game. So if one bank falters, another profits so the net effect is zero. However, there are two issues to consider.

One is counterparty risk. If someone is unable to pay up, the so-called hedges that banks keep referring to, will dissapear instantly. Similar to how most hedge funds don't hedge, the banks will be shown to have no hedges. What one perceived as safe may not be so. When the monolines, as well as multi-line insurers like AIG, blew up, the banks, who relied on them for hedging, soon discovered they didn't have any hedges and were fully exposed. So, the theoretically zero-sum nature of derivatives may turn out to be false.

Secondly, regulators and the government may be unable to cushion any blows. The numbers may simply be beyond the ability of even the largest economy in the world. Furthermore, if profit from the derivatives keep flowing overseas, the public may force the politicians and the central bankers to avoid doing anything. For instance, some Americans are unhappy that hundreads of billions that were used to cushion the blow from AIG, flowed directly to foreign interests (mostly banks in Europe.) From a global point of view, what the American government is doing is good (it minimizes systematic risk). But from an American taxpayer's point of view, it is questionable.

Are Derivatives Modern Day Bucket-Shops?

I don't always agree with Charlie Munger—he's right-leaning and I'm left-leaning—but I think he may be onto something in suggesting that derivatives may be the modern-day bucket shops. Writing for the Washington Post early this year, Munger had this to say:

But the new trading in derivative contracts involving corporate bonds took the prize. This system, in which completely unrelated entities bet trillions with virtually no regulation, created two things: a gambling facility that mimicked the 1920s "bucket shops" wherein bookie-customer types could bet on security prices, instead of horse races, with almost no one owning any securities, and, second, a large group of entities that had an intense desire that certain companies should fail. Croupier types pushed this system, assisted by academics who should have known better. Unfortunately, they convinced regulators that denizens of our financial system would use the new speculative opportunities without causing more harm than benefit.

I never even knew what a bucket shop was until I read his piece several months ago. Even after reading up on it, I thought it was a radical view to be comparing derivatives to bucket shops. Certainly the whole banking establishment, which is dominated by the big banks, incidentally the ones mentioned above who are exposed to all these derivatives, would disagree with him (tens of thousands of employees working in this area will also lose their jobs if government cracks down.) As Munger mentions in his opinion piece, even academia seems to be against his views. But I suspect that the academics are falling by the wayside just like how the notion popularized by Alan Greenspan that derivatives diversify risk—this view was widely supported by Academica, especially the pure free-market supporters of the Chicago school followers—is sounding dumber by the day.

From my amateur investor vantage, many derivatives do seem like the bucket shop bets of the early 1900's. For instance, just like the bucket shops, you are placing bets on derivative outcomes with no underlying link to the asset and, most importantly, without it passing through any exchange or being recorded anywhere (I don't work in the industry or anything but it seems there are some services that try to provide pricing information for transactions, like Markit*, but it is not clear to me if transactions need to be reported to them or if it can be kept hidden. There are also derivative associations who attempt to oversee the players.) Furthermore, as this Wikipedia entry says of the bucket shops of the early 1900's (quoted below), I wonder if similar manipulation does not occur on a large scale right now:

The terms of trade were different for each bucket shop, but bucket shops typically catered to customers who traded on thin margins, even as low as 1%. Most bucket shops refused to make margin calls, so that if the stock price fell even momentarily to the limit of the client's margin, the client would lose his entire investment.

The highly leveraged use of margins theoretically gave the speculators equally large upside potential. However, if a bucket shop held a large position on a stock, it might sell the stock on the real stock exchange, causing the price on the ticker tape to momentarily move down enough to wipe out its client's margins, and the bucket shop could take 100% of their investments.

It's not clear to me if the banks, who definitely have the firepower equivalent to the bucket shop operators, can manipulate the underlying asset to wipe out the opposing derivative participants.

Having said all that, there is one thing that may make the derivative situation different from the bucket shops of the early 1900's. The bucket shop participants were small investors who were not knowledgeable and seem like pure speculators. In contrast, the participants in the derivatives world are thought to be sophisticated, and at a minimum, educated, participants of the market. There is no doubt that some traders working at banks or hedge funds are pure speculators. However, most will be knowledgeable about what they are doing. In a free market, participants will only act in their interest. So, perhaps, the situation isn't as devious and disastrous as the bucket shops. Even if banks on one side of a derivative contract are manipulating everything in sight, the participant on the other side may not participate or price the contract as needed. So, there is a possibility that derivatives may be better than the bucket shops that they seem to resemble.

