Tuesday, March 31, 2009 0 comments

An M&A deal to consider: En Pointe Technologies (ENPT) management buyout

The En Pointe Technologies (ENPT) management buyout seems like an attractive M&A arbitrage position to consider, except for one thing. Management is offering to buy out the company for $2.50 per share and given the current stock price, it offers a 21% return. The deal is expected to close in the 2nd quarter of 2009.

The balance sheet looks clean, assuming it can be relied upon. It has almost no debt and actually has cash equal to almost 2/3 of market cap. However, it seems to have posted a massive loss in the 4th quarter of 2008.

This is a microcap with a market value of around $15 million.

What's Not to Like?

As I said, everything looks good except for one thing. The exception comes from the possibility that this may be a shady company with dubious ethics. Reading the Yahoo! Finance message boards, one gets the impression that some investors, or at least one investor, is disgruntled and thinks this is a near-fraud.

En Pointe Technologies seems to have had problems conforming with Sarbanes-Oxley earlier this year:

...it has received a notice from the Nasdaq Stock Market ("Nasdaq") on January 5, 2009 indicating that the Company is not in compliance with Nasdaq Marketplace Rule 4310(c)(14) because it did not file in its Annual Report on Form 10-K (the "Periodic Report") for the year ended September 30, 2008 a completed management report on internal controls over financial reporting. As was stated in the Company's recently filed Form 10-K, the Company was unable to complete the evaluation of its financial and information technology controls due to limited resources.

The company did file a response outlining steps it is taking to rectify the caution from NASDAQ.

The fact that management announced a buyout so soon after the NASDAQ warning seems a bit fishy. If someone wanted to hide something, the easiest way would be to take the company private. Yet, it is also possible that they decided to take the company private for legitimate reasons. Conforming to Sarbanes-Oxely and other NASDAQ regulations is expensive so they may have wanted to avoid it all at once. They are also buying out the company at a reasonable price--a huge premium from where it was trading but not a good deal for investors who have owned this company for more than an year.

Conditions of the Buyout

Here is the press release announcing the deal, along with some details:

The merger agreement contains customary representations, warranties and covenants made by the Company, including covenants that the Company will run its business in the ordinary course of business consistent with past practice and will refrain from taking certain actions between the date of the merger agreement and the date of closing of the merger. The transaction is subject to obtaining regulatory approvals and other customary closing conditions, including no material change in the Company's representations and warranties prior to closing, the Acquiror's ability to obtain sufficient financing (a debt financing commitment letter having been obtained) and holders of not more than ten percent of the Company's outstanding common stock seeking appraisal rights of their shares. The transaction is subject to the approval of the merger agreement by the holders of a majority of the outstanding shares of the Company's common stock as well as the holders of a majority of the outstanding shares of the Company's common stock held by the Company's disinterested stockholders (e.g. stockholders other than the Acquiror and Mr. and Mrs. Din and their family).

Usual stuff. A shareholder vote, requiring 50% of non-affiliated owners, is pending. Financing seems ok, with GE Capital indicating that it will finance the deal (although this can fall apart if they discover accounting problems or other issues.)

As usual, anyone really interested should check the SEC filings as well, particularly the proxy (here is the preliminary one).

Will Keep An Eye On It

I'll be watching this and may make an investment. If don't gain further confidence in this company, I will limit any investment to a small amount. Last year, I said that large arbitrage spreads was likely due to panic selling and the exit of many professional arbitrageurs. This year I don't believe that is the case (credit isn't as tight and anyone that can't play the game is out and won't be coming back.) So a 20% spread, like here, implies real risk. However, some of the spread is because it is a microcap and hence unavailable for professional arbitrageurs (a typical pro can literally buy the whole company, $15 million worth, with less than 10% of their portfolio.) I do notice that the price has been drifting slightly downards from the annoucement date and I'm not sure why.

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Current crisis & employment ...the good, the bad and the ugly

The current economic recession, like others in the past, can fundamentally alter the economic fabric. Often a benefit is created but it involves pain and suffering. Here is a good example of a situation where the good, bad, and ugly all happen at the same time:

The New York Times has a very good story on how the economic recession is resulting in employment contracts being torn up.

The depth of the recession and the use of taxpayer dollars to bail out companies have made it politically acceptable for overseers to tinker with employment agreements.

So federal and local governments are looking for ways to pare payouts, endangering the promises made before the financial storm to people like Wall Street traders, automobile workers and garbage collectors.


The Treasury Department is seeking broad powers to seize troubled companies and rewrite contracts like the ones promising bonuses at the American International Group. Some A.I.G. employees, meanwhile, have been pressured by officials into repaying their bonuses to the giant insurance company rescued by the government.

Across the country, Vallejo, Calif., just got permission in bankruptcy court to tear up its contracts with firefighters and other workers. In Stockton, the city manager is studying whether to follow Vallejo’s lead.

In Michigan, Gov. Jennifer M. Granholm just ordered the city of Pontiac put under emergency financial management, after it failed, among other things, to rein in the cost of police, fire and trash collection services.

And President Obama’s auto task force, after replacing the top management at General Motors, is looking for ways to overhaul the contracts that G.M. and Chrysler have signed with unionized workers.

As far as I'm concerned, some of this was inevitable. A lot of financial workers are overpaid and it was ridiculous that bonuses for AIG employees at AIG Financial Products were paid (it's ok to pay bonuses to other divisions of AIG but AIGFP seems like a dubious choice.) I'm also disgruntled somewhat that Ambac paid $2.5 million to its CEO. He certainly had a tough job but it's debatable if it required such a large sum, especially for someone who was part of the whole apparatus that led to the collapse of the company. Similarly, a lot of government employees, particularly police officers, fire officers, and politicians, are overpaid in my eyes. All these employees and many more, in other areas, will likely end up getting paid a lot less. I'm not wishing pain upon others, and this isn't something out of jealously, but I just don't see how the situation justified such compensation schemes.

The fact that contracts are being torn up is not something to celebrate; however, at the same time, it was inevitable. It made no sense, for instance, for some police officers or politicians in some small towns in California to be paid more than similar jobs in larger cities in California or elsewhere.

Here's how I see the situation:

The Ugly - Clearly the decline in salaries or potential job losses will be painful. It'll be tough for those impacted. If leveraged, the affected employees may declare bankruptcy and cause losses for lenders. There could be negative social cost with confrontations, legal battles, and so forth.

The Bad - Declining wages will be deflationary. If done on a large scale, this is going to set off a huge deflationary shockwaves. Businesses, citizens, and others who depend on high income from these employees will suffer.

The Good - Re-structuring compensation schemes will benefit governments and businesses in the long run. A lot of what was happening was unsustainable and would have eventually bankrupted the businesses and governments in question.


Unlike recent past, stock market unlikely to recover quickly

I get the feeling that many think stock market valuations will improve quickly over the next two or three years. It is doubtful that will be the case. Let me go over the various factors that will be a drag on the market. None of these are earth-shattering views but one should keep them in mind, especially if you are making macro bets or are a newbie, like me, who has a hard time telling when a stock is actually cheap.

Psychology Will Impact Stocks

I have suggested several times that the market may stay weak due to psychological reasons (i.e. people who get burned will largely exit the market; distrust of equities; etc.) If you look at long-term history, you almost always see the stock market overshooting on the downside after major booms. Since the market never hit extremely low valuation levels--even in November of last year--it is possible that market valuations may drop much lower than what many think is possible. (But do note that this doesn't mean that prices will necessarily drop significantly. Instead, it is possible for prices to stay flat for a long time while the economy grows.)

Leverage Is Not Fashionable Anymore

The other reason the stock market won't do as well in the future, and this is a widely acknolwedge point, is that leverage (i.e. usage of debt) will decline in the future. Stocks were getting a big boost from usage of debt. There are less than 10 AAA rated companies in America right now because there is higher leverage than in the past, say 1970's. However, the leverage of American corporations do not seem excessive (the story is different in Europe.) Outside non-financial firms, American corporations did not seem to have relied on excessive debt (but European corporations seem to be more leveraged.)

Even for those companies that don't directly rely on debt to boost shareholder returns, they may be severely impacted because of their customers. The consumer was using leverage so even the lowly-leveraged companies will face difficulties from declining consumer spending, consumer bankruptcies, and so on. Some companies without financial problems that have good balance sheets have been sold off sharply and I suspect it is due to the market marking down future expected returns.

Decline Of Share Buybacks

Share buybacks by corporations are not going to end but it is possible that they will decline (this is a point made by Buttonwood of The Economist as well.) In the last four years (roughly), American corporations bought back $1.73 trillion worth of shares. Such activity is bullish and pushes up stock prices. So if buybacks decline then we will lose the support that was pushing up prices in the last few years.

