Wednesday, September 30, 2009 6 comments

Operating in heavily protected markets

Bloomberg has a story that illustrates the difficulty of operating in a market that forces foreign companies to form alliances with local companies. The case here is China but it can apply to numerous other countries.

SAIC and other Chinese carmakers that work with overseas companies are introducing their own models to boost margins in a country set to become the world’s biggest auto market this year. Foreign automakers typically have no remedy because Chinese law forces them to work with a local partner.

“There’s nothing they can do,” said Scott Laprise, a Beijing-based CLSA analyst. “Your goal as a foreign automaker is just to stay ahead, come up with new technology, spend more money, and be one step ahead of your Chinese partner.”

SAIC will add about 30 own-brand models by 2012, threatening Volkswagen and U.S. government-controlled GM. China’s biggest domestic automaker more than tripled sales of Roewe sedans this year.

The set up is somewhat similar to how brand-name consumer goods companies such as P&G and Unilever use manufacturers who also produce goods under their own label. In consumer goods, brand reputation, quality, and other intangible benefits play a bigger role than the manufactured products. With cars, no so much. Maybe high-end cars rely on intangible factors but the mid-end and low-end depend more on the manufactured item. Therefore, I think foreign car companies will have a really tough time in China (and other countries like that.) If, say, GM's partner releases a product similar to GM, I think the partner will slowly come to dominate market share (this is especially true if the technology developed and owned by GM is also used in the partner's vehicle.)

It's a tough decision for foreign businesses and their shareholders. Given how countries like China present huge potential, it is difficult to stay away. But at the same time, the concessions made to the government essentially means that you are working with a partner who will, in all likelihood, become your biggest enemy in a decade or two.

Sunday, September 27, 2009 2 comments

Financial Times interview with Michael Pettis

I ran across a very good Financial times interview with Michael Pettis that touches on some of the key macroeconomic issues pertaining to China (it's a 3-part interview so it will automatically continue to the other parts if left alone.) Michael Pettis, as some of you may know, writes a generally insightful and unique blog at China Financial Markets. I say unique because, on top of being an expert on China, Michael Pettis teaches at Peking University in China and appears to have a greater understanding of the situation on the ground. None of this means that his views are always right but it does mean that China investors should pay attention.

The interview with FT covers global trade issues and potential outcomes to the imbalances that permeate through the air. I especially recommend that everyone listen to this 3-part interview because Micheal Pettis clearly explains complex trade mechanics in a manner anyone can understand. On this, he is almost like Paul Krugman and his writing. Articles on Pettis' blog or on financial websites tend to be dry and complicated but Pettis articulately explains it in a few sentences. In particular, I like how he explains that it is almost impossible for China to reduce its US$-denominated asset purchases. This is also the first time I have seen anyone suggest the notion of a 'US$ glut.'

(Thanks to Prieur du Plessis and SeekingAlpha for bringing this to my attention.)

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Investors should never forget the two types of leverage: financial and operational

Writing for The Globe & Mail, Avner Mandelman produces an insightful article reminding investors about two types of leverage present in their portfolio. Leverage comes in two forms: operational leverage and financial leverage.

Financial Leverage

Financial leverage is the most obvious but most long-term-oriented investors avoid it. Put simply, financial leverage amounts to borrowing money from someone and investing it. If the investment does well, you make more money than you otherwise would have—you make money using other people's money. If it blows up, well, you end up with an even larger loss.

My impression is that financial leverage of portfolios—known as using margin—is more common with traders and other short-term investors. It is also commonly used by investors of exotic assets and derivatives. For long-term investing, it is not that common. Following what Warren Buffett has suggested, I personally do not use any leverage in my portfolio and probably never will.

It should be noted that the discussion here pertains to the financial leverage of a portfolio. You can have businesses using financial leverage themselves. That is, just like how you can borrow money for your portfolio investments, a business can also issue debt or take on bank loans to increase its financial leverage. In addition to your own portfolio financial leverage, you should factor in the financial leverage of the businesses you are investing in.

Net Exposure Not What It Seems

What if you balance your borrowing as with a long-short fund? Avner Mandelman goes on to detail how net exposure is not representive of actual risk (bolds are by me):

However, some managers (like those who e-mailed me) insist they can minimize margin risks if they balance longs with shorts. Say you have $10. You buy one stock for $8, then borrow another stock at $8 and sell it short. Your net long position is zero, but you are really 60-per-cent margined. And your market risk is still high, because what if both your picks are wrong? What if the long goes down and the short up? You could lose a lot in a hurry.

To make it worse, some hedge funds use even higher leverage, such as 130 per cent long/100 per cent short. Their pitch is: We are only 30 per cent net long and so should fluctuate less than the market while giving you higher returns. So, on a risk-adjusted basis you are better off. But is this true? Nope. Risk is not volatility. Such a fund's market exposure is 230 per cent, so if they are wrong on both longs and shorts, the portfolio can melt - as many such did last year. Further back, in 1997, Long-Term Capital Management went bust carrying high long/short leverage to a ridiculous extreme.

Which is why good hedge fund managers always look at two key ratios: long exposure (long minus short, divided by total assets); and market exposure (longs plus shorts, divided by total assets). The first ratio indicates how bullish (or bearish) they are. But the second ratio indicates how safety-conscious they are.

Shorting is not part of my portfolio strategy but it is something that is more riskier than it seems. As Mandelman points out, you could have net exposure of 30% but your worst-case exposure could be 230%! Although being long and short appears to balance the portfolio, you can get blown up pretty badly if you are wrong on both the longs and the shorts.

Some of the hedge fund portfolios I have looked at are short some stocks and long others but their risk is never clear to me. Two examples of investors who use substancial long and short positions are Hugh Hendry of Eclectica Asset Management and David Einhorn of Greenlight Capital. The net exposure for these long-short funds appears low (because shorts offset longs) but I have no idea what the ultimate risk is.

Operational Leverge

The other leverage that can be present is operational leverge. This is not something that that is within the control of the investor and is part of the business you are investing in.

Now for operational leverage: Unfortunately it is not one you can compute easily, yet it can decimate your portfolio just as quickly as financial leverage. In simple terms, operational leverage is the increase in a company's profit (and thus its stock price) due to increases in the price of a key product, or a commodity, or volume of sales. Obviously, it is closely related to cost structure. For example, say you are bullish on gold, and have a choice between two companies: one with low production costs, the other with high costs. The first makes money now. The second barely does. But if the price of gold rose 10 per cent, the first company would make 10 to 15 per cent more profit, the second's profit - starting from a low base - could double or more. Thus buying an operationally levered company is similar to buying a call option - here, a call on gold price. Of course, if gold prices fell, the second company's stock would plunge. Thus if you own stocks of operationally levered companies, your financial leverage may still be low (you haven't used up all your cash), but your portfolio's operational leverage would be high - it's as if you had filled your portfolio with call-option equivalents. Very risky.

Operationally leveraged companies tend to be in industries related to natural resources, manufacturing, and transportation—at least that's my impression. In such industries, fixed costs tend to be really high. If you wanted lower risk then you should look for companies with low operational leverage.

Unlike financial leverage, I notice a lot of long-term investors, especially value investors, invest in operationally leveraged companies. Many who invest in cyclicals such as an oil & gas E&P company or an airline attempt to capitalize on operational leverge. For these companies, a small change in sales will result in massive swings in profit.


Many proably already do this whether they realize it or not, but it pays to think about the leverage of the portfolio, as well as the leverage of the companies themselves. One should think about the financial leverage and the operational leverage inherent in their companies or their portfolio. Leverage isn't necessarily bad and can boost returns. However, one should never forget that leverage cuts both ways!


Sunday Spectacle XXVIII

(Illustration by S Kambayashi. "Chucking the buck," The Economist. September 24 2009)

Saturday, September 26, 2009 0 comments

Articles for the week ending September 26th of 2009

Here are some written words that may benefit you...

  • The paradox of the US dollar & interest rates (The Economist): Buttonwood touches on an issue that has been puzzling me for months. Buttonwood wonders if the US dollar is destined to decline significantly, whereas I look at it from the bond yield point of view. Namely, why are US government bond yields remaining low if all assets are rising and the US dollar is declining? Sure, it could be due to Quantitative Easing but that doesn't seem to be very large (also, haven't the central banks started reducing their QE?) It's also possible a US$ carry-trade has developed but it is hard to say.

  • (Highly Recommended) Jae Jun looks at Microsoft's Earnings Power Value (Old School Value): I am not familiar with Earnings Power Value (EPV), a method that seems to have been developed by Bruce Greenwald, but it looks interesting. Jae does an excellent job running through the analysis and I recommend that you take a look at it even if you have no interest in the EPV method.