Derivatives Are a Great Threat

Overall, derivatives may pose a great threat to America. It's a difficult problem for America because the top banks are very influential and they employ tens of thousands in the affected areas. I feel that something will have to happen. As you saw above, it's crazy to have 80% of the risk tied up in 5 banks. This wouldn't be so bad if these were some no-name investment banks no one cared about but, unfortunately, they also hold most of the citizen deposits. Hopefully society does something proactive before an actual crisis. So far, my impression is that the US government has strong-armed the derivative bodies into agreeing to list derivatives on exchanges. We'll see what happens after that.

(* I also wonder about the legitimacy of Markit, which I understand is owned by the major players in the derivatives world. To see how ridiculous this is, imagine you were betting on something in a bucket shop and the outcomes are published by the bucket shop operators. I believe there are some indepedent competitors but I'm not sure if a similar conflict of interest exists there.)

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Should we favour those who hold high amounts of cash?

The post where I was speculating on Seth Klarman's performance generated a lot of interest. A lot of it was due to the excellent blog, Distressed Debt Investing, picking up the post. Everyone has their own view on performance evaluation—some don't even think you can compare performance—but I want to address one point that was raised by several people. It has to do with Klarman holding high levels of cash.

Several people feel that Klarman should be looked upon more favourably because he holds high levels of cash. What do the rest of you think? Is Klarman being handicapped by his cash levels? My answer, which is strictly my opinion, will probably be controversial.

My view is that I would not give a bonus to Klarman just because he holds cash. The way I look at it, what matters in the end is the actual performance. If you were risk-averse, you may value cash but I personally don't. If one used debt, then I would be a bit wary but it depends on the levels.

Holding cash will be drag on your performance when times are good. So, yes, Klarman's performance was dragged down by his cash during the booming 90's. However, one should also realize that holding high cash improves your performance when times are bad. Klarman would have got a huge boost, relative to the broad markets, during sell-offs. Given the massive crashes, he would automatically get a relative boost from 2000-2002 and 2007-2009.

So, to sum up, the argument that Klarman was better than his numbers indicate because he holds sizeable cash positions is not a strong one in my eye. The drag during good times is cancelled out by the benefit during sell-offs. Klarman is still one of the best investors out there but if his performance is dragged down by high cash levels, it's a strategy he is following on purpose.


BTW, I have typically held 20% to 50% cash in my small portfolio in the last 2 or 3 years—I don't measure performance with the cash so my performance is overstated in good times and understated in bad times—so it's not as if I'm against the strategy. All I'm saying is that one should not suggest that this is somehow better than it seems. I think of it as something that cancels out in the long run.

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

Sunday Spectacle XIX

Illustration by Charles Barsotti for the New Yorker. Illustrated books and other gifts available from New Yorker's Cartoon Bank.


Innovative ideas are rare... Is that really so?

(This post has nothing to do with investing; if you are interested in science, do check out the fascinating essay.)

(Illustration by Barry Blitt for The New Yorker)

In mid-2008, writing for The New Yorker, Malcolm Gladwell, arguably one of the top writers in America, wrote an essay that questioned the commonly held view that innovation is rare. Titled In the Air, it is a fascinating piece that, as is usually the case with any of his works, happens to be provocative and somewhat controversial. Skeptics of Gladwell always accuse him of extrapolating small observations into large, all-encompassing, hypotheses. I am a big fan of Gladwell—I actually haven't read any of his books yet; I find his essasys in The New Yorker or other publications to be more interesting—and admit that Gladwell has a habit of painting with a broad brush. What I love about his writing is how he turns over stones and shines the light on seemingly minor issues that society ignores. He tries to connect the dots in ways that others simply don't even think about. So, whether one agrees with his final opinion or not, I find that one can learn quite a bit in the journey that he charters us on.

The main subject of In the Air is innovation and scientific discoveries. I, like the rest of the population, had always felt that innovation and scientific discoveries were rare. But is that really so? Malcolm Gladwell goes on a fascinating journey, starting with dinosaur hunters in Montana to the invention of the telephone, and concludes that scientific advances are far less rare than they appear. We, as a society, bestow great fame, and sometimes fortune, on the the inventors of new technology—Alexander Bell and the telephone for instance—but Gladwell almost argues that many technologies would have been developed eventually. He argues that as great a scientist or inventor as one may be, it is not quite like a unique artist.