(There is also a possibility of dividend payouts declining but it's not clear to me if that will happen. This article in The Economist expects dividends to fall but it also points out how companies are reluctant to cut dividends. It is possible, as in 1933, for companies to earn less than they pay out in dividends (i.e. have to issue debt to pay dividends.) It is possible that management will pursue such irrational policies, that incidentally destroy shareholders, in order to placate dividend investors. We have already seen it happen with some banks issuing a ton of shares while paying out dividends. Canadian banks, for instance, have been issuing a ton of preferred shares in order to maintain their dividends (needless to say, a disastrous policy for common shareholders.) In any case, I don't think dividend policy will be a drag on the markets.)

Less Stock Buying By Institutional Investors

It is highly likely that institutional investors will withdraw from the stock markets (i.e. allocate less and less to stocks.) These sources were net buyers in the last few decades and will be smaller buyers in the future.

Insurance companies, for instance, have suffered massive losses on stocks and will likely play it safe from now on. My core holding, Montpelier Re, a reinsurer, suffered unexpectedly large losses last year and I suspect management will ratchet down risk. Governments bonds are richly valued right now so I hope management doesn't overload on them but instead go into corporate bonds, but you just never know what they will do. I suspect other firms are in a similar state, with massive losses on stocks last year, and will contribute less to equities in the future.

The key players that will likely withdraw from the market are pension funds, endowments, and the like. I have already covered stories of massive losses at endowments such as the one at Harvard University, or Caisse de Dupot et Placement, the Quebec pension fund in Canada. Now we get stories of potential losses from Pension Benefit and Guaranty Corporation, the American government's pension agency. All these bodies--these are just the biggest and most famous--will likely ratchet down buying of stocks in the future.

You can get a sense of the shift in asset allocation by pension funds looking at the top two charts in this post. I don't think the pension funds are going to go back to the days of 90%+ in bonds. But I do think we will end up with maybe 50% in bonds (and other fixed income like REITs.)

There is nothing wrong with diversifying into emerging markets or private equity or whatever. As someone who is not a passive investor and hence doesn't believe in so-called wide diversification, the question in my mind is whether these funds are actually lowering risk. No doubt returns will be higher but how about risk? I suspect governments will be stricter in the future and hence this will contribute to less investment in stocks. Unfortunately, this is the worst time to be shifting away from stocks and into bonds, given how government bonds are richly valued and stocks are somewhat attractive. But it's difficult to change policies of these behemoths at the optimal time. Hopefully these funds start increasing their corporate bond exposure rather than government bond exposure.

(In an extreme case--one that I am not predicting--it is possible that governments may force pension funds to invest part of their assets in their own government bonds if they have difficulty issuing bonds. If I'm not mistaken, this is the case in countries like India where the banks are forced to hold Indian government bonds.)


Several factors that boosted stocks, such as usage of debt, will now work in reverse and hurt stock valuations. Furthermore, a lot of parties that provided liquidity to stocks (i.e. engaged in buying and selling stocks) may withdraw, at least partially, from the market. These parties pushed up stock prices in the last two or three decades but will now act as a drag. They will be net sellers over the next decade.

Monday, March 30, 2009 0 comments

Opinion: A problem with government intervention...it creates murky property rights

I'm left-leaning and hence am generally supportive of government intervention. However, I like to see it limited to extreme cases. This is definitely true when it comes to business where everyone is trying to profit one way or another. A good example is the unfolding saga of the American auto manufacturers.

As The New York Times reports, the US government forced out Rick Wagoner of GM and is asking for steep concessions from Chrysler:

The White House on Sunday pushed out the chairman of General Motors and instructed Chrysler to form a partnership with the Italian automaker Fiat within 30 days as conditions for receiving another much-needed round of government aid.


Mr. Obama’s auto industry task force, in a report released Sunday night assessing the viability of both companies and detailing the administration’s new plans for them, concluded that Chrysler could not survive as a stand-alone company.

The report said the company would get no more help from the government unless it can finalize a proposed alliance with the Italian automaker Fiat by April 30. It must also reduce its debt and health-care obligations.

If a deal is reached between Chrysler and Fiat, the administration says it would consider another loan of $6 billion to Chrysler.

G.M., on the other hand, has made considerable progress in developing new energy-efficient cars and could survive if it can cut costs sharply, the task force reported. The administration is giving G.M. 60 days to present a cost-cutting plan and will provide taxpayer assistance to keep it afloat during that time.

Along with Mr. Wagoner’s ouster, the task force said most of the company’s board would be replaced over the next few months. In a statement Monday, Mr. Wagoner said he had been urged to “step aside” by administration officials, “and so I have.”

His resignation is the latest example of the government taking a hands-on role in making major decisions at companies it is bailing out. The government has already pushed banks to make management changes and sharply reduce or eliminate their dividends, and it also is directing many of the decisions at the troubled insurance giant American International Group, which is nearly 80 percent owned by the government after its rescue.

The merits of the strategy can be debated but my concern here is the murky environment the government is creating for property rights. The problem with all this is that these are publicly owned companies (actually GM is publicly owned but Chrysler is owned by private equity.) How can the government force out the executives and the board? It's the shareholders that are supposed to own these companies. I'm not a lawyer but my layperson view is that this is getting close to trampling on property rights (in this case, shareholder rights.)

One can claim that these companies would be bankrupt without the government funding. If so, then why isn't the government nationalizing these companies? If you don't nationalize it outright then you are doing an under-handed deal that may benefit shareholders while taxpayers get very little in return. The government will be open to accusations of favouratism and various other unethical behaviour.

Ideally, though, the government should only provide funding and fire the board and executives after the company declares bankruptcy. Then, the government wouldn't be trampling on any rights, although it will set off a battle with bondholders. (But some argue that if the car companies declare bankruptcy, they will lose customers and will have difficulties surviving.)

Sunday, March 29, 2009 0 comments

Sunday Spectacle II

(Illustration by Bill Mayer for The New York Times. Slightly edited to remove text. Where's the Plan, Wall Street?, March 26, 2009. The New York Times)

Saturday, March 28, 2009 0 comments

Articles of interest for the week ending March 28th, 2009

Here are some articles, in no particular order, you may find interesting:

  • Self-proclaimed "Canada's Chinese Warren Buffett" goes down Madoff style (The Toronto Star): "Tang, who bills himself as "the Chinese Warren Buffett" and "the king of 1 per cent weekly returns," is a prominent figure in Toronto's mostly Mandarin-speaking mainland Chinese community...In late February, Tang sent a letter to his clients, apologizing for "the sin that I had committed" but insisted that he did not steal investors’ funds." Classic Ponzi scheme. We are going to see many more cockroaches--sorry for the harsh metaphor--come out into the light. I really hate to see many working-class people with very little wealth, in this case Chinese immigrants, lose everything :( BTW, I don't know anything about this guy but I am pretty sure that he isn't even a value investor so calling himself Warren Buffett is nothing more than a bait to attract non-investors.
  • Wow, Lawrence Summers actually predicted the big bust...sort of (New York Times): Writing for the NYT, Robert Shiller repeats an event from the late 80's where Lawrence Summers submitted an economic paper detailing a fictional story that somewhat mimics the last decade. I'll take a look at it later when I get a chance but Shiller references this paper by Summers.
  • [Highly Recommended] Value investor reference (ValueHuntr): I ran across a new blog called ValueHuntr and it's very good. It seems to deal with special situation investing but I want to highlight their excellent collection of shareholder letters, articles, and interviews by Benjamin Graham, Warren Buffett, and so forth. Most people may have run across most of them but there are some gems in there. I haven't seen some of the articles by Walter Schloss anywhere else before. I especially liked this lecture (I might cover this in more detail later on.) For those that haven't seen some of Graham's Forbes articles from the 30's, I would recommend those as well (it's remarkable how there are so many similarities between the last decade and the roaring 20's--I'll post more in the future). One of the important things to realize is that you have to find a method that works for you! Walter Schloss points out how he is different from Graham and Buffett. I see a lot of newbies blindly follow Buffett when, perhaps, someone like Graham or Schloss might suit them better. Or even non-value investors like George Soros or Jim Rogers may fit some people. To the horror of value investors, I would even go as far as to say that some prominent speculators and momentum investors may suit some people better. Value investing will beat all other methods and survive the longest but not everyone is cut out to be value investor...
  • Where is the stock market bottom? (The Economist): A few ways of roughly gauging the stock market bottom are examind in the Buttonwood column. Needless to say, the market is not yet flashing an all-clear signal.
  • What is going to happen to dividends? (Buttonwood's Notebook): (What I'm about to say is highly confusing and my writing is poor; it is a macro-only issue.) Buttonwood started a blog at The Economist recently and I find most of the topics quite interesting. Reading the linked blog entry--it's about stocks vs bonds but my thought is on a different point--it makes me wonder if we are witnessing a monumental shift. While no one was looking, something happened: dividend yields surpassed (government) bond yields. In the early part of the 20th centurty, dividend yields were higher than government bond yields. In the last 40 years, however, dividend yields were far lower than bond yields (refer to this article by Peter Bernstein suggested by a commentator for further historical comparison.) Buttonwood suggests that the behaviour in the last 40 years may have been because real dividend growth was strongly positive, whereas it wasn't in prior periods. My thought is this: did the market accept the low dividend yields because it was banking on dividend growth? I wonder. I am not into dividend stocks but I notice that many dividend-oriented investors snap up stocks even though the yield is quite low. This is almost as irrational as someone snapping up a bond that has a low yield. The dividend investors, in my observation, are clearly betting on sizeable growth in dividends. The question I have is, what happens if dividends don't grow? Or grow slowly? If that happens, will the dividend yield stay above bond yields? Something to think about. If dividends don't grow yet stay high then share prices may fall or stay low.
  • [Recommended] Summary of principles from Contrarian Investment Strategies by David Dreman (part i) (part ii) (Old School Value): I can't remember if I linked to this before but if not, do check out the links summarizing the investment rules suggested by David Dreman in his book, Contrarian Investment Strategies. The most important thing I learned from his book is that contrarian stocks--he uses low P/E, low P/BV, low P/S, and high dividend yield--rise even when news is bad, while popular stocks fall even when news is good. This thinking is what gives me confidence to invest in distressed, out of favour, and ignored stocks. You don't necessarily need an overly rosy scenario for these stocks to do well.