  • (Recommended if interested in entrepreneurship) Entrepreneur - Cynthia Barcomi and her German cafe (BusinessWeek): If you are into entrepreneurship, check out this story. It's an inspirational story of a small cafe business that was started by an American woman in Germany. The business is small but I like the hard work she had to to go through... BusinessWeek has a whole bunch of stories on entrepreneurship so, if this topic interests you, check out other stories by following this link.

  • (Recommended if interested in entrepreneurship) An inside look at shoe retailer Zappos (The New Yorker): Amazon recently acquired Zappos, the online shoe retailer, and, in this timely article, Alexandra Jacobs provides us with a detailed look at Zappos. It gives us the background of serial entrepreneur Tony Hsieh who became wealthy with a technology venture in the late 90's but Zappos will probably be his lasting legacy.

  • EDCI potential liquidation (CSG; via GuruFocus): I have done zero due diligence so can't say if this is an attractive deal yet. I'll take a look when I get a chance.

  • (Recommended) Inflation vs deflation debate with Mike Shedlock (Mish's Global Economic Trend Analysis): Mike Shedlock debated Daniel Amerman on the topic of inflation vs deflation during last week's Financial Sense Newshour (MP3 audio here) and he writes up a rebuttal for Daniel Amerman's original post debunking deflation (part 1 here and part 2 here.)

  • AEI on China's boom (American Enterprise Institute; h/t Evan at GuruFocus): Always be careful with think tanks since they tend to be very opinionated. I'm not a fan of AEI but thought this publication was quite good in describing how the methodology used to measure economic performance differs between China and USA. I recommend that you read at least the first half of the article to get an idea of differences. For example, the article mentions how "China's economic statistics are based on recorded production activity, rather than being a measure of expenditure growth--defined as the sum of consumption, investment, government spending, and net exports--as U.S. data are."

  • (non-investing) The Economist's obituary of neoconservatism "founder" Irving Kristol (The Economist): Irving Kristol was one of the most powerful conservatives of the last few decades. His ideology started gaining prominence with Ronald Reagan and attained its peak with the George Bush administration, which presided over America from 2000 to 2008. Many on the left hate neoconservatives but fail to realize that Kristol and other neoconservative thinkers originally were left-leaning. My guess is that neoconservatism has died along with the passing of its main proponent. The big mystery to me is who will take control of American conservatives now.

  • Are you the worst investor out there? You can win a trip to Rome. No joke! (The Economist): LOL A company is running a promotion where the three worst investors during a select period during the crash can win a trip to Rome. Contest closes soon :)

  • Marc Faber Bloomberg video interview (Bloomberg; via GuruFocus): Lengthy interview covering some new topics.

  • CNBC Julian Robertson interview (CNBC; via GuruFocus): I don't usually follow traders, unless they were macro investors, but it's always worth listening to diverse sources.

  • (Highly Recommended) Warren Buffett's desert island indicator (Ravi Nagarajan; via GuruFocus): Warren Buffett rarely says anything new, at least for followers who have heard him talk before, but when he does, it is often highly insightful and worth thinking about. Buffett was supposedly asked what single economic measure he would look at if he were stuck on an island. He responded by saying that rail car loadings will be one of his top measures. One should probably also consider marine shipping, airborne shipping, trucking, and other similar measures. If you don't want to look at economic indicators, you can probably look at share prices of transporation companies (companies like UPS, FedEx, Canadian National, etc.) (As a side note, although many consider technical analysis to be voodoo, perhaps rightly so most of the time, some measures may have some merit. For instance, the Dow Theory looks at the Dow Jones Tranportation Average relative to the popular Dow Jones Industrial Average. The Transporation Average, which consists of shares of transportation companies, can be thought of as a rough proxy for rail car loadings, airborne shipping, marine shipping, and so on. Although share prices don't perfectly track economic indicators, they do provide a crude proxy.)

  • Slide-show: 25 highest paid female executives (Fortune): All the desperate, greedy, single men now know who to target. Women always went for wealthy men; time to reverse the roles now ;)

  • Jobless recovery in Canada? (The Globe & Mail): The job situation right now is definitely not pretty. My company isn't doing too well and my job may be cut hence I have started looking for a job. So these stories are interesting while kind of scary to me. One of the things about job losses is that it can be indiscriminate. As this story, covering several cases in Canada, illustrates, you can be a well-paid professional making $100k+ for what many would have considered an attractive industry, oil & gas, and suddenly lose your job. The surprising thing to me is the huge disconnect between the unemployment rate and the economic growth in Canada. Unlike USA, Canada's GDP did not contract very much. In fact, the recession was very short and is considerd by Bank of Canada to have been very mild. Yet the unemployment rate has risen quite a bit. In contrast, it makes sense that unemployment in USA is skyrocketing because US GDP did contract quite a bit. USA is seeing massive restructurings in industries such as financial services, construction, automobiles, and so forth. These industries are likely seeing permanent destruction of jobs.

  • (non-investing) Synthetic biology - revolutionary and kind of scary at the same time (The New Yorker): Of all the hard sciences, biology is my weakness. I was never interested in it and didn't really take many courses, either in High School or University. This also means that some topics are kind of puzzling to me. Just like how some people look at the stars and are puzzled—unlike such individuals, I like astrophysics so am not as puzzled—I wonder about biology. In particular, genetics are puzzling to me. This article in The New Yorker by Michael Specter covers a revolutionary field called synthetic biology. This is the area of biology that seems to deal with creation of new organisms. Scary and fascinating at the same time.

  • (non-investing) Review of several books on a great American president, Abraham Lincoln (New York Review of Books): A great orator and a revolutionary, Lincoln's importance to America cannot be overstated.

  • The evolving nature of news (New York Review of Books): An excellent run-down of the present newspaper situation. I like how the author, Michael Massing, details the alternative sources that are emerging and how the business models are shifting. I sincerely hope that the news media survives in some decent shape. The media provides a check on the power of government and businesses. Without it, corporations and/or governments will rule...

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Friday, September 25, 2009 0 comments

Who would have thought? Muni bond yields hit a 42 year low!

Bloomberg is reporting that American municipal bond yields hit a 42-year low. This is news because municipalities are supposed to be the hardest hit portion of government (since many rely on property taxes, service fees, and the like.) Yet, it appears new issues have slowed while capital seeking muni bonds has increased.

Benchmark borrowing costs for highly rated state and local governments dropped to a 42-year low this week, as the pace of new municipal-bond issues slowed and cash flowing into mutual funds accelerated to a record.

Municipal issuers led by Ohio sold about $5.7 billion of fixed-rate bonds with final maturities longer than 18 months, down from $9.9 billion last week, according to data compiled by Bloomberg. California sold $8.8 billion of notes to be paid off by the end of its fiscal year that began July 1 at yields of 1.5 percent and 1.25 percent.

The weekly Bond Buyer 11-Bond index, which tracks tax- exempt yields on 20-year general-obligation debt with an average Aa1 rating, fell 14 basis points, or 0.14 percentage point, to 3.79 percent, its sixth straight decline. That’s the lowest since May 1967, when Lyndon B. Johnson was U.S. president.

Part of the reason is because of Federal government subsidies but it's still amazing that muni bonds are doing so well.

Thursday, September 24, 2009 2 comments

Bond yields during three deflationary busts - 1990's Japan, 1930's USA, 2000's USA

(Sorry about the lack of posts. I wrote this post over several months so the text is a bit rambling and incoherent. Hopefully someone finds it useful :) )

Deflation is probably the last thing on anyone's mind. After all, gold has surpassed $1000, oil is up over 100% from its low this year, and, well, stocks are on fire. But then again, this is a contrarian blog and I don't quite think like the mainstream. This doesn't necessarily mean that I am right so it's up to you to figure out if my thinking is right.

I haven't altered my stance, which amounts to a tilt towards deflation. Apart from specific stocks, I have been investigating a macro bet on deflation. Apart from shorting select assets, you really don't have many choices if you are betting on deflation. The simplest bet is to overload on cash—cash is king during deflation—but the classic investment is long term government bonds (assuming the issuing government is solvent.)