(source: In the Air, by Malcolm Gladwell. The New Yorker. May 12, 2008)

People weren’t finding dinosaur bones, and they assumed that it was because they were rare. But—and almost everything that Myhrvold has been up to during the past half decade follows from this fact—it was our fault. We didn’t look hard enough.

Myhrvold gave the skeleton to the Smithsonian. It’s called the N. rex. “Our expeditions have found more T. rex than anyone else in the world,” Myhrvold said. “From 1909 to 1999, the world found eighteen T. rex specimens. From 1999 until now, we’ve found nine more.”


This phenomenon of simultaneous discovery—what science historians call “multiples”—turns out to be extremely common. One of the first comprehensive lists of multiples was put together by William Ogburn and Dorothy Thomas, in 1922, and they found a hundred and forty-eight major scientific discoveries that fit the multiple pattern. Newton and Leibniz both discovered calculus. Charles Darwin and Alfred Russel Wallace both discovered evolution. Three mathematicians “invented” decimal fractions. Oxygen was discovered by Joseph Priestley, in Wiltshire, in 1774, and by Carl Wilhelm Scheele, in Uppsala, a year earlier. Color photography was invented at the same time by Charles Cros and by Louis Ducos du Hauron, in France. Logarithms were invented by John Napier and Henry Briggs in Britain, and by Joost B├╝rgi in Switzerland.

“There were four independent discoveries of sunspots, all in 1611; namely, by Galileo in Italy, Scheiner in Germany, Fabricius in Holland and Harriott in England,” Ogburn and Thomas note...

For Ogburn and Thomas, the sheer number of multiples could mean only one thing: scientific discoveries must, in some sense, be inevitable. They must be in the air, products of the intellectual climate of a specific time and place.


You can’t pool the talents of a dozen Salieris and get Mozart’s Requiem. You can’t put together a committee of really talented art students and get Matisse’s “La Danse.” A work of artistic genius is singular, and all the arguments over calculus, the accusations back and forth between the Bell and the Gray camps, and our persistent inability to come to terms with the existence of multiples are the result of our misplaced desire to impose the paradigm of artistic invention on a world where it doesn’t belong. Shakespeare owned Hamlet because he created him, as none other before or since could. Alexander Graham Bell owned the telephone only because his patent application landed on the examiner’s desk a few hours before Gray’s. The first kind of creation was sui generis; the second could be re-created in a warehouse outside Seattle.

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Friday, July 24, 2009 2 comments ++[ CLICK TO COMMENT ]++

More thoughts on Hugh Hendry & Eclectica; A quick look at Kanaden (8081)

Read a whole hoard of articles on the Eclectica website and Hugh Hendry is really into technical analysis. Although I like his macro views, his investment style is not attractive to me. Here is some tidbit from the Feb/Mar 2006 Hedge Fund Journal article (as usual, any bolds in the quote are by me):

A key point here is the importance of technical analysis to both Hugh Hendry and OAM. For some years veteran chartist Brian Marber had provided a technical input on markets/stocks/sectors to the investment professionals at OAM. Through the course of time Hendry came to recognise that he was placing more reliance on the chart patterns and levels than his mentor Odey. Just as Hendry was increasingly relying on technical signals to tell him he was right (or wrong) on the timing or correctness of his market and stock views...


What is Eclectica Fund? It is described by its management company as “an opportunistic fund investing in global equity, fixed income, currency and commodity markets,” and it “aims to fully utilise the balance sheet.” The last part expresses the risk appetite necessary to produce “superior risk-adjusted returns over the long term”.


The fund comparisons that come to mind are not even latter day American hedge funds: Hugh Hendry is on a path to re-create the funds that Steinhardt, Soros and to some extent Robertson became, funds that outgrew their equity-focussed beginnings, and that flowered to utilise the full scope of wide investment powers.

Eclectica doesn't do much fundamental analysis (so they clearly aren't value investors.) Based on the article, it seems they are more like the famous hedge funds of a few decades ago. However, I'm not really sure how much technical analysis was used by George Soros (anyone know?). Jim Rogers doesn't seem to use technical analysis at all and he was a key member of Soros' team a few decades ago, so I wonder if Soros used technical analysis at all (anyone know?).

I remember looking at some technical analysis stuff when I started investing in 2004 but sort of gave up on it completely in the last few years. Just about the only technical analysis stuff I pay attention to, if it comes across my view, is the Dow Theory, sentiment indicators, and margin usage. I don't use technical analysis to make purchase decisions. I break one of the cardinal rules of technical analysis in most of my purchases. That rule is the one that says never to buy stocks that are falling and to buy stocks that are going up (this is usually measured by a short-term moving average crossing above or below a slower-moving average e.g. 50 dma (day moving average) above 200 dma is bullish.)