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Fairfax enters choppy waters but making safe investments

An article written by James Daw for The Toronto Star summarizes the investment performance of Fairfax Financial and details the current investments Fairfax is pursuing. Fairfax, in case one is not familiar, is the insurance company run by Prem Watsa. I don't follow Prem Watsa or Fairfax closely and hence am not a follower of them. He is thought to be one of Canada's top investors, and certainly one of the top value investors in Canada. Fairfax has done exceptionally well in the last few years, betting against the financial bust through CDS (credit default swaps). The future is very uncertain and Fairfax is entering a tough stage.

Let me summarize some points mentioned by the author of the article.

But what have the smarty pants at Fairfax Financial Holdings Ltd. been doing lately? A freshly printed annual report reveals they:

Dumped contracts that insured their stock holdings from losses, partly in October and entirely by mid-November.

Jumped back in to buy $2.3 billion (U.S.) in stocks late in 2008.

Sold almost all their U.S. federal government bonds, and switched to state and municipal bonds, most of them insured by billionaire Warren Buffett's company Berkshire Hathaway.

Watsa tells shareholders he still expects a long, deep recession, with a contraction in debt comparable only to the 1930s in the U.S. and in Japan from 1989 to the present. He expects this will be offset only partly by multi-trillion-dollar government bailouts and spending plans.


The only stocks he discusses buying are Johnson & Johnson, Kraft Foods (maker of the dinners we once ate with pork butt in our first apartment) and Wells Fargo Bank for a total of $822.8 million.

One of the things one should keep in mind is that Prem Watsa, similar to Warren Buffett, runs an insurance company so it's never clear how much of it is driven by need for liquidity and safety. One should also keep in mind that only a portion of the assets are deployed into common stocks, whereas an average investor off the street, like me, would invest 100% into stocks.

Prem Watsa seems to be riding Warren Buffett's picks. I don't like any of the stocks suggested (Johnson & Johnson, Kraft, Wells Fargo) since returns are likely to be low. J&J and Kraft are "safe" but the upside seems low. J&J is a megacap and Kraft is a big large-cap and both share prices will likely be driven more by the market action than anything. Wells Fargo seems risky but will do really well if losses on mortgage and other lending remains manageable. Verdict on Wells Fargo is quite murky, with some bears claiming it may be under-reserving for losses. Bulls, in contrast, tend to argue that Wells Fargo has a good culture and wouldn't have taken on a lot of risk (and would have properly priced the Wachovia assets.)

In any case, Prem Watsa equates, to some degree, the current environment to the credit bust in the 1930's and the Japanese credit bust. I think that is a fair comparison. The question is whether it will be "really bad" or simply "bad". So far, it isn't so bad, mainly because governments are acting to cushion the blows. I don't think the residential mortgage losses are anything to worry about, since most them have been accounted for and likely priced in--although do note that I thought Ambac's losses were also priced in an year ago :(. My concern is with commercial real estate loans, commercial loans, credit card loans, auto loans, and the like. If these liabilities blow up, we will face the "really bad" scenario. So far there is no reason to believe this dire scenario will materialize.

The author also points out how Fairfax seems to sidestep some losing investments:

Watsa does not mention the large holdings in such hard-hit stocks as Torstar Corp. (owner of this paper), Canwest Global Communications Corp. (owner of television networks and newspapers) and AbitibiBowater Inc. (a maker of newsprint). Fairfax's own stock is down about $80 (Canadian) or 20 per cent in Toronto from $400, a bigger loss than stock markets in general since the start of 2009.

I have been tracking some of these and all have been hit really hard. These are Canadian companies and may not be familiar to most readers. Torstar is a left-leaning newspaper company that publishes Canada's most popular newspaper (it's sort of like New York Times of Canada but not as recognized internationally.) Canwest is a right-leaning media company that owns major television stations and newspapers. Canwest is on the verge of bankruptcy and will go under if it can't cut deals with its creditors. AbitibiBowater is the a forestry company that happens to be the largest newsprint paper producer in North America. Needless to say, the decline in the newspaper industry has seriously hurt them.

Prem Watsa also owns bonds of some of these companies so it is possible for him to break even in a re-organization if he can seize control of these companies. But amateur investors only investing in shares will likely suffer massive losses.

I remember looking at these deep value stocks a few years ago but have moved away from them. Back then I was following them more closely because they were some of the few contrarian stocks that seemed cheap. Many of these companies are in industries that are facing secular declines (newspapers, forestry, paper, media, cable companies, etc) and my strategy was to buy the survivor of last resort. From my limited readings, such a strategy has historically worked. Right now, however, there is little reason to look at these distressed companies given how leading blue-chips and potentially high-growth stocks seem cheap.

Another reason I have lost my interest in some of these stocks is because I started putting more emphasis on one of Warren Buffett's strategies. Warren Buffett has suggested at times that companies with high capital expenditures and low returns are not very good investments*. Needless to say, some of these companies require heavy capex and have low returns.

It remains to be seen how Prem Watsa does on these investments. A weak economic environment, on top of being in a secularly declining industry, will be very painful.

Fairfax has some positive thoughts about muni bonds:

"If you look back, even into the Depression, very few municipalities defaulted; and you can pick your spots and see that Berkshire (another holder of insurance companies) is guaranteeing them," said Rivett [ chief legal officer and spokesperson].

The bond insurers, including their shareholders like me, are really hoping that muni/state bonds don't blow up. Fairfax seems confident with many of them. Warren Buffett actually warned about potential problems with them but, as quoted above, muni bonds have rarely ever defaulted. Yes, the credit bubble is much bigger now but most of the excesses lie with consumers and financial corporations. The government, believe it or not, is less leveraged now than it was during the 30's or 40's**. Some municipalities, states, and public-private partnerships will face serious problems but I'm thinking they will be isolated cases.


(* Yes, I realize that Warren Buffett invests in Burlington Northern Santa Fe which has pre-2005 ROE less than 15%--long-term American corporate average is an ROE of around 15% and leading companies should beat that--but I believe he purchased it for its massive moat, rather than for its efficiency. BNI has posted ROE above 15% in the last 5 years but, since I'm bearish on commodities and also somewhat bearish on world trade, I think those are peak earnings. I don't know anything about BNI but when I looked at Canadian National, a major Canadian railroad, a few years ago, its profit boost seemed to have come from intermodal (likely due to imports from China) and commodities (like coal, wheat, and forestry products). Rails will be less competitive against trucks if oil prices stay low.)

(** Many people don't even know this but the US government, if you exclude the GSEs, is less leveraged than in the distant past. Check out the following chart from Morgan Stanley (from a Michael Panzer article on FinancialSense.com).

