Articles for the week ending August 15 of 2009

At the start of the year, the bond market and the stock market were pointing in different directions. Bonds were forecasting high defaults and economic malaise, while stocks were more subdued. So far the stock market has been right. Will the year finish that way? Something to think about...

Some articles for you to check out, in no particular order...

• (Recommended) Interview with Paul Sonkin (Street Capitalist): Tariq Ali at Street Capitalist does a good job interviewing Paul Sonkin. Don't know much about Sonkin but he tends to specialize in small-cap and micro-cap stocks so anyone who likes tiny companies should check out the interview.
  
  
• More than 150 banks at dangerous loan loss levels (Bloomberg): The question is whether this is the peak or not. I think the stock market is pricing in the loss rates as the peak. If we have hit the peak, things will look bleak but should improve over the next 5 years. But if it is not the peak, watch out...
  
  
• Battle over fair-value accounting continues (Bloomberg): Bloomberg had several articles on fair-value accounting this week. I can't believe this issue hasn't been settled. I have been a critic of fair-value accounting ever since I encountered it. However, there isn't a right answer. It's sort of like a political decision where there isn't an ideal solution that satisfies everyone. America's FASB is working with the international IASB to expand fair-value accounting. I'm not too knowledgeable about accounting but my impression is that most international accounting systems use more market values in their accounting. For example, real estate in most Asian countries is listed at market value, whereas it is (historical) book value in America. Cross-shareholdings, a big corporate strategy in Japan, are listed at market value on the accounting statements whereas they tend to be historical values in American balance sheets. And so on. Bloomberg's Jonathan Weil is a fan of fair-value accounting and has an article on it. I disagree with Jonathan Weil, who suggests that management is less reliable than the market—if so why is anyone even investing in these companies if management cannot be trusted? I am a firm believer in the view that the market will misprice assets during stressful times. I am not a supporter of most forms of efficient market theory. Even if the mark-to-market proponents are correct in saying that managements are less reliable, their proposal has zero net benefit in the long run. After all, under fair-value accounting, assets would be grossly inflated during booms. I don't know what the mark-to-market accounting supporters are going to say when we are in the thick of a big boom, when the "rational" market values assets at ridiculous prices. Regardless of what the accounting body believes in, it should just lay low until the current crisis is over (perhaps in 5 to 10 years.) Trying to change the rules amidst a financial crisis is not recommended. If we face another collapse, which is highly likely in my opinion, the US government will likely over-rule the accounting bodies and I don't know if they want to end up like that. During the Great Depression, FDR essentially re-wrote the accounting rules and ignored something resembling mark-to-market accounting (Some say that the US govt was also close to taking over the Federal Reserve at one point (because the FedRes was tightening, mainly to defend the gold standard.)) I'm not saying the same thing will happen again but if we get another chaotic environment like late last year, anything is possible.
  
  
• Berkshire Hathaway under-estimated derivative volatility (Reuters; via Crossing Wall Street): Crossing Wall Street picks up a Reuters story that sheds some details on the SEC investigation of Berkshire Hathaway over its derivatives transactions. Berkshire is saying it underestimated market volatility—Bloomberg says risk, but volatility is probably the right word—but thinks the transactions will ultimately be profitable. My guess is that the put options will be profitable in the end (Buffett's CDS contracts on some "highly rated companies" likely will be a loss though.) However, the profits on the put options won't be very large since Buffett may have wrote them near a multi-decade peak in the stock markets (except for the Nikkei.) Barring high inflation, it's possible that the stock market may not hit the 2007 peak for more than a decade (the 2007 peak is close to the major peak in 2000.) Macro speculators like Hugh Hendry have suggested that it typically takes 25 years to surpass major bull market peaks. But it comes down a whole hoard of factors, including, mostly importantly, inflation. Berkshire Hathaway will earn income on the premiums it collected but, since I am somewhat bearish on the economy for the next decade, I think returns will be far lower than some imagine. Remember, unless you see a P/E expansion, profits have to come from the real economy. If you are forecasting a long slump, like I am, corporate profits will be remain subdued. In the 80's and 90's, stocks not only saw valuation expansion, but the economy also grew strongly so corporate profits grew strongly.
  