The Eclectica Fund also has very high turnover (at least when the article was published back in 2006) and Hugh Hendry seems to hold as many as 100 or 200 securities at once.

Like nearly all hedge funds, they also use a lot of leverage. The article mentions that in January 2006, Eclectica was net long 277.4%, which consisted of:

+31.4% in bonds
+56.8% in commodities
+70.5% in currencies
+223.6% in long equity
-104.9% in short equity

The use of leverage is why I am skeptical of high returns attributed to many hedge fund managers. It completely masks skill! I'm not saying they shouldn't use it—they should do whatever works for them and whatever enables thme to become rich :)—but we need to discount any high returns. It just doesn't compare to a typical, unleveraged, retail investor or mutual fund manager. In the Seth Klarman post, I mentioned that Klarman didn't use much leverage, and some readers also suggested that his leverage is actually a drag (negative) since he tends to hold a lot of cash.

Eclectica's hedge fund posted returns of -4.5%, +49.9%, +8.1%, +15.6%, and +13.0% in 2002 (4 months only), 2003, 2004, 2005, 2006 (January), respectively. Hugh Hendry also became famous and certainly came within my radar after he posted something like +30% last year. Nevertheless, it's just really tough to say how good Hugh Hendry's skill is.

A 2003 Barron's interview, when Hugh Hendry was part of Odey Asset Management, had this to say about his style:

Hedge-fund manager Hugh Hendry happily concedes that he’s an apostate from fundamentalism, uses technical analysis liberally, and hasn’t met with a company management in “five years, thank God.” The Scotsman with Glasgow working-class roots admits to having no friends beyond the Reuters mini-terminal he carries in his pocket. He eschews the focused-fund approach and what he calls Taliban-like fundamentalism in the market. Instead, Hendry believes that asset allocation is crucial. Choosing among a wide variety of asset classes that he considers promising, he populates the fund with hundreds of small positions. “We’re like a centipede. You can lose 30 legs and you can still march forward,” he says.

Hugh Hendry's thinking is closer to someone like Marc Faber or Jim Rogers than Warren Buffett. Similar to Faber and others, his view is that being in the right asset matters most.

Pretty Good Macro Forecasts

Hugh Hendry is very good at macro investing. His timing seems to have been somewhat off but read the following, which was said in 2003 and think about what just happened in the last two years.

Barron's: Today, liquidity is being pumped in by Greenspan, then?

Hugh Hendry: Yes. The mechanism is the government sponsored enterprise sector in America, the Fannie Maes and the Freddie Macs. The U.S. has nationalized the credit-creating process, previously the preserve of the banking sector. Freddie and Fannie can borrow money at almost the risk-free rate. At times of anxiety, they are profitmotivated to expand their balance sheets because government bond yields, the risk-free rate, fall during times of risk aversion. The spread widens between riskier assets like mortgage-backed securities, which Fannie and Freddie buy, and Treasury bonds. The combined balance sheet of Fannie and Freddie is $3 trillion, 30% of the U.S. economy. The annualized growth rate in September and October of their balance sheets was 50%. Now when people talk about M2 or the old monetarism, it hasn’t kept pace with the disintermediation, which has gone on in the economy. It doesn’t include agency paper. The money supply looks as if it’s waning. It’s not. There’s enormous dollar creation. You can control the domestic price of money. Short-term interest rates have not gone up in America because of this economic Frankenstein. But you can’t control the external price: The dollar is weakening versus everything, even versus the ruble.

The response to the crash since March 2000 has been to create even more money. Just as it was 300 years ago [he is referring the disastrous policy by another Scot, John Law, in France.] We’ve created a tidal wave of liquidity, with the Dow back at 10,000.

Everyone was warning about the GSEs. Warren Buffett criticized them; Alan Greenspan was critical of them; the GSEs even had to restate their financials a few years back; but I haven't seen anyone suggest the GSEs were going to facilitating the creation of so much money. I think Hendry is way to extreme in comparing to John Law's France but he did say, back in 2003 in this interview, that there was huge risk.