Eyeballing the chart, US govt debt is around 50% of GDP right now, with GSEs being an additional 60%; while govt debt was around 80% of GDP in 1933. I know a lot of people are bearish on anything to do with the GSEs, but if you think about how the GSE debt is backed by real estate (admittedly declining) it's not as bad as it seems.)


Bonds have outperformed stocks for the last 41 years...but this is not bearish for stocks

Yes, as hard as it may to believe, bonds have supposedly outperformed stocks since 1968. This, according to a short blurb from Barron's [free; scroll to bottom article], which quotes some research by Rob Arnott of Research Affiliates. (Thanks to The Big Picture for bringing the story to my attention.)

(source: Streetwise, Lawrence C. Strauss. March 28, 2009. Barron's)

Before we look into what all this means, I should note that I haven't looked into the details and hence am not sure if this chart is plotting total returns or only price returns. If this chart is price only, I suspect that bonds would still beat total returns of stocks in the recent period but the period would be shorter. So the key conclusion still remains.

The key point the chart is making, and what Rob Arnott is suggesting, is that, stocks may underperform for long periods of time. The chart suggests that stocks underperformed bonds for 70 years in the 1800's, 20 years starting with the Great Depression, and the current 41 year period starting slightly after the stock market hit a major peak in the late 1960's.

Overall stocks have outperformed bonds but if one was living during a period when bonds beat stocks, then it wasn't a great asset to own.

As far as I'm concerned, all this overvaluation/undervaluation is not important if you are a value investor or a contrarian who is attempting to buy cheap assets. If you are stockpicker, your goal is to make money no matter what. The successful ones do make money even if stocks are in a major bear market. The classic example is how Warren Buffett, as well as many other superinvestors, did really well in the 70's even though it was the worst bear market in history if adjusted for inflation. The key thing is to buy something that is fairly cheap.

If, on the other hand, you are a passive investor, I think it definitely matters whether bonds outperform stocks or not. It is also important, in my opinion, for macro-oriented investors and that's one reason I look at these macro market valuations. I think newbies will also probably benefit by looking at these valuations since it gives some notion of whether assets may be overvalued or not.

Price Matters

If one hasn't figured it out by now, they will learn really quickly that, if you are a long term investor or a value-type investor, what matters is price. This is something that all of us sort of know but we never utilize it to any appreciable degree.

Stocks may be the best asset in the long run but sometimes are not. I alluded to this excellent insight from Geoff Gannon (I am sure this is nothing original but he is the first one that really hammered home this point for me):

Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.

This is sort of a key tenet of value investing and is sort of what contrarians try to capitalize on.

This thought can be generalized to every asset out there. Some asset does well at times, not because there is anything special about it, but because it may be extremely cheap. For example, real estate is generally a very good investment. I'm not an expert on it but my understanding is that it outperforms all other assets in the long run, including bonds, commodities, and gold (the only exception is stocks.) This has been the case for almost 100 years (do note that the nature of real estate has changed and there was likely a macro supercycle arising from increased urbanization which boosted real estate in many cities and densely populated provinces/states.) But if you bought real estate two or three years ago, it's doubtful that they will outperform bonds or commodites or maybe even cash for the next decade or more. It is possible that someone who purchased a home in the US 3 or 4 years ago will underperform all other assets for most of their life (I am not saying that real estate will post negative returns; rather, all I'm saying is that it will underperform other assets.)

The valuation concern is one of the reasons I have not really made a long term investment in more than an year. Since my Ambac investment, admittedly a disaster of epic proportions, I haven't purchased any stocks (except for special situations, which are event-based and short to medium term.) Stocks are attractive but I am compelled to wait for them to get really cheap. If they don't get cheap, I'll miss out on some gain but that's ok.

Is That Chart Bearish For Stocks?

Going back to the chart, and the notion of bonds beating stocks for almost 40 years, are we to draw a bearish conclusion for stocks? I would say no!

If you are a contrarian, that chart is actually bullish. It's not extremely bullish--that's why I'm still waiting--but it is getting there. The fact that bonds have outperformed stocks for so long may mean that the cycle is about to turn. Who knows how long it will take but you can basically buy shares that are reasonably valued now--whereas they were richly valued in the last two decades.

Indeed, Jeremy 'stocks for the long run' Siegel is quoted in the article as saying:

...the worst backward-looking stock returns were in July 1932 [and] yet that was the single best time to buy stocks ever, [as they outpaced] ALL other assets over the next five, 10, and 20 years.

This is absolutely true. You were better off buying right after major crashes than at almost any other time. However, I do feel that one should keep the following caveats in mind.

Some Concerns About Stocks

The first thing to note is that it is highly probable that stocks will outperform government bonds (which is what is compared in the chart.) Government bond yields are really low and they will only beat stocks if we get a Great-Depression-style environment or one like the recent Lost Decade in Japan. Even someone like me, who leans more towards deflation than inflation, does not believe that either scenario will unfold. Hence, stocks will likely beat government bonds... What is uncertain is whether stocks will beat the bond market in general, which includes corporate bonds, foreign government bonds, asset-backed securities (ABS), mortgage bonds (MBS), and so on. Corporate bond yields are much higher and so are that of many ABS and MBS. If one was making an asset allocation decision between bonds and stocks, it is worth considering, to some degree, non-government bonds over stocks. I'm just guessing here but, it's possible that non-govt bonds will beat stocks for as long as the next 10 years.

The other concerns have to do with potential macroeconomic shifts. Like most economic issues or macro trends, this is purely speculation on my part so you should form your own opinion.

It is possible that we may see a shift away from stocks and into bonds. Part of this will be due to psychology. Namely, people who get burned may avoid stocks in the future. Already, I see many people off the street--like you and me but not into investing--saying that they won't be directing as much into stocks in the future. I haven't heard many say they were going to liquidate all their investments but many do say that they won't be contributing new savings to stocks. These are just some random cases on television and newspaper so who knows how representative this is of the world. One thing I can say with certainty is that retail investors in Japan have basically been shunning the stock market ever since the crash (supposedly the vast majority of the volume on the Tokyo Stock Exchange in the last decade has been from foreigners.) There is a risk, albeit a small one, that this may occur in America and Canada as well.

Another concern is the possibility of baby boomers, who hold most of the wealth in America and Canada, liquidating stocks to service their retirement. It is possible that many will gradually shift most of their assets from stocks to bonds. Companies that do not pay dividends or are highly volatile may be vulnerable to selling from the baby boomers. Such an action would be bullish for bonds and bearish for stocks, although the degree of impact is not clear.


So to sum up, bonds have supposedly beat stocks for 41 years (not sure if this includes dividends.) I personally do not view that as being bearish; and in fact think it is quite bullish for stocks. However, it is possible that corporate bonds/ABS/mortgage bonds/etc may outperform stocks for the next 10 years. Even if stocks look attractive, they may see liquidation from baby boomers and anyone that was burned by them (especially younger investors who only started investing in the 90's and ended up being clobbered by two crashes: the dot-com crash and now the credit bust.) These parties were net liquidity providers to the market in the last 20 years but may turn out to be a drag for the next twenty.

Friday, March 27, 2009 0 comments

Splitting commercial banks from investment banks and Ken Lewis

CORRECTION: It seems Ken Lewis doesn't advocate separating commercial banks from investment banks. Bloomberg corrects the original story, with Lewis claiming he was misinterpreted. Bloomberg reports:

Bank of America Corp.’s Chief Executive Officer Kenneth Lewis said he doesn’t advocate a legal division of commercial and investment banking and that his comments about separating the two referred to rhetoric and public perception.

“I was talking about the rhetoric, not physically separating the two,” Lewis said in an interview with Bloomberg Television. “We have an investment bank, we have a commercial bank as well that is the fabric of every community in which it operates.”


Original post follows...

Ken Lewis, CEO of Bank of America, suggested that he will advice Barack Obama to split commercial banks from investment banks:

Bank of America Corp. Chief Executive Officer Kenneth Lewis said today the U.S. should consider separating commercial lenders from investment banking activities.

Lewis made the comment on his way to a meeting with President Barack Obama and U.S. banking chiefs. Asked what he would tell Obama if given the chance, Lewis said it would be that “commercial banks are the fabric of any community in which they operate and we probably need to separate the commercial banks from the investment banking activities.”

I have held a similar view for a long time--basically I think the anyone that finances the shadow banks should be detached from normal banks--but the question I have is the following. If that is what Ken Lewis, who I actually think is a good CEO, says then why did he, acting on behalf of Bank of America, purchase Merrill Lynch? Is this an opinion he formed after getting entangled in Merrill Lynch's toxic assets or did he hold that view before?