As I mentioned a while ago, Hugh Hendry opted to enter into swap contracts (or maybe options contracts) on interest rates and that is one option worth looking into. Interestingly, this appears to be opposite what Francis Chu was contemplating (however Chu said he will only enter into the contracts when deflationary fears are high.) In any case, this is something that I have thought about but haven't done much homework on it yet. I have always said to myself that I won't purchase derivatives because they are a zero-sum game (I have zero confidence that I can outsmart Wall Street and professional investors.) But I think an exception can be made for macro bets. This might run counter to some people's thinking but I think it is probably "safer" to make a macro bet using derivatives than it is to use derivatives to place bets on specific stocks.

In this post, I will be discussing the behaviour of bond yields during the 1930's, 1990's Japan, and the last 10 years. The first two periods are major deflationary busts and the present period may also be one. The purpose of this analysis is to figure out how low bond yields may fall. That is, if one is going to bet on bonds due to deflationary expectations, they need to figure out how low bond yields can fall (because the big returns are in capital gains and not interest.) This is important because bond yields have already fallen quite a bit in the last two years (if 10 year bond yields were over 5%, the bond case is more obvious.) If they can't drop much further, there is little benefit to betting on bonds even if you expect deflation.

Notes About the Data

I will be painting with a broad brush and everything I say should be thought of as rough ideas rather than anything concrete. There are marked differences between the periods that one can't assume anything will repeat in the same way. For example, flow of information was more limited in the 1930's than now; for all intensive purposes, the US government took control of the Federal Reserve during the 1930's whereas that hasn't happened yet (from what I understand, the Japanese Central Bank is not very independent and can also be thought to be heavily influenced by the elected government); the poor demographics of Japan automatically results in a big deflationary pressure whereas that's not the case with present USA or 1930's USA; and so on.

All yields are for 10 years government bonds. The Japanese government bond yield is from Bank of Japan and I'm using the TSE-listed bond futures, which are very close to the actual government bond yield. I'm using the bond futures for cotinuity reasons (if you look at the BOJ source spreadsheet, you'll see that the official bond yield listings are broken up into two sections.)American data come from Robert Shiller's online data.

Bond Yield - 1930's USA

The chart below plots the 10 year US government bond yields during the early part of the 20th century.

What I am interested in is the deflationary late 20's to early 40's, but I'm plotting a bigger time period to illustrate how bonds were in a bull market long before the onset of deflation. The bond market started a bull market somewhere near 1920 and stayed in a bull market for a very long time. However, keep in mind that corporate bonds (not shown) were a complete disaster during the Great Depression and foreign soverign bonds of the weaker nations (not shown) were another disaster.

From the US government bond market perspective, the Great Depression wasn't really noticeable. There was a minor sell-off in late-1928/early-1929 but it was largely business as usual. (As a side note, this is probably what saved wealthy investors and insurance companies back then. Many more people owned government bonds back then and their wealth was largely preserved—in fact it went up—during that period. In contrast, deflation will be far more ruthless now since ownership of bonds is far lower now, with higher ownership of stocks.)

The whole purpose of this exercise is to figure out how low bond yields can fall. Unfortunately we can't draw any conclusion from the 1930's. We can tell that bond yields kept falling but it's hard to say what is a reasonable minimum. The reason is because the US government essentially seized control of the FedRes during World War II. Once the FedRes started monetizing bonds en masse, the yield basically fell to a ridiculously low value of 0.2%.

If I were to speculate, I would say a 2% yield, hit in 1940, is probably a good minimum to expect during normal times; a more conservative estimate might be around 2.5%, which is what it was from (roughly) 1942 to 1944. Beyond that it's hard to be confident with anything because the yield was driven down due to special circumstances.

Right now, the 10 year US government bond yield is around 3.41%. So, we are probably looking at no more than another 1% decline in yield. If you assume a 1% move results in 10% change in price (rough estimate; actual result depends on duration and convexity of bond) then the upside to investing in 10 year bonds is around 10%, plus another 3% from interest. This is not too attractive IMO.

Bond Yield - 1990's Japan

If deflation materlizes in USA, I think it will resemble 1990's Japan and not 1930's USA. So, let's look at how Japanese 10 year government bonds behaved in the 90's.

Unlike 1930's USA, Japanese bonds were not in a bull market before the deflationary bust. So Japan presents a clean look at how bonds are profitable during deflation.

Bond yields peaked roughly one year after the stock market peak (for newbies, do keep in mind that a yield peak means a price trough i.e. falling yield is bullish for bonds). Yields have kept falling ever since, although they may have hit a bottom in 2002. (On a side note, rising bond yields is usually bearish for stocks, since you will discount stocks at a higher discount rate. But I believe if the Japanese bond market has entered a bear market, it will likely be bullish for Japanese stocks. We should start seeing a massive shift of capital from Japanese bonds to stocks if my guess is correct.)

The Japanese case resulted in bond yields hitting a trough of 1%. I would consider this low as a "clean" bottom because we had none of the crazy central bank interference as was the case during WWII in USA. There is nothing to say the present, let alone the interest rates in totally distinct country, has to match what happened in Japan. But if you do think that US bond yields will mirror Japan, then we are looking at another 2.4% decline in bonds, from the present 3.41%. This scenario is attractive to me. If I thought a 1% yield was a high probability outcome, I would have no problem tying up capital with 10 year bonds.

Bond Yield - 2000's USA

The verdict is still out on whether the last 10 years and perhaps the next decade will be considered as a deflationary period. Unlike many, I conside the stock market peak to have occurred in 2000 (in contrast, many consider 2007 as the major peak.) Price inflation (CPI), commodity prices, real estate prices, and so on, do not indicate deflation in the last 9 years but it's too early to say for sure. In real terms, many seemingly well-performing assets, like stocks or real estate, haven't done that well. Even at the stock market peak in 2007, stocks were nowhere near their 2000 peak in real terms. In fact, if you were a Canadian, you never saw US stocks come anywhere near the 2000 peak (because the US$ declined quite a lot.)

Bonds were in a long bull market that started in 1981 but there was a niceable sell-off in late the 1990's; there was a multi-year peak in yields that was set in 2000. Bond yields peaked approximately 3 months before the S&P 500 hit a very major peak (especially in real terms) on March 24th of 2000. It is possible that this stock market peak may not be bettered in real terms for 20 or 25 years.

Bond yields have continuously declined for the most part in the last 9 years. Yields started rising between 2003 and 2007 but it wasn't very large. The 2003 low made many think it was a multi-decade trough in yields (peak in bond prices) but it turned out to be incorrect. As we now know, the crash last year took yields all the way down to 2.44% in December of 2008 (based on monthly prices.)

Yields have risen this year and stand around 3.4%. The question is, can yields go much further down? Or if you are making a risky bet like Hugh Hendry, will yields stay close to the current levels?

Bond Yields of all Three Scenarios

What I am about to say may be a seriously flawed way of comparing different periods so use caution if you are deriving any conclusions. For instance, there is nothing to say that yields are comparable across countries or across distant time periods. Even with some risk, I think it's ok to compare yields because I liked to think that valuations sort of normalize over time and across countries. The numbers may not be identical but I like to think that they should be somewhat similar. This is similar to how macro investors generally assume that present P/E ratios should be similar to what they were 50 years ago. There is no reason present P/E ratios have to be anywhere near what they were 50 or 100 years ago but I like to assume it will be close. In a similar vein, I am assuming that present bond yields will resemble those during the Great Depression and Japan to a large degree.

Even with all these flaws, I'm pursuing this line of thinking because I don't know of any other way to determine how much further bond yields may fall (if at all.)

The chart below looks at the three scenarios covered above on one chart:

The starting point was picked arbitrarily as one year before the bond yields peaked. The selection of the starting point may make this analysis flawed but there is no way around it. In the next section I look at the same chart with equalized peaks (this captures percentage change) but that may not be any better.

Another way of comparing the scenarios is to simply plot the charts with the peaks aligned at the same point without adjusting the values (i.e. this would have the effect of simply moving up the low-value curves.) I think this is even more flawed and chose not to look at this.

What you believe depends on how you interpret bond yields. Should you look at raw bond yields? Yield peaked around 3.5% in 1929 whereas they peaked around 6.5% in 2000. If you believe 6.5% in 2000 is sort of "equivalent" to 3.5% in 1929 then you should look at the raw yields as plotted above. In contrast, if you believe that a 33% decline in yields from, say, 3% to 2% in the 1930's is equivalent to a 33% decline in yields from, say, 6% to 4% then you should look at some chart that equates the peaks.

Anyway, going back to the chart, which means we are looking at raw yields, we see that Japanese yields seem to have stabilized in a range between 1% and 2%. During the Great Depression, US government bond yields stabilized between 2% and 2.5% (ignoring the unbelievably low yield in 1945.) If we end up in a deflationary period and assume the present must be somewhat similar, I think a good guess is for yields to fluctuate between 1% and 2.5%. That's a huge range but the important point is that they are much loser than where we are today. This implies that if you believe in deflation, 10 year (or longer) Treasury bonds still look quite attractive.