He suggested two scenarios back in 2003. The first one:

He [Alan Greenspan] knows the consequences are a period of prolonged economic weakness and that terrifies him because he’s got so much debt in the economy. Debt today is 360% of GDP. Not just in America but elsewhere. We’re ill-prepared for a rise in savings. And so he’s done everything to prevent a rise in savings. If the Fed succeeds in re-inflation, then the good news is that the Dow is going to be at 10,500 . . . in 2020.

Hugh Hendry was actually wrong with the timing. The Dow actually hit 10,000 much sooner... His second scenario:

The stock market today is capitalized at 100% of GDP and debt is 360%. Here we are with the U.S. gross domestic product recently having shown 8.2% growth, a classic economic recovery. But history suggests that if growth continues, then 10-year bond yields will have to go to 6%-7%. But that debt level—i.e., mortgage refinance-based consumer spending—can’t accommodate such high interest rates. That’s why the Fed keeps saying that it will be putting the short rate up; it’s desperate to control the long rate. This is a bear-market rally... If it rolls over, if all the bears are converted back into bulls, concluding it’s a natural cycle, then this market will test last year’s lows. If those are breached, then I believe you could lose 80% of the value of the S&P and the Dow from their peaks.

I think his second scenario actually unfolded but not quite how he or anyone else imagined. The market did not fall below the 2002 low; instead, the bears were converted to bulls and it rallied all the way to a new nominal high.

But the crash that Hugh expected did materialize—sort of. The market crashed almost the day after the Dow hit 14,000. It didn't fall 80% as Hugh was expecting but it did fall around 40%. It can still fall but I don't think it will fall 80% from the peak.

If we look at returns in real terms, the market is certainly approaching the 80% figure. In real terms, it is close to the 1930's collapse. But as I remarked when I wrote about the 1930's comparison, the stock marke was more overvalued in 2000 than in 1929 so the fall can be even larger (but do note that the stock market hit an extremely low valuation in 1932 and we may not hit such valuations; instead, something like the valuation in 1933 is more probable.)

The rest of the Barron's article contains his stock picks and shows how he was right one certain themes. He was loading up on commodities (this was 2003) and was even bullish on Japan. I can turn out to be wrong but I think it is too late for commodities. Even if commodities still have room to run, they are not out of favour, with very low valuations like they were in early 2000's. But I think whatever he said of Japan is applicable since Japan sold off sharply and is literally back to what it was in 2003. He mentions a few Japanese real estate companies, as well as a company called Kanaden.


Just to show why people keep saying that Japan is Benjamin Graham's dream right now, Hugh points out that Kanaden (TSE: 8081), an electronics component supplier, was trading at a remarkable price to sales ratio of 0.03!!! This for a company that has $1 billion in revenues. Wow! Can you think of a company that is trading for $30 million while having sales of $1 billion? Assuming its debt situation is under control, that's amazing. There are many microcaps in America that trade at p/s of 0.03 but they have very low sales and depend on one customer or stuff like that. But a billion in revenues is amazing. One still needs to do their homework and make sure the balance sheet is good, there are no legal problems, and so forth.

Hugh suggested that he bought on the thesis, not that sales would increase or the situation would improve, but, that the market would re-price it upwards to a p/s ratio of 0.2 (he gets 0.2 by looking at the lowest p/s ratio for any company in Europe).

Here is quick look at the stats from the Tokyo Stock Exchange (note: some numbers may be wrong so one should look at official documents if available; not sure if anything in English):

Without knowing what happened in the intervening time period, it looks like Hugh's targets weren't hit. The stock "only" ran up 100% (roughly 30% annualized.) Assuming the sales didn't change much, Hugh's estimate (admittedly wildly optimistic :) ) would have seen the p/s go from 0.03 to 0.2, which is roughly +567% (if my calculation is right.) I'll take 100% any day of the week though. Like nearly all Japanese stocks, Kanden did a round-trip and is basically back to the 2004 price (I hope Hugh Hendry sold it by 2006 ;) ). If English information is available, this company may warrant a look... I think the sun is about to rise over Japan...

To sum up, I think Hugh Hendry is worth checking out once in a while, if you are into macro stuff.

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Thoughts on Hugh Hendry

I remarked recently that I ran across the Scottish CIO of Eclectica Asset Managament, Hugh Hendry, and was quite impressed by him. He reminded me of the first time I encountered Marc Faber, who incidentally had a huge impact on me. Like Faber, he is outspoken, quite controversial, and a bit arrogant (I don't like his arrogance though.) Most importantly, however, Hugh Hendry, like Faber, seems to have a good understanding of investment history. I would say that Faber knows a lot more than Hendry but Hendry seems good as well. Interestingly, Marc Faber and Hugh Hendry are both skeptical of central bank actions but they take completely opposite views: Hendry is a deflationist while Faber is a hyperinflationist (do note that they may change their opinions over time.)