Ken Lewis almost bankrupted Bank of America, which largely avoided the toxic mortgages and various other toxic assets, when he purchased Merrill Lynch. Granted, Merrill Lynch may not be a pure investment bank like Goldman Sachs or Lehman Brothers. It is more of a broker and was once affectionately known as America's broker (it was considered the average citizen's broker.) Nevertheless, it probably does belong in the investment bank category more than the commercial bank one. I don't know why Ken Lewis purchased Merrill Lynch.

Before someone mistakens what I'm saying, let me say that I am not as critical of Ken Lewis as many others. Some are calling for his head, for the buyouts of Merrill Lynch and Countrywide, but I think he should be given time. Do note, though, that I'm speaking as an observer and not as a shareholder.

Thursday, March 26, 2009 2 comments

Anyone think Ambac will survive? Added Alliance Semiconductor (PK: ALSC) to watch list

Does anyone out there believe that Ambac will survive? I am specifically referring to the insurance company (and not the holding company).

Well, I ran across an interesting investment opportunity thanks to a write-up on ValueHuntr. A potential opportunity lies in the liquidation of a company called Alliance Semiconductor (PK: ALSC). Needless to say, anything that is uttered in the same breath as Ambac is a very high risk investment.

I'm not going to do a thorough write-up here (if you are interested read the ValueHuntr post, along with my long comment I left on that blog) and will simply summarize the situation.


Alliance Semiconductor, a tiny microcap worth less than $10 million, is undergoing liquidation. It has managed to liquidate everything except about $60 million of Auction Rate Securities (ARS). Unfortunately, the ARS market locked-up last year and the company was unable to sell its ARS. To make matters worse, the ARS securities were issued by entities called Anchorage Finance Master Trust and Dutch Harbor Finance Master Trust. These two trusts were created to provide emergency funding for Ambac whenever Ambac needed it. Not surprisingly, Ambac exercised its option last year and tapped $800 million in funding, and in return, it issued preferred shares to the trusts.

The preferred shares are issued by Ambac Assurance, the insurance subsidiary of Ambac. This makes them have a higher claim than the common shares of Ambac. Ambac Assurance cannot pay dividends to the holding company without paying these preferred shareholders first (there are some exceptions which allows the insurance company to pay money to cover operating expenses and debt costs.) I'm not an expert but my guess is that these preferred shares are subordinate to policyholders (always #1 for insurance companies), insurance company bondholders, and possibly holding company bondholders. The preferred shares will be senior to holding company shares of any sort.

Standard & Poors rates the preferred shares as BBB, but who knows how accurate these ratings are.

The preferred shares have no market and it never may. If there is no market, it will be extremely difficult for Alliance Semiconductor to monetize them. They will either sell them at a distress value to anyone that wants to buy them; or they will wait until a market develops, which can take many years (and may only happen after Ambac's future is certain.)

Right Now It's Up To Management

Alliance Semiconductor will, in the end, own those preferred shares. It is not clear what Alliance Semiconductor's management will do. There is a risk that management will unload the preferred shares at distressed values (basically close to nothing.) They will do this if they just want to wind down the operations and could care less about the value of the holdings.

Another possibility is that management will pass on the shares to shareholders.

They can also keep Alliance Semiconductor alive and collect the interest on preferred shares, and pay them out to shareholders periodically.

I have no idea what they are going to do. Whatever it is, anyone investing in the liquidation are hoping that the value is much higher than the share price they paid. There is a risk of management doing something stupid but it's hard to say.

Potential Return On Dividends

The preferred shares pay some low interest (something like LIBOR + 2%). It is not cumulative and Ambac doesn't have to pay that but it will suffer some big penalties if it does not pay (I think the preferred shareholders can elect two board members until dividends are paid for 4 quarters--I need to double-check this.) So, I think Ambac will only refuse to pay if it is well on its way to being taken over by the insurance regulator (basically equivalent to bankruptcy.) The amount Ambac pays is less than $20 million and the company, from all that I know of it, can easily cover it. However, one should still factor in the possibility of Ambac not paying anything to the preferred shares.

This low rate may actually be really high for Alliance Semiconductor shareholders. I have to double-check the numbers, but if Alliance Semiconductor owns, say, $50 million (easy to use number; actual number is slightly higher) then a 2% return (say LIBOR is zero) will be $1 million per year. Given how the market cap is less than $10 million, that's a 10%/year return (it's actually slightly higher for those buying today given how the current share price is lower.)

Distress Liquidation

If the preferred shares are sold at distress values to anyone off the street, it may fetch as low as 20% of par value. Ambac's exchange-traded bonds (AKF, AKT) are trading at less than 20% of par value (but these are bonds of the holding company whereas the preferred share are from the insurance company.) So a rough price, if you assume the pref shares will yield something simliar to the holding Co bonds is around 20% of par value. It can even be lower but I really think management will be acting incompetently if they tried to sell it for anything lower, especially if it still pays dividends.

If you think you will only get 20% then the book value needs to be chopped down by 80%. This yields a price of around $0.36 (using ValueHuntr's estimated liquidation value). This is only a 44% upside from current prices.

Looks Like a Low Return for High Risk?

A 44% return for an illiquid penny stock with many risk elements doesn't seem so great. Why would I even consider this?

Well, if you do think that Ambac will survive, or at least that the preferred shares can be sold near their par value, you have massive upside.

If you think you can recover the full amount listed on the balance sheet (i.e. can get 100% of par value), then, using ValueHuntr's numbers, you are looking at an upside of around 628%! Transaction costs, liquidation costs, management expenses, may cost a few percent of that. If you think you can only get half of the value, you are still looking at 300%+.

I don't know what management is going to do but if they transfer the shares to the shareholders, and if takes 5 years (a reasonable time to figure out if Ambac is truly insolvent) you will still probably receive a 25% to 100% per year return.

Having said all that, the investment in Alliance Semiconductor may end up as a zero if (i) management does something stupid, and/or (ii) Ambac ends up bankrupt without paying anything to the preferred shareholders.

The shares are thinly traded and if anyone is considering buying them, use a limit order and check with your broker ahead of time to see what the commissions will be. This is the type of investment that gives an edge to small investors (professional investors really can't invest in this company given its microscopic size.) I'll be watching this to see what happens. One should never invest based on the potential upside (this may turn you into a gambler) so the real question here is what the downside is.

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Wednesday, March 25, 2009 0 comments

A common flaw with charts: not going back far enough

One of the things one has to be really careful about is, avoiding the comparison of the near-future to the last 30 years. I am of the view that the near-future will be more like the 30's to 50's (in an investing sense) than the 80's to 2000's. I see a lot of people, including the mainstream media, using charts that only go back to the early 80's and I always shake my head. Although it is worth looking at the last 30 years, it is quite possible that the future will be nothing like that period.

Consider the following chart from The Globe & Mail purporting to show that junk bonds outperform stocks for a few years after a recession:

Conventional wisdom seems to hold that bonds outperform stocks in the immediate period after a recession. This may very well be true; but it's dangerous to form that opinion from that chart above. On top of only having 3 data points, one also needs to keep in mind that bonds have been in a bull market since the early 80's (yields have continuously fallen.) It's true that junk bonds, which is what is plotted, behaves more like equity than bonds but nevertheless, the fact that yields were declining would have boosted the junk bond. I'm just speculating here but it's not clear if such a marked outperformance will exist if yields were rising (this would be bearish for bonds.)

Even if the conclusion is valid, I would be more confident if the data went all the way back to the 1920's (modern junk bonds didn't exist but you can probably use defaulted railroad bonds and the like.)


S&P warns Berkshire about AAA rating

MarketWatch is reporting that S&P has warned Berkshire Hathaway about its AAA rating, and calls for Berkshire to raise its capital cushion within 2 years:

Standard & Poor's Ratings Services said Wednesday that it may cut Berkshire Hathaway's AAA rating if the insurance-focused conglomerate run by Warren Buffett can't boost its capital in a year or two.

S&P affirmed its AAA rating on Berkshire but revised its outlook to negative from stable.

If, over the next 12 months, Berkshire's big equity investments stabilize or improve, or if the company can rebuild capital in one to two years through earnings or other means, the outlook could be revised back to stable, S&P said. Reducing the volatility of Berkshire's capital position might help too, the agency added.

However, S&P warned that if further big equity market declines dent capital more, or if insurance earnings and other sources of capital aren't enough to restore capital, then Berkshire's AAA rating may be cut. Any downgrade probably would be no more than one notch, the agency noted.