Bond Yields of all Three Scenario (Normalized)

The analysis in this section could be flawed so use caution.

The following, final, chart plots the three scenarios with the peaks normalized. Note that this is not the same as simply aligning the 3 peaks! What you are seeing is percentage changes in their respective periods (except Japan, which is left as the base case.) The numbers that are shown on the chart, except for Japan, do not represent yields and should not be treated as such.

This chart produces different conclusions from the prior chart. In the prior chart dealing with raw yields, it appeared that bond yields can still fall much further if deflation sets in. In this chart, that is not obvious. Presently, bond yields look like they can still fall further if we follow the Japan scenario. However, we have actually declined more (in percentage terms) than during the Great Depression! As usual, I'm ignoring the crazy situation during WWII when the FedRes was literally buying all the bonds the US government was issuing (I believe this was the case in other countries involved in the war as well.)

It's worth reiterating what this chart is saying: bond yields have already fallen more than during the Great Depression. So, this chart introduces some doubt into any potential bond investment.

Overall, it's very complicated and one cannot blindly follow anything. As I said, both, during the Great Depression as well as the 2000's, the bond market was already in a massive bull market. It's always possible that yields already fell a lot more prior to 1929 whereas they may not have fallen as much prior to 2000. I never bothered analyzing what happened in prior periods and it's just too complicated to start looking at additional scenarios. For instance, if you start looking at pre-1929, you have to somehow factor in the gold standard (which is inherently deflationary and keeps nominal returns on financial assets low); similarly, if we start looking at pre-2000, the starting point can be tricky and one may need to consider the possibility that the 1981 peak in bond yields may be a spectacular 100-year bubble in yields (i.e. irrationally low bond prices.)

Don't Look For Solid Conclusions Here

I started writing this post a few months ago and I'm as confused as ever. Overall, there is nothing concrete to be drawn from any of this. Similar to how one cannot say whether the stock market deserves a P/E of 17 today, it's hard to say how far bond yields will fall if deflation materializes. It ultimately comes down what return market participants are willing to accept.

I personally think that raw yields are what matter. Therefore the 2nd last chart is what I would rely on. Based on that, long term bond yields can still fall. I would estimate a minimum yield between 1% and 2.5%, which is way below the current 3.4%. Even if they don't fall, they can easily go sideways, in a narrow band of 1%, for more than 5 years (which was the case during the Great Depression and Japan.)

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Tuesday, September 22, 2009 5 comments

Thoughts on Jim Grant's change into bull costume

(source: Mick Coulas for The Wall Street Journal)

Most of you may have seen The Wall Street Journal article by Jim Grant, where he morphs from a bear into a bull. Surprising to some perhaps. I thought I would post my views (made on a GuruFocus message board) on his opinion piece.

Jim Grant isn't just any other bear. The fact that he is bullish is big news, at least to me.

However, it's not clear to me if he is bullish on assets like stocks and bonds, or if he is bullish on the economy. The two, as historians would know, are not correlated (for example, the economy actually did quite well in the 70's but the stock market did not; conversely, the stock market did well from 1932 to, say, 1938, but the economy did not.)

If he is turning bullish on stocks, I think he may be a bit late to be riding the bulls and I would bet against him. But if he expecting a strong economy, he may turn out to be right (although I'm still not convinced.)

The way I look at it, the forecasts come down to whether you believe in Keynesian Economics or Austrian Economics. Jim Grant, being the Austrian persuation, is saying that interest rates are too low, and likely at negative real rates, so it makes sense to expect booms. Keynesian-types, in contrast, seem to suggest that we have hit a liquidity trap and interest rates may even be too high. I lean more towards the latter, which is more consistent with my tilt towards deflation.

It remains to be seen what actually materializes. Nearly all assets--stocks, bonds, emerging markets, real estate, commodities--have rallied but I'm not sure that it due to negative real rates. Instead, it appears to be driven by fiscal spending (especially in China and USA, but in other countries as well.) The real test is what happens when fiscal stimulus dissapears.

The amazing thing to me is that long-term bond yields remain low. I don't know if the FedRes monetization has anything to do with this, but if we just take the signal for what it is, it may be important. The ultimate issue is still the inflation vs deflation question and the bond market seems to be betting against other assets. Bonds are generally thought to be more correct than stocks but that hasn't been the case this year. The super-high default rates forecast by the bond market early in the year is nowhere to be found.

Sunday, September 20, 2009 0 comments

Sunday Spectacle XXVII

US$ Index


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Friday, September 18, 2009 0 comments

Articles for the week ending September 19th of 2009

Was busy with my movies at TIFF*, thinking about my future, and starting my job hunting. Hope no one minded the infrequent posts this week...

(* Non-investing thought: Of the 7 films I saw (still one more left,) none of them really blew me away. I think the best one that will appeal to mainstream fans is The Road, directed by John Hillcoat, and starring a young Kodi Smit-McPhee and Viggo Mortensen. It should open in theatres soon so keep an eye on that. If you are into pure science-fiction or drama, you may enjoy it (it's not an action film.). Cinematography, set design, and special effects were excellent, while the acting was superb too. The film deals with a post-apocalyptic world where a man and his young son are trying to survive. It's based on a book and, as usual, people who read the book may not find the film as enriching (I don't read novels so I can't say about this film.) Unlike post-apocalyptic worlds in movies like Mad Max or video games like Fallout, this one was extremely interesting to me. The neat thing about the setting in this film is that food is extremely scarce. It's so bad that cannibalism is a real threat. I found the film touching on some aspects of the worst of humanity and it is illuminating to realize what we are as humans. Oh yeah, got to shake hands with John Hillcoat, and I congrtulated on his film... for those into indie films, I thought the provocative She, A Chinese by Xiaolu Guo was pretty powerful...and sad. It's hard to explain the plot without revealing important details but it's basically the story of a Chinese girl trying escape from her meaningless life. The director showed up for the screening and what she said about the film being universal and applying to almost anyone is true. Youth all over the world face similar situations and the dice doesn't roll your way sometimes. Sadly, all these Chinese films are banned in China but I'm hopeful that the Chinese government sees the errors of its way and relaxes their censorship within a decade.)

Moving back into the investing world, here are some articles you may find interesting... as usual, not in any order and covering a broad spectrum...

  • One hedge fund manager's thoughts on concentrated holdings (Tim du Toit of EuroShareLab; via GuruFocus): Interesting thoughts on sizing of your portfolio holdings if you are a concentrated investor.

  • Death of brands exaggerated? (The Globe & Mail): One of the topics many, including me, have wondered lately was whether the value of brands have started a long decline. This article, referencing the BusinessWeek-Interbrand global brand rankings (click here for rankings; here for BusinessWeek story), suggests that brands are largely maintaining their value. It's always difficult to discern how much of the value of a firm comes from the brand but it is critical for investors since brands are arguably the strongest provider of moats. My opinion is that it is easier to lose advantages from superior technology, better management, better distribution systems, lower costs, and the like, than it is to lose the advantage of an established brand. However, everything is inter-dependent initially, with, say, technological advantage leading to the build-up of brand equity. The brand rankings haven't changed much since Interbrand started doing the rankings back in 2001 and this shows how difficult it is overtake some of these brands. The top 5, in order, are Coca-Cola, IBM, Microsoft, GE, and Nokia. Some value investors consider technology companies as having unpredictable moats but in terms of their brand value, technology companies can be almost as good. For instance, it would not surprise me if the shareholder wealth generated for shareholders over the next 50 years by Microsoft is greater than that of Coca-Cola (assuming you do not buy either company when it is wildly over-valued.)

  • While on the topic of brands... LVMH is doing well (Economist): Even if one is concerned about consumers trading down, elite luxury brands should do well. I remember seeing ads for luxury goods from the Great Depression so the super-wealthy will still be able to afford the super-high-end goods. Luxury brands also have more of a global focus so they are not generally vulnerable to weakness in one region. Such is the case with Louis Vuitton Moet Hennessey. Although near-term risks are likely all priced in, I think the longer-term risk of any potential decline will be in the mid-market or mid-upscale segment. For instance, without knowing many of the details, I would be more comfortable buying shares in LVMH than Coach. I also find it interesting that LVMH is doing well in China even though it is notorious for fake goods. Perhaps other Western firms can consider how LVMH operates with counterfeit goods all around.