I did some research on Hugh Hendry to see if he is actually someone worth listening to. Not being part of the hedge fund world or having access to his hedge fund letters, I am limited to his public writings and appearances. Here is my opinion of the man, right now.

Interviews and Writings

You can access some video interviews of Hugh Hendry from the Eclectica website. You can also access some articles by Hugh and his team from that site.

Investment Style

Eclectica manages some mutual funds as well as a hedge fund. The hedge fund is the one that is interesting to me because that is where Hugh can put his ideas into action. The mutual funds are limited and seem to be underperforming the market it seems (more on this later.)

Hugh Hendry is partly driven by momentum (but doesn't seem like a momentum-oriented trader or quantitative investor.) He has said in his interviews that they only take positions when the market is moving in a particular direction; and they sell if the market goes against them (I'm sure that I'm oversimplifying his strategy.) This is contrary to my investing style. In other words, people like me, who follow the classic value investing thinking, believe that the market is there to serve you and should be ignored if one can't find reasons to believe its actions. In contrast, Hugh, like George Soros, believes the market to be correct and they live off the signals provided by the market. This might seem confusing but do note that none of this means that you never go against the market. Indeed, Soros' most famous action was betting against the market with his bearish bet on the British pound (technically, I can see some argue that he was betting against the central bank and not the market.) Instead, my view is that it comes down to whether you value signals from the market or not.

Overall, Hugh Hendry is a true contrarian and this is what attracts me to his thinking. His investment history is way too short—who knows if he was lukily a contrarian last year, when he posted +30% and was one of the few who was bullish on US Treasuries—but I do notice his arguments go against the consensus. Of course, the big risk with being a contrarian is mistakenly being a contrarian for the sake of being a contrarian.

Major Calls: China

One of the major calls he is making is a superbearish outlook for China. He seems far more bearish than almost anyone I have seen. (Of course, this goes against investors like Jim Rogers and Martin Whitman, who have huge stakes tied up in China or its economic performance, either directly or indirectly.)

I share some of Hugh Hendry's views of China but I'm not really sure how bad things really are. In one video clip, he heads over to Ghuangzhou and chronicles the countless skyscrapers that lay unoccupied—the implication being that there is a massive real estate bubble and undisclosed losses are sitting on someone's balance sheet (basically the bearish argument that we are seeing Japan in 1989 or 1990.) It's hard to say how much Hugh's investigative work reflects reality. Some commentators to the YouTube video say that some buildings are marked (in Chinese) as being under test. So some of what Hugh perceives are unoccupied buildings are ones that aren't even completed yet.

I also think the video analysis is a bit weak because it doesn't cover multiple cities (unless I'm mistaken and the video is an amalgamation of several cities.) Guangzhou is the heart of export-oriented China so it makes sense that it would be hit harder than the rest. The real question in my mind is how other major cities are doing. Beijing is a government capital so I would ignore that (govt can prop up such cities) but how about Shanghai or some place like that?

In any case, China's all murky and, given my bearishiness, I'm avoiding it for the time being. This means, if you share a bearish view like me, you should be careful with commodity businesses and capital goods companies. But, staying bearish on China will mean that you may miss out on some of the biggest opportunities of your lifetime. If China is USA in the early 1900's, as Jim Rogers suggests, you may miss out on great potential*. The consensus is that the situation in China is pretty good. In fact, many analysts on the Street seem to suggest that any future, positive, economic performance in the world will come from strong growth in China. So, any bearish view will be contrarian.

Major Calls: Deflation

I don't know if Hugh Hendry will change his view on this but he is a hardcore believer in deflation right now. He has been bullish on US Treasuries all throughout this year. The market, needless to say, has had other ideas, with US Treasuries posting massive losses so far this year. In one of his interviews, he did say that he is very light on Treasuries and expects to consider further purchases later in the year. This is consistent with the view of several others who have suggested that the September/October time frame will decide the fate of many this year.

I lean slightly towards deflation but I believe it will be mild. I'm not really sure if it will be as big as Hugh Hendry has suggested. Yes, there are massive losses lurking around in all sorts of assets (the one under the spotlight right now is commercial real estate in America.) But will it actually take down bond yields all the way down to 2%? I don't know. We'll see.