S&P's warning comes on the heals of a downgrade from Fitch Ratings, which cut Berkshire's issuer default rating to AA+ from AAA and its senior unsecured debt rating to AA from AAA on March 12.

I don't follow Berkshire that closely but I imagine rating cuts will lower earnings, by raising cost of capital, and weaken Berkshire's competitive position in certain industries (such as bond insurance and reinsurance.) It will also slightly hurt Warren Buffett's reputation and prevent him from entering certain derivatives positions.

Monday, March 23, 2009 0 comments

Art market in China weakening

The art market in China had been booming over the last half-decade or so. The boom is a sign of creation of wealth in China, and in other parts of the world. It looks like the art market is starting to show signs of a bust. My impression is that a lot of art investors are wealthy speculators so it is not surprising to see the Chinese art market weaken.

As China's decades-long economic boom cools, one clear sign of changing times is falling demand for contemporary art.

For years, Chinese contemporary was one of the hottest tickets on the international market, making the fortunes of many Chinese painters, sculptors and photographers. Celebrities such as Hollywood director Oliver Stone and top British art collector Charles Saatchi paid millions for works by big-name Chinese artists.


Reports in the Chinese press say that more than 30 galleries in Beijing's trendy 798 art district have closed their doors. Less than half the Chinese 20th century works put up for auction by Christie's in November were sold. A survey last month by art market research company ArtTactic showed that most buyers and sellers thought prices would fall further before rebounding, with pessimists outnumbering optimists six to one.


Art was not the only bubble sent soaring by the China wave. The Shanghai stock index rose to more than 6,000 from 1,000 between 2005 and 2007, then dropped half its value in six months. The price of a famous blend of tea, pu'er from southwest China, saw its value rise tenfold to $150 a pound before collapsing in 2007. Apartments in one luxury development in Shanghai went on sale in 2005 for $16,000 a square metre.

But art was among the biggest bubbles, with prices rising nearly sevenfold over the past five years as foreigners and well-heeled Chinese looked for big returns.

My guess is that if China becomes the largest economic power in the future, its art will rise in value. It might even outperform the Chinese stock market. This is clearly why a lot of foreigners seem to have been buying heavily. But, like all booms, the Chinese art market may have reached an irrational exuberence stage and is collapsing now. Overall, though, I think the art investors will do really well if China becomes wealthy.


Zimbabwe slays hyperinflation dragon

Two interesting articles from The Globe & Mail today. I'll cover the first one in this post.

It looks like Zimbabwe is in the early stages of getting their hyperinflation under control. The opposition party gained some power a few months ago and this has led to radical changes in policy. It's not clear if these policies will be opposed by Mugabe's party in the future, but so far so good. As to be expected, hyperinflation was pursued largely for political reasons rather than anything economic. Nearly every single episode of hyperinflation was due to purposeful actions. Even the infamous German Weimar Republic hyperinflation in the early 1920's was purposely undertaken.

Also disappearing is Zimbabwe's phenomenal level of hyperinflation, which last year reached a stunning 89.7 sextillion per cent (a number expressed with 21 zeroes), making it the most extreme hyperinflation crisis of any country in modern times.

Zimbabwe's new coalition government has cracked both problems with an absurdly simple solution: It has abruptly switched to foreign currencies, allowing customers to pay for products with U.S. dollars or South African rand or Botswana pula.

The entire economy, almost overnight, has switched to a unique system of multiple foreign currencies.

Equally swiftly, hundreds of Zimbabwe's long-closed shops and groceries have reopened, retail licence fees have been slashed, and the new competition has reduced prices to stable levels.

Make no mistake about it: no other country comes anywhere near the inflation experienced in Zimbabwe. The figure is truly mindboggling, especially when you consider the fact that there wasn't a war or any other foreign debt that forced the government to pursue hyperinflation.

Dollarization seems to have killed off inflation but the question is whether the political climate is stable enough to maintain it.

Those goods are still unaffordable for many people, of course. The unemployment rate is estimated at 94 per cent, wages are often unpaid, and the vast majority of people are dependent on donated food rations.

Not surprisingly, there is a severe shortage of the foreign money. Shops don't have enough foreign cash to provide change to customers, so they issue "credit notes" on little bits of paper - or persuade their customers to accept change in candies.

I'm not sure if the 94% unemployment rate is correct. In a strict sense it is probably correct but I also suspect that it doesn't count anyone working in the black market or the grey market. It is likely that the vast majority of the population works in the underground economy. Developing countries also tend to underestimate the GDP contribution from rural areas which often aren't measured properly (this is the case in countries like China and India as well.)

It's interesting how the free market forces have rapidly adjusted to stabilize the economy. Perhaps with the opening of shops and the like, the economy will prosper.

Investors, including Canadians, are watching closely. Toronto-based Caledonia Mining Corp., which suspended production at its Blanket gold mine in Zimbabwe last October, is considering a reopening of the mine within the next few weeks because the new government is promising that producers can export a much higher percentage of their production. The mine could produce up to 40,000 ounces per year.

Someone that wants to make a highly speculative bet might want to consider that company. I don't know anything about it but it is listed on the TSX under the symbol CAL, and on the US OTC market as CALVF. The company has been losing money for ages and might go bankrupt any minute now but it's something to research for the commodity bulls contemplating betting on Zimbabwe.


Monster rally...almost every industry up today

We may have seen one of the biggest rallies in decades today. The catalyst seems to have been the Geithner asset buying plan, which is somewhat similar to Warren Buffett's idea of providing low cost financing to private investors. In my opinion, this is as close to a free market solution as we will see (liquidationists will obviously prefer the free market solution of letting everyone fail but that's neither feasible nor desirable.) The question with this plan comes down to the degree of the transfer of wealth from taxpayers to private investors. The stock market loves it because it is money transferred from taxpayers to banks and investors (financials were the strongest sector today) but politicians shouldn't be blindly rewarding private investors and incompetently-run banks. If this plan fails, the US government will be forced to consider the nuclear option of nationalizing banks.

Almost every industry in America, using the Dow Jones classification system, was up strongly today. The only ones that were down were alternative energy, renewable energy equipment, and alternative electricity.

Days like today are why I said that shorts, as well as longs, will likely have a tough time this year.

Sunday, March 22, 2009 0 comments

Sunday Spectacle I

I'm going to start off a new series on this blog, Sunday Spectacle. Every Sunday, I'll post an image related to events in finance, business, investing, economics, and econopolitics. At times, it may be relevent to the present but at other times it may just be something to think about. In the vein of a painting in an art gallery, there won't be any text, except possibly a title. The goal is to present an image for the user to contemplate and draw their own conclusion. Perhaps fittingly, the inaugural graphic pertains to AIG...

(Illustration by JAS for The Economist. March 22, 2009)

Saturday, March 21, 2009 0 comments

Articles for week ending March 21, 2009

Perhaps the most significant event of the week was when the FedRes indicated that it will start using quantitative easing and buy up long-dated US Treasuries. The market reaction was largely neutral in my opinion. Inflation-sensitive assets like gold rallied but it didn't provide much signalling to me, given how gold is still below the March 2008 peak. The real question for macro-type investors is whether we have seen the bottom in the markets (i.e. a bull market has started) or whether this is a bear market rally. I believe it's the latter but I'm often wrong.

Anyway, in the list below you'll find some articles you may find interesting. A lot of the articles I have linked in these lists in the last few months have been macroeconomic, political, or social stories. I want to move towards more stockpicking ideas (it's time to deploy capital) but I still haven't found many stock ideas that I find really attractive. If someone has long-term stock ideas, feel free to leave a comment.