  • The Globe & Mail interview with Nassim Nicholas Taleb (The Globe & Mail): I'm not a fan of Nassim Taleb but many readers are. If you haven't checked out this interview already, do read it. Although kind of funny I think his parting advice is pretty good: "Also, it's good to have more than one profession, in case your own profession goes out of style. A Wall Street trader who's also a belly dancer will do a lot better than a trader who winds up driving a taxi."

  • Latvia slowly recovering (BusinessWeek): Painful adjustment but hopefully the Baltics will get out from this safely. The last thing the world needs is another country ending up as a failed ex-Soviet state and ending up under Russian control.

  • (Recommended) Searching for special situations and other investment ideas (Old School Value): Jae Jun runs down some techniques for searching of investment ideas.

  • Ships, ships, and more useless ships (Daily Mail; h/t Naked Capitalism): Amazing story with nice photographs of idle ships. I wonder what will happen to the shipbuilding industry, particularly in South Korea. If world economy does not recover strongly, we may see the whole industry devasted. Having said this, we should always be careful about stories like these. One, it may be painting the picture of the past. Two, as one of the commentators are the bottom of the article says, he/she saw a similar environment in the late 80's/early 90's in Singapore. Maybe all these idling ships look ominous but it is always possible that the industry can adjust without a total catastrophe. The final outcome is uncertain. The Baltic Dry Index supposedly hit a post-May, 4 month, low today. Oil tankers are probably doing ok but if oil falls, watch out. (As a side note, indicators like the Baltic Dry Index, or commodities in general, are very important because they track real prices in the economy. The BDI is exactly what people are paying to ship dry goods so it touches the real economy. In contrast, changes to financial instrument prices may or may not mean much. Someone may bid up the price of a share or bond because they are willing to accept lower returns, and this may not necessarily reflect a similar change in the economy.)

  • (Recommended) American banking wars: Sandy Weill vs Jamie Dimon Part 1 & Part 2 (Excerpt from Duff McDonald's Last Man Standing; via Fortune): Fortune excerpts Duff McDonald's upcoming book on Jamie Dimon, Last Man Standing. Suffice to say, I don't think I'll ever be a CEO, let alone one in a bank. These guys are cut from a different cloth for sure. I'm always amazed how arrogant and selfish many executives are—bankers and lawyers always look the "worst" to me; I rarely see such arrogant executives in other industries. This book is likely biased in favour of Jamie Dimon and I don't know Dimon's background well, but I consider him as one of the "good guys", at least so far. I have always been impressed with him ever since I saw his Charlie Rose interview (part 1 & part 2; If you haven't seen it, I highly recommended the Dimon interview to anyone interested in management, banking, or leadership.) As long as JP Morgan sits on a trillion in (notional) derivatives, I won't consider Dimon to be the best banking executive. But if JP Morgan survives through all this, Jamie Dimon has to be considered as the top banker in America. The only other widely known person (at least to me) that even comes close is Richard Kovacevich of Wells Fargo (but Wells Fargo has its own problems and is sitting on its own timebombs with scary-looking labels such as Alt-A, 'Liar Loan', CMBS, and so on.) (For what it's worth, Kovacevich is a hardcore Republican while Dimon is a typical Democrat so you know which guy I want to see come out on top ;)

  • Film dealmaking at TIFF (The Star): A look behind the scenes of producers trying to sell their films to studios at the Toronto International Film Festival.

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Thursday, September 17, 2009 7 comments

A value investor takes a quick look at Lexmark

UPDATE: Fixed a tiny grammar mistake as suggested by reader Guest.

A little less than a month ago, I e-mailed Geoff Gannon and inquired about Lexmark (LXK). I don't usually do that but decided to ask him about his opinion of Lexmark because he was wrong with his initial view a few years back. I was curious about his views of how the company has changed (apparently for the worse if the stock price was an indicator) in the last few years. Geoff Gannon was kind enough to post a lengthy response detailing his thoughts and I thought readers would benefit from his comments (used with permission.) Even if you could not care less about Lexmark, read this post because it illustrates the thinking and approach of a value investor.

He also responded to a follow-on questoin and another unrelated question pertaining to Coca-Cola which I will quote in future blog entries. The topics of the other e-mail were slightly different and it is useful to read them as a stand-alone piece. This first entry covers Gannon's quick look at Lexmark; the second post will cover the type of investments that Gannon feels are suitable as a Buffett-style concentrated investment; and the final post will deal with why Warren Buffett may have purchased Coca-Cola in 1989 instead of in 1987 (during the crash), 1986, or earlier (I may not post the Coca-Cola e-mail because it is highly speculative and I don't agree fully with Gannon. It also may not be benefitial to many.)

I am not quoting the full e-mail and I have bolded some text to emphasize what I feel are insightful points made by Geoff Gannon. My emphasis may not be consistent with what Gannon feels. Also, note that none of this should be construed as a recommendation (either long or short) and the details, such as prices/interest rates/etc may have changed.

Thanks to Geoff Gannon for taking time to write up lengthy responses—he's a good writer BTW—and for giving me permission to liberally quote his e-mail.

Gannon On Lexmark

When asked about Lexmark, Gannon took a quick stab at its valuation as follows:

Lexmark is cheap based on past performance. And diversified group operations (buying a lot of stocks like Lexmark) usually work out. Here's the math based on data provided by GuruFocus (see the actual 10-Ks and most recent 10-Q if you're serious about Lexmark, I'm just using GuruFocus to answer this email):

5 year average EPS: $3.98
5 year average FCF: $3.44
Book Value: $11.69 (From most recent 10-Q not from GuruFocus)

A basic earnings power calculation - more similar to Benjamin Graham than later Warren Buffett - goes as follows:

Book Value of $11.69/share * Investment Grade Bond Yield (5.33% according to Bloomberg) = $0.62/share

In other words, if Lexmark earned 5.33% on equity it would earn $0.62 a share. Take this number and add it to the 5-year average EPS ($3.98) and 5-year average FCF ($3.44) and the average is $2.68.

What cap rate should you apply to this? A good range is the yield on investment grade bonds (5.33%) to the yield on junk bonds (11.18% again courtesy of Bloomberg). The multipliers work out to 8.94x at junk bond cap rate and 18.76x at investment grade cap rate.

We calculated our triangulated earnings power (that is we used three different sources: income statement, cash flow statement, and balance sheet) for LXK at $2.68. Applying the above multipliers we get a range of:

Low end: $23.95/share
High end: $50.28/share

And the last trade was: $17.32/share. That's $6.63 a share or 27.68% less than the low end of an honest appraisal based on past performance alone.

If you did this calculation for all stocks (took 5-year average EPS and free cash flow and Investment Grade Bond Yield * Book Value Per Share) you'd find that most stocks do NOT trade below the low end. It's quite rare.

I hope readers learn something from the method utilized here. I usually just take normalized earnings and multiply it by some low P/E multiple (usually between 8.5 and 10) but Gannon uses more of a classic value investing technique that averages various sources. It's an interesting technique that relies heavily on published financial statments—as Gannon points out, it's triangulated off all three financial statements—and hence is rooted in solid, albeit, historical, numbers.

You can see how this method (or any similar method that relies on historical financials) stacks up against my simplistic method of applying a somewhat arbitrary P/E multiple. In my rough estimate from a while ago, I came up with Lexmark as being around 30% undervalued. Gannon's quick estimate yields an undervaluation of around 27.68% based on the low value.

You can see the disadvantage of financial statements in this example. Gannon's estimate, which is similar to my base estimate, may turn out to be wildly optimistic if sales, and hence profits, fall off a cliff. In the post with my estimation, I speculated that the share price should be worth much less if sales decline substantially. Since Lexmark had strong historical numbers while the present market position looks poor, value investors relying heavily on financial statements may be vulnerable to downward surprises. This is where qualitative judgement comes in.

Value Trap?

I was wondering whether Lexmark was a value trap and Gannon had this to say:

As for whether it's a value trap or not - I don't know. That's an interesting term. It's a business facing challenges. Historically, there's little evidence to suggest that businesses move in only one direction.

An important point here is Lexmark's financial position. How good is it? Generally, "value traps" are NOT operationally challenged ONLY. They tend to be financially challenged. Very, very few businesses that have rock solid balance sheets end up in trouble. A great many businesses with debt do. Lexmark's balance sheet is not perfect. For instance, it doesn't have a positive Net Current Asset Value (NCAV). Usually, a positive NCAV is a good sign for a value investment.

I notice that value investors, including successful ones, often downplay the notion of value traps. I don't know why. To me, value traps are the achilles heel of value investing. Anyway...