Not surpringly, like most deflationists Hugh Hendry seems a long bear market in equities. He has suggested in the past that we may be in a bear market for 25 years.

Major Calls: Agriculture

One seemingly inconsistent call by Hugh Hendry is his bullishness on agriculture. He has dedicated agriculture funds and I wonder about the merits of the agricultural call. Another portfolio manager seems to manage the agriculture fund but since he is the CIO, I assume it fits his views.

Hugh Hendry made a major bullish bet on agriculture last year and it totally blew up. He was overloading on fertilizer companies last year near the peak, and, well, it completely collapsed thereafter. It appears that they are more favourable towards value-added agriculture companies like Monsanto and Syngenta. Unless you were very good with commodity analysis, it is probably better to invest in companies like Monsanto than in wheat or rice. But, of course, the established companies like Monsanto, Syngenta, Bunge, and so forth, are rarely ever cheap. I was looking at them near the bottom of the stock market collapse and they didn't seem cheap.

I mentioned a long time ago that it was probably better to invest in soft commodities (agriculture) than metals or energy. But I wasn't bullish back then and still am not. I don't see what Hugh Hendry sees in agriculture.

Overall, Hugh Hendry seems like an interesting guy. I'm curious to see how he does this year. Since he is one of the few deflationists around, I'll be paying more attention to him.


(* Even though USA grew quite well in the early 1900's, it was actually very bad for stock market investors. The US markets were in a very severe bear market that lasted for several decades, until 1920. One of the reasons the bull market in the Roaring 20's was because valuations were extremely low in 1920. Even though the economy grew, and corporte profits rose, for two decades in the early 1900's, stock prices kept falling until 1920. Even if you believe Jim Rogers' thesis, valuations will matter a great deal.)

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Thursday, July 23, 2009 3 comments ++[ CLICK TO COMMENT ]++

Charlie Gasparino of CNBC disses Tyler Durden of Zero Hedge

I don't hit Zero Hedge that often—it's really for professionals or traders—but I found it kind of funny that Charlie Gasparino of CNBC actually called out Tyler Durden of Zero Hedge. Obviously, Charlie never saw the critically acclaimed film Fight Club or heard of the book it was based on...

One of the difficulties for a business television station like CNBC, or its employees, is that it is in the entertainment business. Without keeping things entertaining, they won't make much money. Yet, at the same time, they touch on important issues. I see a lot of people bashing a station like CNBC yet they are precisely the ones that keep watching stations like that and paying for it (or contributing indirectly to advertising.) No one bashes Bloomberg or Fox Business Network (or Business News Network in Canada) because, well, no one watches them; they are not entertaining...


Bank of Canada: Recession over

From The Globe & Mail:

Canada's recession is over, and the country is beginning what will be a long reconstruction of the wealth destroyed by the financial crisis, the Bank of Canada said Thursday.

Gross domestic product will expand at an annual rate of 1.3 per cent this quarter, compared with an earlier forecast for a contraction of 1 per cent between July and September, the central bank said in its latest monetary policy report.

The dramatic shift is the result of stronger financial conditions, surprisingly high consumer and business confidence and a first-half contraction that was less severe than the economic catastrophe the central bank was bracing for when it last published its views on the economy in April.

If the bank's new forecast proves correct, Canada's first recession since the early 1990s lasted three quarters, making it one of the shortest downturns on record.

This would be a pretty short recession in Canada. Unlike USA and most of Europe, Canada avoided any serious collapse in the financial sector. The resource sector also has held up relatively well (even though foreign resource demand collapsed, the fact that the Canadian dollar also fell sharply probably mitigated the damage.) However, Central Canada, which is where I am, suffered terribly and will continue to do so for a while. Ontario and Quebec, two major central provinces, depend on manufacturing. Ontario, in particular, saw its auto sector decimated and its manufacturing sector collapse (this has been going on for the last 5 years but it hit a peak late last year.)


Asian governments having difficulties issuing bonds

This is the type of story that very in North America is aware of, yet can portend to huge changes:

For all the talk this year about the Chinese refusing to buy U.S. bonds, the real story is about the People’s Republic of China’s failure to find buyers for the equivalent of $1.7 billion of its debt because too many investors showed no interest at auctions that would be considered disastrous if their outcomes were repeated on Wall Street.