  • US Treasury ready to roll out its asset-buying plan (Bloomberg): Many market participants are skeptical of anything coming out of the US Treasury or the Federal Reserve, or even the US Presidency, but one has to keep in mind that many are very short-term-oriented--many of these were the same guys & gals who was in love with the government in the last 10 years when all the imbalances were building. I am pretty sure that the latest plan from Tim Geithner--the one to get private sector to invest--is influenced by Warren Buffett. Buffett will never attach his name to it since he is so protective of his name but I'm sure he is trying his best to help out, before his time is up. I remember Buffett being one of the first persons I have seen say that private investors will invest alongside the government if they were able to leverage themselves (he said this several times but I remember him saying this explicitly in the Charlie Rose interview last year.) The low-cost funding provided by the government will attract private investors but the question is whether it amounts to simply transferring taxpayer wealth to banks and private investors. The cleanest solution is to nationalize insolvent banks but (i) so-called capitalist Americans, most of them "conservative", would not support it, and (ii) the credit markets will lock up again.
  • Scathing criticism of Warren Buffett (The Toronto Star; thanks to pturino at GuruFocus for original mention): In the article, David Olive of The Toronto Star criticizes Warren Buffett on various matters. The Toronto Star is left-leaning and it attacks corporations and investors quite often, so it's not surprising to see a severe attack on Buffett. I think it's a good article in that it summarizes criticisms of Buffett over the years. I do think the author is correct in calling out Buffett for his criticism of derivatives while being attached to Moody's, which generated a big chunk of its earnings from structured products and is at the center of the whole financial mess. However, I think the author is too short-term-oriented and mistaken in almost equating Warren Buffett to a self-serving, inconsiderate, capitalist. Dissmissing conglomerates and equating Berkshire Hathaway to Brascan and Olympia & York is a joke. My personal view is that Warren Buffett is one of the best capitalists I have ever encountered but he is not perfect.
  • This won't be like 1929 (FWallStreet): Pretty good analysis of the current economic environment. The article dismisses the view that this won't be like 1929. I agree. I don't think we'll see unemployment rate of 20% or GDP contraction of 25%. However, I am more bearish on the stock market than the economy. Although losses won't be anywhere near the 1929-1932 bear market, easy returns are going to be a thing of the past. People expecting 10% to 15% per year, as was the expectation in the 90's, are going to be in for a shock.
  • Did naked short-sellers bring down Lehman Brothers? (Bloomberg): Lehman Brothers certainly had bad assets but did the naked short-sellers cause a panic in Lehman (and possibly other financial stocks)? The answer is not obvious to me. The problem is that financial institutions are based on trust, especially when funding comes from short-term investors and you need to roll them over literally every day. But on the other hand, a lot of financial institutions are sitting on bad assets that cannot be properly valued, even by the firms themselves.
  • London Falling (The Globe & Mail): A detailed story on how the fast rising financial city, London, has fallen hard. I think London will decline somewhat and Britain in general will face some tough times. On top of the collapse of various financial companies in London, Britain had a bigger housing bubble than America, and the financial institutions may be too big to be bailed out by Britain (in the worst case.)
  • Interview with David Dodge, former Canadian central bank governor (The Globe & Mail): David Dodge is considered to be one of the top Canadian central bankers ever, and is respected outside Canada as well. In this interview, which caused some controvery earlier in the week since it contradicted the central bank and our government, Dodge gives his thoughts on various matters including the financial crisis, what to expect in the future, and what Canada should do. Economists, like all of us, cannot predict the future but it's always good to read multiple opinions. I might excerpt this in a stand-alone post later.(Recommended)
  • Mike Mandel's view of the current crisis (BusinessWeek): Mike Mandel, the chief economist at BusinessWeek, writes a nice blog that often provides unique perspectives. In this blog entry, he covers how he views the situation and what he views as the only solution to this. He suggests that the situation is complicated by the fact that this is a global problem--hence FedRes or US Treasury cannot solve the problem as easily as they have in the past. His solution is for the whole world to come together and negotiate a world-wide resolution to clean up the bad assets on bank balance sheets. Unfortunately, I don't think such a multi-lateral agreement is plausible until the economic situation gets much worse. I'm not hoping for that by any means but individual parties, especially the well-off, have very little reason to negotiate anything right now. For instance, consider a creditor like China that likely owns a whole hoard of US government debt, including Fannie-backed and Freddie-backed mortgage bonds. China has recently been pressuring USA (indirectly) to make them whole on all of their US holdings. If Fannie and Freddie post massive losses on the mortgages--I'm taking about real losses, instead of mark-to-market losses--that cannot be absorbed by the US govt, then the bondholders may have to take losses. Or consider another example where a country like Germany, which has a good balance sheet and has avoided most of the financial losses, or even France, which seems to be ok, have little incentive to re-negotiate or fund the failing states, say Ireland or Spain, or even Britain. But if these states see serious economic deterioration, it will hurt these stronger countries as well. So a deal may need to be cut. Such agreements cannot be reached until the world situation deteriorates much further. (Recommended)

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Reaction not that big for the FedRes plan to monetize long bonds

One of the big stories of the week was the annoucement of the plan by the FedRes to monetize long bonds. This basically means that the FedRes will print money and buy US government bonds. Bond bears, and those that believe the central bank has more power than the free market, believe that this will cause high inflation in the future (I don't share that view but it depends on how much money is monetized. The $300 billion that was mentioned is unlikely to cause much inflation in my opinion--unless the economy unexpectedly recovers quickly and the velocity of money turns all this into high-powered money.)

What is the Goal of the FedRes?

For those not familiar with central banks, they almost always target the short-term rates. The move to buy long-term bonds is unusual and is an attempt to drive down the long-term rates. By driving down the long term rates, it will lower the cost of financing, particularly for home buyers (mortgage rates) and corporations (corporate bond yields).

My understanding of history is that, in the past, the FedRes has monetized debt generally to finance wars. When taxes didn't provide enough money, and foreign flows weren't enough, as seems to have been the case during World War I, the government asked (forced?) the FedRes to print money and buy its debt. This was especially true during the gold exchange standard. If you couldn't finance your war, your country was toast so it was easy to print money at will without much citizen dissent, even though it was supposed to be on a gold standard--some countries completely went off the gold standard during wars (those who promote the gold standard don't seem to realize that almost every single major war by any country has resulted in dumping the gold standard--what's the point of the standard then?) I'm bringing up all this because some say that the FedRes will be forced to monetize the US govt debt--according to some USA will run a $1 trillion debt for at least 5 years--because there won't be buyers for it. Such a situation would be similar to the distant past when FedRes monetized war debt. We are not there yet but it's something to keep an eye on. If the FedRes monetizes say $5 trillion then inflation may be an issue--but even then, it's not as inevitable as the inflationists claim.

What Was the Reaction from the Market?

The reaction from the market wasn't that big. Perhaps it's not surprising given how it was telegraphed for many months, and some economists even mapped out various scenarios from the impact, well in advance.

The following chart plots various ETFs representing key interest-sensitive assets. I am plotting mostly bonds and precious metals. Do note that the 10 year bond yield is plotted, whereas all the others are prices.

It started off with a big bang late Wednesday, upon the FedRes annoucement, but nothing much happened in the following days. The 10 year bond yield declined a little over 15%, which is roughly a 0.5% decline in long-term interest rates. Most other bonds rose slightly (a bit under 5%) but have given up some of their gain on Friday.

The TIPS (Treasury Inflation Protected Security) bond, which is supposed to be highly sensitive to inflation and pays out more if inflation is higher, rose 5% but has given up some of the gain by end of Friday.

Depending on the starting point of measurement, gold is up about 5% to 10% since the annoucement. Silver was initialy up about 5% on the news, and is up 10% to 15% its low point, right before the annoucement. Gold stocks are up around 20% since the news broke. Many other commodities (not plotted) were also up after the announcement.

Although precious metals were up on the news, it wasn't anything spectacular. Gold is barely back to $1000, which is simply where it was a month ago (it also hit that level about an year ago and an year-and-a-half ago as well.) The fact that gold hasn't hit a new high, even on such bullish news, shows how tenuous the inflation argument is. The market is clearly unwilling to place a big bet on inflation.

Final Word

Overall, the market basically shrugged off the FedRes plan. Precious metals and commodities rallied, only to give up some of their gains by Friday, and the US$ declined, while bonds rose, but none of it was earth-shattering. The behaviour of the market, so far, is consistent with my view of mild-deflation/disinflation in the future.

The fact that the FedRes is manipulating the long-term rates, although the success rate is uncertain, means that investors are going to face a new environment. Price signals from interest rates may be meaningless to some degree in the future (assuming the monetization continues for years, as it has in Japan.) USA hasn't seen such an environment in more than 40 years.

My totally unsubstantiated contrarian theory is that investors will likely err on the side of inflation, even though the reality may be more in line with mild deflation*. Since nearly everyone alive has grown up in an inflationary environment, it is possible that investors will price assets based on inflationary expectations. It'll be the opposite of the 1970's or 1980's, when everyone was scared of inflation and were running away from high quality bonds with 15% yield. There is no guarantee that the macro environment has changed but I have a feeling that it indeed has. Even if you don't buy my view, at least consider it as a Black Swan and don't get caught off-guard if it comes true.

(* Do note that when most people say deflation, or when I say mild deflation, it will be nothing like the 1930's. Rather, I, as well as many others, expect it to be more like Japan. One should also not mix up the 1930's with the modern developed countries when it comes to ecoomic growth. Outside developing countries such as China/India/etc, it is highly unlikely for GDP growth to drop more than 6% or 7% on an yearly basis. Even Japan has been growing around 1% or so in the last 18 years.)