Gannon makes the very insightful point that value traps tend to have financial problems on top of operational problems. I think contrarians should keep that in mind. A lot of contrarian, or beaten-down, stocks have serious financial problems. In the past I have looked at financially distressed firms but I have pretty much come to the conclusion that I should stay away from them. For example, I have done some preliminary research on MegaBrands (TSX: MB), which is a toy company on the verge of bankruptcy due to some product recall issues (basically a textbook case of a horrible buyout that literally bankrupted the firm,) but have essentially crossed it off my list because it has serious financial problems. It is possible that MegaBrands may never be able to pay off their debt (they took on huge debt as an emergency during the crisis) and the shareholders will lose most of the company to the bondholders. Similarly, one company I have looked at in the past, Eastman Kodak (EK), which has been hobbled by debt, just announced that KKR, a private equity outfit, is buying Kodak debt as well as up to 20% of the company.

Having said that, do keep in mind that some types of distressed situations involve potential financial problems that are hard to discern. This is usually the case with financial companies (e.g. Citigroup or AIG) or non-financials that are exposed to financial instruments, often through derivatives or off-balance-sheet obligations that are not obvious (e.g. Enron or GE). My investment in Ambac (ABK) is one such case. Ambac was vulnerable to huge financial losses but it wouldn't be too obvious looking at financial statements. Contrarians like me bought Ambac after its problems were evident (we misjudged the scope) but those investing in it 2 years ago were probably shocked by its exposure. Similarly, anyone investing in GE, Morgan Stanley, Wells Fargo, American Express, and the like, have to make a judgement call about the financial strength.

As for whether operational problems are "better" than financial problems, I don't know. You can lose a fortune if problems persist in either area. Financial problems appear to be worse because the damage occurs quickly: usually the company goes bankrupt or ends up diluting shareholders heavily due to emergency capital injections. In contrast, operational problems may take longer to play out but the end-result is similar.

This Ain't A Benjamin Graham Investment

Basically, an investment in LXK is a bet on the past earnings and cash flow rather than a bet on the balance sheet. It would be nice if LXK had no debt and a lot of current assets. That would make this a very easy decision. Unfortunately, that isn't the case. It may be the case that LXK is a once wide-moat company now in constant decline.

Yep. As Gannon alludes to, Lexmark clearly isn't a Graham-type investment. I'm ok with this but classic value investors in the Graham mold will likely ignore situations like these.

The only thing I would say is that most Graham-type investments are terrible businesses. It is extremely rare for a company of any standing to trade below NCAV or have a strong balance sheet with low debt while posting good profits. This doesn't mean that these are poor investments but it does mean that the analysis likely has to be completely different. At a minimum, anyone investing in something like Lexmark cannot rely on the balance sheet as a backup in case the investment doesn't work out (because the liquidation value is so far below the current price.)

I have decided not to be a Graham-type investor (whatever that means ;) ).

Final Suggestion

Gannon closes off by suggesting that Lexmark is not the type of investment for concentrated investors:

Lexmark isn't the kind of business it's easy to own. Therefore, my suggestion is that if you buy it you should buy it and not reconsider it again for a certain amount of time - I would suggest two years - so if you buy it now, don't look at it again until September of 2011.

Lexmark is an appropriate investment at say a 5% of portfolio position size, because 20 or so investments at price to past performance relationships similar to LXK will almost certainly work out. As for LXK alone, I don't know if it will be a success because that depends on a lot of qualitative judgements I can't make.

An honest appraisal based purely on past performance would be something in the $25 - $50 a share range. Beyond that, you are speculating as to future performance. And that's really a personal call. If you can limit your position to say 5%, it's definitely a good investment in the sense that the probabilities clearly favor you.

Will Lexmark prove a value trap dwindling to nothing? Probably not. That's relatively rare. You see that mostly with highly leveraged businesses. Value traps are really more cheap looking growth stocks than Graham and Dodd type bargains. If you pay a low enough price for a sound enough balance sheet you will rarely suffer really large permanent losses.

Lexmark's issues as an investment are that it still trades quite a lot above book - because it's historically earned high returns on equity - and it's balance sheet is not as liability free as you'd like in this kind of investment.

To sum up, Gannon suggests that an investment like Lexmark will likely work out in a diversified portfolio. He doesn't feel comfortable making a concentrated bet on it without some qualitative reasoning. For what it's worth, I'm trying to be more of a Buffett-type investor so I have been trying to improve my skills on qualitative business analysis. In particular, I have been reading up on competitive advantage, moats, brand creation, barriers to entry, consumer perceptions, and so on.

I think my original wording on the value trap could have been better. I wasn't really implying that they "dwindle to nothing," although those are the words I used; I was really wondering about the possibility of a waterfall-type, continuous, decline over a few years.

I actually disagreed with Gannon and wondered why he felt this type of investment was not worthy of a concentrated bet. I questioned his answer in light of Warren Buffett's investments and Geoff Gannon was kind enough to respond to that. In a future post, I'll quote Gannon's thoughts on the type of investments he feels are worthy of concentrated bets in a Buffett-like manner.

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The casino known as the Chinese stock market

I have repeated this point many times but here is another look at the Chinese stock market and how it resembles a casino. This story, about IPOs, comes from The Globe & Mail:

The China Securities Regulatory Commission quietly shut down new stock offerings nearly a year ago, after uninhibited speculation fed a freefall on the country's stock exchanges, and the demise of Lehman Brothers warned of darker economic times ahead.

This June, with China's economy growing on the back of government spending and more cash infusions to continue that growth, regulators reopened the field to IPOs, armed with a new set of rules designed to limit speculators' ability to cash in.

The scene on China's benchmark Shanghai composite index before 2008 was something akin to a Wild West of stock markets. Eager, fast-growing companies launched IPOs with spectacular results, grabbed up by an equally eager public for whom the stock market represented a new kind of excitement: gambling, only with seemingly guaranteed profit.

The 76 companies launching IPOs on mainland China in 2008 saw prices leap an average of 152 per cent, according to Bloomberg. The year before, the average was even higher - 199 per cent, based on 109 companies' launches, according to HSBC.

Among the most dramatic was an offering by Guangzhou Tech-Long Packing Machine Co. in January 2008, which saw its value jump 404 per cent on its first day on the Shenzhen market.

But like many other stocks with brilliant beginnings, the Guangzhou machine company then had its worth plummet, by 71 per cent over the next eight months.


But still, there are warnings that too much liquidity is inflating China's stock markets, along with real estate and commodities, and that this is creating "bubbles" that will, inevitably, burst. "The potential risk is that a lot of liquidity goes to the asset market," Bank of China's vice president Zhu Minsaid. "So you see asset bubbles in commodities, stocks and real estate, not only in China, but everywhere."

The government has been attempting to rein in the wild beast known as the stock market for years. The question is, can they do it? So far they have been unable to neither prevent a bubble from developing, nor to stop a bubble from imploding. Wrong on the way up; and wrong on the way down ;)


One analyst forecasts a huge bubble in China...but not yet

Thanks to a link from Naked Capitalism, I ran across a blog entry quoting an analyst that foresees a massive bubble in China—one that surpasses the 1980's Japanese bubble. I actually don't share the analyst's outlook but am referencing it as a dissenting argument to my views.

The interesting thing to me is that the analyst suggests that China will enter a massive bubble after capital controls are removed. The thinking, obviously, is that foreign capital will flood into the country causing misallocations (don't forget that a bubble is a misallocation of resources.) This view goes against my view since I believe China may have already entered a bubble in real estate and manufacturing (the stock market may be a bubble too but I don't care about their stock market bubble since it is tiny and has little impact on anything.)

Another way to contrasting our views is as follows. People like me are bearish on China and staying away from it. The analyst's view, interestingly, would lead one to be bullish on China, even though he/she is calling for a massive bubble later some time in the future.

I think the foreign capital flow argument makes sense: large inflows do cause bubbles. But it requires developed capital markets and I don't think China is going to hit the 1980's Japan state for at least 15 or 20 years. Japan's capital markets were far more developed in the 80's—it was already a developed country whereas China is still a developing country—and hence absorbed capital far more easily. So, overall, I don't see capital flows being a culprit in any major bubbles in medium term.