Other Asian countries face similar difficulties. India’s underwriters had to purchase 3.1 billion rupees ($64 million) of 25-year securities they were unable to sell at a July 10 auction. Vietnam and the Philippines abandoned offerings because investors demanded higher yields than the governments were willing to pay. China’s 11.9 billion yuan in unsold short-term debt represented 14.3 percent of the 83 billion yuan it offered in three sales this month.

A lot of people who bash the US sovereign debt don't realize how attractive it is compared to emerging market soverign debt. This isn't just my opinion; it's the market's opinion.

Rising bond yields is equivalent to tightening of money so it remains to be seen how economies in those countries will be impacted. I'm also curious to see if the bond yield in America splits off from the emerging market ones. That is, will bond yields in America stay low while they rise in emerging markets?

Wednesday, July 22, 2009 17 comments ++[ CLICK TO COMMENT ]++

How good is Seth Klarman?

I see some value investors suggesting that Seth Klarman is in the same league as Warren Buffett. How good is he?

Quite frankly, I know very little of Seth Klarman so my comment should be taken in that light—namely, a distant observer with limited information. Institutional investors and others in the hedge fund world will have a better, truer, picture; but I have to go with what I have.

I have no idea what Klarman's performance in the last decade has been. But I did run across the Baupost Fund letters in the 1990's—I think I linked to them before but if you haven't seen them, do check them out—and let's look at how he performed.

If we go with the latest available information, at least to me, it is the 2001 letter. I extracted the performance table, which represents inception to 2001, which is around 10 years, from that letter:

Well, you can get a feel for an investor's skill and investing style from long-term performance. It's sort of like looking at a 10 year history of a business. A business with fluctuating profits, with losses once in a while, is not so great (such a business would represent my investing skills :( ). Another with stable, good profits, will represent a skilled investor (like Warren Buffett).

The first thing that jumps out is that Klarman is no Warren Buffett (I'm sure Klarman himself would agree that it is a ridiculous comparison.) Warren Buffett posted around 20% annual returns in the 1960's while Klarman posts 12.83%.

What was initially surprising to me, when I looked at this many weeks ago, was how Klarman underperforms the S&P 500. The margin is sizeable (around 2.4%) and someone investing $50k would have generated almost $40k more in the S&P 500. However, note that S&P 500 was wildly overvalued in 2001 (it was even more overvalued in 2000). In any case, it's interesting to me. A lot of value investors underperfomed in 1999 and 2000 but Klarman underperforms in the pre-1996 period as well.

However, we can easily tell that Klarman's strategy generates absolute positive returns. You'll notice that he rarely ever lost money and does not seem very correlated with the broad market. Even when he was underperforming the S&P 500, he was posting around +10% per year. The S&P 500 portfolio also didn't lose money, until 2001, but it is more volatile. Klarman's seems more smooth. The real test is to see what happened in the 2000's. Without that record, it's hard to say if Klarman's style actually avoids the volatility and inherent, occasionally massive, losses that are norm for the broad markets.

Based on this limited observation, I would put Seth Klarman a bit below Martin Whitman (admittedly Whitman seems to be having a terrible few years and it's not clear how Klarman did.) Based on my limited knowledge, no one comes anywhere near Warren Buffett. In the modern era, #2 would probably be George Soros (he isn't a value investor though.) There are a few others in the hedge fund world who have supposedly posted numbers that are even better than Warren Buffett's in the 50's and 60's but I have no access to their reports and am unfamiliar with their strategies*. Number three might be Jean-Marie Eveillard or someone like that.


* For instance, a lot of hedge funds post very high returns, compared to public investors or mutual funds, because they use leverage. Even if they don't leverage up much within the fund, they may invest in assets that are inherently leveraged, such as a CDO, CLO or some private equity fund. Some only care about returns and could care less about leverage but I discount anyone using leverage. If you post 30% with leverage, I consider it worse than, say, the 20% generated by Warren Buffett**. But most people, especially the media and the general public, would consider the 30% better because you would be richer and it's hard to tell if someone is using a leverage without extensive analysis.

** Admittedly, Warren Buffett also uses a special type of leverage. Buffett gets a boost for his returns by using the float of insurance companies (some bears, who do not respect Buffett's investing skill, argue for a slight discount to Berkshire Hathaway because this is a somewhat risky strategy if you are a bad investor. This bearish argument is the case for any insurance company you invest in. If you mismanage the insurance company assets, you can end up in more trouble than even if your insurance claims end up being large.) In any case, I don't think the float argument detracts from Buffett's skill because he didn't have quite the same amount of access to insurance float in the 50's and 60's.