  
• Can natural gas prices stay low for a long time? (RigZone; via GuruFocus forums): Thanks to GuruFocus forum user, LwC, for bringing this detailed presentation on natural gas. Natural gas is very contrarian but that doesn't mean you won't catch a falling knife. I haven't studied it much lately but I suspect it will remain in a slump until the economy recovers. It will go through the usual spikes—during hurricanes for instance—but it's hard to see the prices rise in the long run without much stronger economic growth. The price chart is truly ugly with prices close to a 7 year low. All this, while the commodity complex is on a major re-flation rally (admittedly the natgas stocks are up a lot from their bottom.)
  
  
• A small Canadian clean energy power company goes bankrupt (The Star): Privately-held solar and wind power developer, SkyPower, declared bankruptcy recently. Part of it was because its main shareholder, Lehman Brothers, is probably re-thinking ownership of clean energy assets. But, even without that issue, I think it would have run into problems. This shows how difficult it is to develop solar installations. I think wind energy is feasible if caron taxes are enacted but solar seems uneconomic for a few decades (unless oil & gas prices skyrocket.) SkyPower's wind generation will likely be economic but not its solar projects. The worst investments are probably the solar panel manufacturers, many of them Chinese, who likely have an industry-wide overcapacity problem. A lot of people on the left think green energy manufacturing is the way to ressurrect the dying industries in America and Canada, but it won't go anywhere without heavy support from the government (subsidies) or consumers (pollution taxes).
  
  
• Look at Apple's valuation (Old School Value): Jae Jun of Old School Value takes a quick look at Apple's valuation. Jae does not find it cheap but I think his estimate is a bit pricey IMO. The problem with companies like Apple is that they are too big. Apple can easily enter a state like Microsoft where it produces a lot of cash flow but growth starts slowing down. A lot of people think Microsoft hasn't gone anywhere in years because its products aren't great. That's not necessarily true. The problem is that it is so big that its small successes have very little impact on it. For instance, its Xbox video gaming console would have been considered a major success if this was in the 90's but is not a big deal anymore. The earnings from Windows, Office, SQL Server, and so forth, are massive and no product will materially impact the company.
  
  
• (Recommended) Active value investing in range-bound markets (Vitaliy Katsenelson; via Big Picture): Vitaliy Katsenelson's on his thesis for a range-bound market. Worth reading for those who like to look at the big picture.
  
  
• World trade recovering tepidly (The New York Times): As anyone investing probably already knows, world trade has contracted at rates not seen since the Great Depression. The situation might actually be worse than what went on during the Great Depression because trade is far more prevalent now. We might actually be looking at contractions on par with the last major boom in world trade and the subsequent collapse in the late 1800's/very-early-1900's. Here is a nice chart from the story. I'm more bearish than the consensus and even think that countries like China may be vulnerable to a major bust (because it is very sensitive to exports and provides little social welfare for its citizens.) I spent some time looking at world trade earlier in the year and found it highly confusing. It's obvious that trade is down sharply but quantifying it is a bit difficult. The problem I see is that there have been huge changes in the US$, not to mention major declines in commodity and semi-finished goods prices. It's not clear to me how units (i.e. quantity) is doing. I think quantity matters more because the currency fluctuations may be a illusion. For instance, the US$ rallied strongly late last year but has declined significantly in the last few months. Even if the same quantity were traded across countries, you may have seen wildly fluctuating trade numbers.
  
  
• The debate over "free" (UnionSquare; via Simoleon Sense): Chris Anderson, the editor at influential techie magazine Wired, has suggested in his latest book, Free: The Future of a Radical Price, that the future will be made up of more and more "free" products and services. Malcolm Gladwell, when reviewing the book for The New Yorker, does not think the free model works. As a counter-argument, Gladwell pointed to one example where, some, in the 50's, thought electricity would be almost free due to the potential for wide adoption of nuclear energy. Apart from the fact that nuclear energy didn't even become popular, Gladwell points out how most of the cost of the energy was in distribution and energy just wouldn't have been almost-free, even if you could generate a huge amount of energy from nuclear power. Well, one blogger at the venture capital firm Union Square thinks both, Anderson and Gladwell, are missing the point. I think the blog entry is too short and doesn't really refute either side, but do check it out. (I haven't read any of Chris Anderson's books but did read a whole bunch of excerpts and reviews of his first book, The Long Tail. Even without having read The Long Tail, I would say it is one of the most important business books written in the last 50 years. It tries to explain the economics of internet companies—it essentially provides the business model for Amazon—and I think it will become a classic. I don't know about Free but you can get the audio version (there are several) for free from Anderson's blog. It's interesting how the abridged, slightly shorter, audio version costs money while the longer version is free. I guess it attempts to take advantage of wealthier people for whom time is money.)