There is one topic pertaining to China where I completely disagree with most in the mainstream. That topic is none other than the forecasted poor demographics of China. Many argue that China will stagnate in 30 to 50 years because elderly population will increase relative to working population. I believe that is not going to happen. I don't know if I said it on this blog but I have maintained that one of the worst atrocities carried out by China is its so-called one-child policy. Some argue that such a policy was needed to control over-population but, since I am libertarian-oriented, I clearly wouldn't agree with the state dictating private affairs of citizens. Even if people end up as poor, it is better for individuals to decide on their own than let some government official decide. In 50 years, I am sure it will be considered by Chinese to be one of the worst actions by their government (it will be on par with 1989 Tiananmen Square Incident.)

I think China will remove their one-child policy within 15 years. After the abolishment of such a policy, I think demographics won't be as bad for China. I wouldn't bet against China (or stay away from it) just because of apparently poor demographics; it's an easily-solvable problem.

Wednesday, September 16, 2009 1 comments

I thought sovereign wealth funds were swimming in cash

One of the thoughts that was popularized last year, and early this year, was the belief that sovereign wealth funds (SWF) would come to the rescue of troubled, capital-short, institutions. Well, it appears some of those funds weren't exactly swimming in cash as they were commonly portrayed.

Bloomberg has a nice story on Istithmar World, Dubai's soverign wealth fund, detailing the possibility that it may liquidate. Istithmar World is not as big as the SWFs of Singapore or China, but I wonder if it is a sign of things to come—or is this an isolated case? Unlike the widely held view that SWFs use cash, it seems Istithmar World used debt (hence it was more like a private equity fund than a mutual fund or a government institutional fund.) I'm not sure if the SWFs of China/Singapore/etc use a lot of debt.

Dubai investment firm Istithmar World may be the first sovereign wealth fund to liquidate after a $27 billion spending spree financed largely with borrowed money, people briefed on the matter said.

Unlike government-controlled funds in Kuwait and Abu Dhabi, flush with cash from oil production, or in China, backed by export earnings, Istithmar fueled purchases such as the takeover of Barneys New York by borrowing as much as 90 percent of the money, the people said. Istithmar’s parent, Dubai World, tapped Middle Eastern and European banks including Barclays Plc, Royal Bank of Scotland Group Plc and Deutsche Bank AG, leaving those three with combined debt holdings of at least $1.5 billion, the people said.


The fund bought a stake in Perella Weinberg Partners, the boutique advisory firm run by Joseph Perella, and two of Manhattan’s most exclusive hotels, the W Union Square and the Mandarin Oriental at the Time Warner Center. It acquired the Queen Elizabeth 2, the Cunard Line flagship for more than three decades, with plans to convert it into a hotel to be moored beside the emirate’s Palm Island.

Istithmar also bought stakes in Cirque du Soleil, the Montreal-based company known for staging extravagantly acrobatic circus-like performances around the world, and Yacht Haven Grande, a marina complex in the Caribbean catering to so-called mega- yachts.


Many of the deals have soured.

Barneys is in talks with creditors about a restructuring or bankruptcy. Loehmann’s Holdings Inc., a discount retailer with more than 60 stores that was acquired by Istithmar in 2006, had its junk- rated debt rating cut three notches last week by Standard & Poor’s, based on “poor” operating performance.

Shares of GLG Partners Inc., a hedge fund with offices in New York and London in which Istithmar bought a 3 percent stake, have lost more than 61 percent of their value since the deal was announced in June 2007.

Sunday, September 13, 2009 0 comments

The left wing & protectionism

I'm left-leaning and kind of an extremist in that I only vote for left-wing parties. The only exception is libertarian parties, which are neither left nor right from the conventional definition (I have only voted once for a libertarian party, the Ontario Libertarian Party. I never voted for them again since I don't like their reliance on Ayn-Rand-type policies; I favour more of the classical liberal philosophies.) I don't vote for any parties on the right because they are socially conservative.

The downside to left-leaning parties is that they are almost always a fan of tariffs—protectionism if you will. The reason is ideological. The left wing favours labour and the best way to protect labour in the short run is to enact tariffs on foreign imports. Of course, these fail in the very long run (15+ years) but this, unfortunately, is overlooked by many on the left.

I have favoured Barack Obama and Democrats in general. I still prefer someone left-leaning like him but I mentioned a long time ago that if he was elected, the risk with his administration is that it will be way more protectionist. I was hoping that the protectionism would be kept to a minimum but we are starting to see the first major protectionist policy by Barack Obama.

On Friday, the US government slapped tariffs on imports of Chinese tires. This is an obscure case and quite minor. However, it remains to be seen if this is the start of further actions.

Today, Bloomberg reports that China is investigating American chicken and auto imports. Will this escalate into more trade battles? It is definitely a big risk to world trade.

It's easy to say that USA shouldn't pursue protectionist policies but the trade imbalance has to be balanced one way or another. As long as China artifically keeps its currency low, I think world trade won't be stable.

The biggest loser from major trade wars will be China and other big exporters. During the 1930's, USA likely suffered far more from the trade battles than the European countries did. Right now China and others are playing the role of USA in the 1920's and 1930's. It shouldn't be surprise that exporters will suffer more from trade wars. After all, importers can manage without some imports (the discretionary items) and can develop its own industries for those items it used to import (it will be more costly and undesirable but that's how I see things.)

(As a side note, right wing parties also enact tariffs. In fact, the Bush administration slapped on significant tarrifs on steel. But the difference in my eyes is that the right-leaning parties don't do it due to their ideological underpinnings. Ignoring special cases like war or massive disease outbreak, I view it as highly unlikely for a tariff spiral to develop if a right wing party was in power. In contrast, I can easily see left-leaning parties pursue a battle of tariffs.)


Sunday Spectacle XXVI

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

Friday, September 11, 2009 4 comments

Articles that may be of interest - week ending September 12th of 2009

(Minor Update: Altered the link for Geoff Castle's piece on Japan so that it links to his site directly. The GuruFocus title was very poor.)

Posting on this blog is going to be erratic for the next few weeks, or possibly even months.

I'm starting to look for a new job due to various reasons. Doing this in the thick of a severe recession, with forecasts of a jobless recovery, is not the ideal time; I should have done this a long time ago but I guess I'm a slow-moving turtle :( But as capitalists (I'm not a "true" capitalist), we know that heroes—whether individuals or businesses or countries—are born during tough times. So we'll see how my life turns out. I hope I find something by the end of this year. Wish me luck.

As usual, I am also checking out a bunch of films at the Toronto International Film Festival and that is going to keep me busy for the next two weeks or so. I usually purchase 10 tickets each year. I'll be watching 8 films this year, with 2 tickets being used up for two of my friends.

I'm planning to schedule a bunch of posts, many of them written over a period of time, so hopefully people still have something to check out.

As for investments, as you know, I really haven't done anything this year and haven't found too many opportunities worth investigating. I think I made a serious error early in the year by not investing in junk bonds. Stocks were still questionable in my eyes, although they worked out exceptionally well for anyone overoading on them early in the year; but I may have missed a multi-decade opportunity in junk bonds. Stocks can easily collapse 30% to 50% but I'm not sure if we'll see a 20% to 30% yield on junk bonds ever again in the next 30 years (but do note that the original reason for caution still stands: default rates and recovery rates were supposed to set records, and they look like they will.)

The current environment is not the type of market that I find favourable for making long-term investments. So I am spending time contemplating macro bets, particularly investing in long bonds or at least betting on rates remaining low.

I am also refining my investment thinking. I think I have pretty much come to the conclusion that Benjamin-Graham-type investments are not for me. I never really invested in them but now am leaning against pursuing any of them (except in some special cases of fallen angels i.e. popular companies fallen on hard times.) In my view, Graham-type investments tend to be secondary or no-name companies with weak qualitative characteristics (moat, brand name, access to cheap capital, etc) but strong balance sheets (sometimes trading below net cash but generally below net current assets, etc.) There are exceptions to this and I'm being very general here but that's how I look at them (feel free to challenge my view if you believe it's wrong.) Instead, I have decided to pursue Warren-Buffett-type investments (I'm referring to mid-life and late-life Buffett). I think it is probably safer to make concentrated bets on Buffett-type investments.

Anyway, here are some articles you may find useful:

  • Simoleon Sense interview with Joe Ponzio - Part I & Part II (Simoleon Sense): Joe Ponzio writes a really good blog, FWallStreet, that you may want to check out, if you have never heard of it before. I like reading interviews with fellow investors so I'm glad to see Simoleon Sense conduct this interview.