Thursday, March 19, 2009 0 comments

One of the few irreversible things in life... decline of world languages

This post has nothing to do with investing so move along if that's what you are looking for :)

There are very few major things in the world that cannot be reversed. An example in my opinion is pollution. Unless we discover some super-high-end technology to reverse environmental damage, it is likely that pollution right now or any point in the future will be higher than a few thousand years ago.

Another irreversible trend is the decline of languages. I don't view the trend as neither good nor bad; it is what it is. Whenever I look at chart like the following one from The Economist, I'm always speechless. It feels weird. Not really sure what to say other than the fact that humans a few thousand or even a few hundread years from now will wonder how the world was when there were thousands of languages.


M&A deals to ponder

As I have repeated many times, one of the best ways to earn returns in a bear market is through risk arbitrage (you can also add liquidations, tender offers, and so forth, but it's hard to get information for some of them.) Risk arbitrage is largely uncorrelated with the market and you will earn returns based on whether the deals succeed or fail, rather than what happens to the economy or whether a company is increasing profits or whatever. The downside to risk arbitrage (or other special situation investing) in this market is that you may miss the upside of buying cheap stocks. If a bull market starts tomorrow, or if you manage to locate an undervalued stock that the market recognizes, you will earn far more by having normal exposure to companies.

There are a bunch of M&A deals I've been tracking.

I ruled out deals like Wyeth (WYE) because (i) the returns were low when I looked at it a few months ago, especially given the far-off closing date, and (ii) it is not a 100% cash deal (I don't know how to short and I suspect it'll be expensive for me.)

I also looked deeply at Westaff (WSTF) but decided against it due to high risk. This is a company that will basically go bankrupt if the deal doesn't close. If it were a large company then it may be plausible to assume that management will try to close the deal but it's difficult to say with small no-name companies.

Another deal that I have tracked and might invest in is the Nova Chemicals buyout (NCX; TSE: NCX). Nova is a Canadian chemicals giant that was almost bankrupt and was saved by some Abu Dhabi investment fund. The deal requires Canadian regulatory approval. Nova may go bankrupt if the deal doesn't close so this is a high risk one. Approximate return right now is around 5.6%, too low for me.

The Nitromed (NTMD) deal also looks interesting. This is a penny stock that is being bought out based on some formula. Read the SEC filing to get the full details because the price can be slightly higher or lower than $0.80 based on cash on the books. As for right now, this deal's return is too low (~6.8%) for me to consider. It is worth considering this deal closer to consummation.

The most attractive one, although the risk is hard to figure out, is the Verenex (TSX: VNX) buyout. Verenex is a Canadian junior oil&gas company operating in Libya. China National Petroleum Corporation offered a friendly deal for C$10 but the Libyan government's national oil company has suggested that it will block the deal and buy out Verenex instead. This has introduced political and timing risk. There is some speculation that there is risk of nationalization by Libya (my geopolitical view is that it is unlikely given how Libya is trying to shun its past and enter the world's free market.) The original Chinese deal would have closed quickly but the Libyan one could drag on. The stock has sold off and is now around 15% below the offer price. The deal is in Canadian dollars (and the stock is on the TSX) so Americans will be exposed to currency risk (but if the US$ declines, one will benefit.)

Wednesday, March 18, 2009 0 comments

FedRes starts buying long bonds

The FedRes had been signalling this for months and they finally implemented it. Associated Press is reporting that the FedRes will buy up to $300 billion in long-term government bonds, and an additional $750 billion of mortgage bonds from the GSEs.

The Federal Reserve announced Wednesday it will spend up to $300 billion over the next six months to buy long-term government bonds, a new step aimed at lifting the country out of recession by lowering rates on mortgages and other consumer debt.

At the same time, the Fed left a key short-term bank lending rate at a record low of between zero and 0.25 percent. Economists predict the Fed will hold the rate in that zone for the rest of this year and for most -- if not all -- of next year.

Fed purchases should boost Treasury prices and drive down their rates. That would ripple through and lower rates on other kinds of debt. The last time the Fed set out to influence long-term interest rates was during the 1960s with Operation Twist, conceived by the Kennedy administration.


The Fed also said it will buy more mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac to help that battered market. The central bank will buy an additional $750 billion, bringing its total purchases of these securities to $1.25 trillion. It also will boost its purchase of Fannie and Freddie debt.

In addition, the Fed said a $1 trillion program to jump-start consumer and small business lending could be expanded to include other financial assets.

As the article points out, the last time the FedRes purchased long-term government bonds was back in the 60's. If my reading of history is correct, the FedRes also kept buying huge quantities of government debt in the 1940's.

It'll be interesting to see how the market interprets these actions. On the one hand, it'll help the economy. The strategy here is to increase government leverage in order to cushion the blow as the consumer and various financial institutions de-lever. On the other hand, this signals desperate times and shows how bad things really are. The unintended side-effects from all this is uncertain. The battle between inflationists and deflationists rages...


Huge short covering rally in Citigroup

There has been a massive short covering rally in Citigroup (C).

Barron's says its arbitrageurs covering their long-Citi-preferred/short-Citi-common pair trade... but some analysts expect shares to fall once the pref-common exchange is complete:

CITIGROUP (ticker: C) SHARES WERE UP 25% today in late-morning trading amid a big short squeeze in the stock tied in part to an upcoming massive exchange offer for the company's preferred stock that will result in a huge increase in the number of Citi shares outstanding.

Citi shares, which were recently trading at $3.14 a share, now have more than tripled from a low of $1 reached on March 5.

Arbitragers say that Citi shares are virtually impossible to short now because of heavy demand from those who had set up an arbitrage in which they bought Citi preferred and shorted the stock after the banking giant announced the exchange offer on Feb. 27.

Traders say that Citi shares could fall once the exchange offer is complete, which is expected in about a month. That's because of the dilution created by the additional common shares.


John Paulson bets on a gold company

John Paulson's fund has taken a huge stake in AngloGold Ashanti, a South African gold miner. For those familiar, Paulson is famous for making billions off his correct call of the housing meltdown. I know very little about his fund or his strategy other than the fact that he is a hot investor right now. Change Alley picked up the same story but there is an article in The Globe & Mail as well.

Paulson & Co. paid $1.28-billion (U.S.) yesterday for an 11-per-cent stake in AngloGold Ashanti Ltd., one of the world's largest miners of the precious metal.

The deal is just the latest example of a major international investor buying into bullion as a safe haven amid the global financial crisis.

As the economic meltdown has worsened in recent weeks and months, firms such as Eton Park Capital Management LP, Greenlight Capital Inc. and Hayman Advisors LP have been boosting their exposure to the yellow metal.


Paulson owns about 28 million shares of Toronto's Kinross Gold Corp. or about 4 per cent of the company, according to regulatory filings. Earlier this month, Paulson told clients it will offer investors a new share class pegged to the price of gold.


Paulson isn't the only hedge fund getting into gold in the belief that the metal will prove a store of value as some countries default on their debts, putting negative pressure on currencies. According to The Wall Street Journal, gold is the largest investment in the portfolio of Greenlight Capital Inc. The New York-based fund, which is led by David Einhorn, has been buying exchange-traded funds holding gold as well as gold futures contracts.

Hayman Advisors, another fund that boosted returns by betting against subprime mortgages, is also buying gold.

I'm not up to date on gold companies but from what I remember from a few years ago, AngloGold Ashanti (AU) was a high-cost gold producer with most of its operations in South Africa. Needless to say, it was hurt for many years by the decline in the US$ against the South African Rand. I don't know what their present situation is (maybe they hedged the currency--but this would have backfired last year.) Many base metal investors may not realize it but a lot of gold companies have been losing money all throughout the bull market in gold. I think AngloGold Ashanti has lost money for the last 5 years, even though gold went from around $250 to $1000. If my impression of AngloGold Ashanti as a high-cost producer is correct, this means that it has super-high leverage to gold. Small changes in gold price will significantly alter profits. It's not clear if the Paulson bet is a macro bet on gold rising much higher; or if it is a "value type" investment and a bet on AngloGold Ashanti recovering.

There are several hedge funds that are starting to bet heavily on gold and gold companies. David Einhorn of Greenlight seems to be betting his future on gold, now that it is the largest holding in his portfolio.

As for me, I'm bearish on gold and shorting gold may be one of my big investments this year. I'm waiting for gold to hit a speculative peak, like oil last year. Perhaps all these hedge funds jumping into gold--gold is a small market so hedge funds can easily distort prices--will be the catalyst to cause a mania in gold.

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