  • Simoleon Sense interview with Ben "Inoculated Investor" Claremon (Simoleon Sense): An up-and-coming investor and the blogger at Inoculated Investor presents his views (I like reading his blog because he is more macro-oriented but I think his stance is too bearish.) Some people would view interviews like these as useless. After all, who the hell is this guy and why should we listen to him? I personally find interviews like these quite useful. As crazy as this may sound, I have nothing to learn from, say, Warren Buffett anymore—and I haven't even read all his shareholder letters! I learn a lot more from new investors or professionals no one has heard of. What I learn is not any deep new insight but, rather, their process and how they think about investing. I don't necessarily agree or follow everyone I read but it makes me think of new possibilities.

  • Thoughts on the US$ and inflation (Accrued Interest): Accrued Interest contemplates the US$ situation.

  • 30 year bond still behaving bullishly (Research Ahead; via SeekingAlpha): The 30 year US government bond is still signalling lower yields. There are a lot of minor disconnects I notice. The 30 year bond appears to be more bullish than the 10 year bond. US govt bonds are acting strong even though the US$ has be extremely weak, with some new lows set against some currencies recently. Gold also rallied somewhat in the last few weeks, and if you believe gold is correlated with inflation (I actually don't believe this but the market does) then why are bonds remaining strong?

  • Chou Funds semi-annual fundowner report (Chou Funds via Controlled Greed): The most interesting thing to me is how Francis Chou is considering using constant maturity swaps (in particular Constant Maturity Swap Rate Caps (CMS RC) and Constant Maturity Swap Curve Caps (CMS CC)) to insure against high inflation. I don't know anything about this instrument but it resembles something Hugh Hendry mentioned in his latest letter. Hendry is betting on deflation while Chou is concerned about deflation so they have opposite views. However, their timing is different, with Hugh Hendry taking a position now, whereas Chou expects to enter into these contracts whe deflation threat is high, which isn't the case right now.

  • Price deflation in 1930's USA, 1990's Japan, and present USA (Thought Offerings; h/t Naked Capitalism): Very good analysis of how price measures behaved during the two major deflationary periods in the past. The CPI is not a perfect measure of inflation/deflation but it does provide a rough guide. Generally growing economies are accompanied by stronger product prices. One can easily see how USA started recovering in 1933 mainly due to FDR's policies (some of them enacted by Hoover but altered and expanded by FDR). One should also note how Japan's price index didn't really collapse like 1930's USA. The main reason, of course, is because USA was anchored to the gold standard while Japan was not. The other reason is because Japan, contrary to the belief of some, has actually grown over the last two decades. The GDP growth in Japan after the bust is something like 1% real. Nominal GDP growth hasn't been good but, nevertheless, there is a positive, albeit small, real growth. In contrast, USA's economy in the early 1930's contracted significantly in real and nominal terms.

  • Japan's debt situation (Geoff Castle; via GuruFocus): This title for this article has to be one of the most misleading out there. Anyone looking at the title might think it is supposed to be about the "Japanese Warren Buffett," Takeda Wahei, but there is little about Takeda Wahei nor about his investing techniques. Instead, it is a summary of Japan's debt situation. I am linking to it because the article provides some numbers for various countries, including Japan in 1945. It's interesting to see how the ability of debt payments vary across countries—simply looking at overall debt figures can be misleading. I also didn't realize that Japan had an inflation of 500% in 1945 (non-investing political note: as a side note, as much as the atomic bomb drops by the Americans will be hard to justify in the long run—500 years from now, descendents of Americans, orbitting Saturn on a spaceship, will agree that it was an unfortunate action—America could have let Japan disintegrate and suffer like many failed states but Americans actually helped Japan avoid a catastrophic collapse. Too bad humans make war and kill everyone (Japan started the war in this case) and then kiss and make up. An alien would never understand how crazy humans are :( )

  • One analyst predicts further natgas pricing weakness (Hard Assets Investor; via SeekingAlpha): Just when you thought there wouldn't be more bearish news for natgas, here is one analyst who doesn't see any light at the end of the tunnel. Of course, it's hard to say what is already priced in. Furthermore, natgas is very sensitive to hurricanes so it can easily rally if there is hurricane disruption. I'm more interested in what happens in the off-hurricane season.

  • (Recommended if resource investor) Primer on MLPs (Wachovia; thanks to user LwC on GuruFocus): MLPs are tax-advantaged security structures that are in the same class as income trusts (but there are differences.) This 100-page analyst report describes MLPs in detail. I find the standard analyst report analyzing a specific stock and giving a recommendation unhelpful most of the time but reports like these, which provide detailed summary of industries, are extremely helpful. If you have access to some good brokers, you should keep an eye out for reports like these... As for MLPs, which are an American corporate structure, I am not sure if Canadians get much benefit from them (I'm not sure). I have historically disliked Canadian income trusts and I would probably take the same stance with MLPs. If I were to invest in oil & gas, I would prefer plain E&P or integrated companies. Like other securities, whatever you do, do not blindly chase yield. For what it's worth, Seth Klarman invests in quite a few of these but he is extremely complicated to figure out.

  • Pornography industry suffering (The Economist): Los Angeles is not just famous for regular films but also for pornographic films. The industry is thought to resistant to economic slowdowns but appears to be suffering this time around. I suspect it has more to do with Internet piracy and the decline of exclusivity than the economy. The interesting thing to me is how little the "actors" are paid. Amazing that some can make a living off this.

  • Why are people worried about inflation? (James Surowiecki for The New Yorker): James Surowiecki wonders why people seem to be scared of inflation.

  • The financial industry "tax" (Buttonwood for The Economist): The financial industry extracts a small "tax" from the economy. There is some benefit to an expanding financial industry but not when it gets too big.

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Thursday, September 10, 2009 0 comments

US trade deficit starts expanding

The US trade deficit had been shrinking in the last few years but appears to be reversing trend and starting to expand again. The following chart from CalculatedRisk illustrates the trend:

The overall trade deficit is back to 2001 levels. It had declined significantly during the last two years. Notice how the trade defict excluding petroleum actually started shrinking back in early 2007. The big wild card is oil. If oil prices stay where they are now, or decline, the trade deficit will likely shrink. I believe the non-petroleum deficit may never go back to what it was in 2005.

The trade deficit is sort of a theoretical measure that is ignored by many investors but I feel is important in the long run. As Marc Faber has suggested, the US trade deficit provides liquidity (in US$ terms) to the world (i.e. it acts as cheap money and possibly depresses the value of the US$.) When it started shrinking last year, liquidity dried up.

A shrinking trade defict also means that someone on the other side of the trade will see the opposite effect. The country with the trade surplus will likely see some negative consequence due to their dwindling surplus.

If the deficit shrinks or stays small (say 1998 levels), it will likely exert a downward pressure on financial assets.

Tuesday, September 8, 2009 0 comments

Barrick issues shares to close out hedges

The Globe & Mail is reporting that Barrick, the largest gold company in the world and one of the largest companies in Canada, is closing out a big chunk of its hedges using proceeds from a massive share sale:

In a major bet that gold's rally has a long way to go, Barrick Gold Corp. unveiled plans to largely eliminate its troublesome gold hedge book with a massive equity issue worth as much as $3.45-billion (U.S.) – potentially the largest stock sale in Canadian history.

On a day when the price of gold topped $1,000 (U.S.) an ounce, the Toronto-based company said it is selling 81.2 million shares at $36.95 each. It will use the proceeds to eradicate more than half of its hedge contracts which have locked the company into receiving a fixed price for some of its gold production.

The world's largest gold miner, Barrick produces about 8 million ounces a year. But its hedge book totals 9.5 million ounces, fixed at prices hundreds of dollars less than the $1,009 gold hit yesterday.

As The Globe & Mail article suggests, this like it is the largest share issuance in Canadian history (although, if you adjust for inflation I suspect this wouldn't be the largest.) Barrick is issuing almost 10% of its market cap.

The market always discounted Barrick because of its hedge book. Barrick profitted immensely in the 90's from hedges (when gold was declining) but it has been a drag for the last 5 or so years. As reported above, Barrick's full hedge book is slightly more than one year's worth of production. The erosion of the hedge book will attract those who are extremely bullish on gold.

From a contrarian point of view, this is probably bearish for gold. Although there is no proof and one can't blindly assume this, you often see bull market peaks marked by major corporate actions that turn out to be a mistake. The classic one in recent memory is the AOL-Time Warner merger in 2000. More recently, one may recall how some of the biggest base metal M&A deals were done in the last two years, which may also mark a multi-decade top in base metals (too early to call an end to the base metals bull market but I suspect base metals, and probably all commodities, have entered a bear market.) Those massive mergers, in hindsight, are turning out to be some of the worst deals in the last decade.

Will the Barrick share issuance mark the top? Time will tell...