Articles for the week ending Aug 7 2010

Sorry about the lack of posts. Hopefully the linked articles will keep you busy :)

• (Recommended) Top-down look at Microsoft (Bronte Capital): John Hampton of Bronte Capital takes a detailed industry-level look at Microsoft. The comments by readers is also worth reading IMO. I haven't looked closely at Microsoft but my feeling is that it is probably an investment that will produce market(or maybe 1% or 2% more than market) returns. The problem for companies like these is that they are very large and its hard to see a big upside. As for the downside, it is probably exaggerated. As long as Microsoft produces high profits and reinvests a lot in R&D, its downside won't be that large. Microsoft's historical strength is in turning products, often after competitors get first-mover advantage, into relatively lower cost, mass-market, products... Investing in Microsoft is kind of like inesting in Coca-Cola in the 70's or 80's. That is, you really need some high growth markets opening up (like emerging markets) or some out-of-the-blue product innovation. Coca-Cola was probably saved by emerging markets; otherwise, it, just like Microsoft now, would undergo profit margin compression (because the product isn't innovative and special anymore.) Hampton's bullish view seems to rest on emerging markets.
• Housing situation in Canada (The Globe & Mail): A good summary, along with many key charts, of the current state of real estate in Canada. Based on prices, housing seems expensive in Canada but one of the charts showing percent of income spent on ownership costs doesn't look extreme (although it only goes to the mid-80's.)
• Quick book summary of the book, Buying at the Point of Maximum Pessimism by Scott Phillips (Larry McDonald @ SeekingAlpha): Kind of bizarre to be calling something "value investing trends"; I always thought everything was a "macroeconomic trend" since these trends are speculative in their nature. I haven't read the book and probably won't for a long time, if ever, but it looks like an interesting macro-type book and here are apparently the key trends that are identified in the book:
• Ascent of consumerism in China and other EM: It's probably safer to wait and see if this takes off before investing. Many developing countries were never able to transition from low-income exporters to higher-income service economies. For instance, most of East Asia—Indonesia is a good example—haven't had much success increasing the consumer wealth of their citizens.
• Bullish call on "...fertilizer, farm-equipment and Brazilian agribusiness companies catering to the demand for higher protein diets made possible by rising income in developing countries...": This has been a favourite of Donald Coxe for years. I have a feeling this is too played out. For instance, the market bid up potash companies to some stratostrophic levels a few years ago. In my opinion, agriculture is a minefield since it is heavily controlled by governments, especially in poor countries like China and India. Historically it hasn't been a great industry but I think agricultural equipment, as well as high-tech seed companies, are a better bet, given their higher returns on equity and stronger moats.
• Bullish call on crude oil: Risky bet from a contrarian point of view since crude oil has gone up 300% in 10 years. Major commodities rarely ever go up much beyond that unless there is a disruption to markets (war, embargoes, etc) or there is a paradigm shift. The author is expecting a paradigm shift here but I remain bearish. My wild guess is that the world economy probably can't support oil prices higher than around US$110.
• "...bright future for aquaculture (fish farming) arising from the “tragedy of the commons” playing out in the overexploitation of ocean fish stocks along with rising demand for fish protein from emerging nations": Interesting call and one I think that is slowly coming true. Changing people's diets is much harder than you would imagine and people, even poor people, pay premiums to maintain their diet (for instance, even if there is a shortage of, say, wheat, people generally don't switch to, say, rice or corn even if excess amounts were available.) Since a huge chunk of the population relies on fish, especially so outside North America, I can see acquaculture taking off. On top of environmental concerns with these operations, the difficulty will be earning high returns. It's easy to say this or that trend will materialize but hard to find companies that will earn above-market returns.
• "...educational firms providing online/computer-based training, prep courses, tutoring books, etc. to students in China and other emerging countries, where the value of education is deeply embedded in the culture": I have had similar thoughts for years and think this is an interesting macro trend. The Internet, like the printing press a few hundread years ago, has lowered the cost of information and allowed poorer people access to it. I think we will see the demand for online education to increase. Even within wealthy countries, the shift in the economy towards knowledge-oriented industries has forced people to continually seek information. I think there is a huge opportunity here but it's an industry in its infancy with uncertain business models, dubious operators, and the like. The author of the book apparently lists companies such as "ATA Inc. (ATAI), China Distance Education Holdings Ltd (DL)., Aptech Ltd. and MegaStudy Co. Ltd."
• "rising demand for rare-earth elements, driven by growth in high-end consumer and green technologies and supplied mostly by China": I think this trend won't materalize as suggested. Yes, rare earth materials will be used more and more; but I doubt the investment opportunities will be any better in those goods. There are two problems with it. First of all, the market will likely remain very small. Many of these industries will never be multi-billion-dollar industries since they are, by defintion, rare and can never be used widely in goods. They can never scale up and engineers/designers will take that into consideration when building products. Secondly, I know the author is calling for a paradigm shift (due to high-end consumer goods and green tech) but if we assume the future will sort of repeat as in the past, one probably wouldn't be so bullish. If you look at the commodity complex and look at the areas that have created the greatest wealth, they tend to be in mundane and common commodities like oil, natural gas, copper, iron ore, silicon, and the like. Rarer stuff like platinum, gold, germanium, uranium and the like, haven't really created much wealth. If the cost is too high, the rare ones are substituted—even if it can't be substituted now, businesses spend billions researching and developing substitutes that may exist in the future—and they probably don't achieve the economies scale of the common commodities. As many have said, a low-cost business tends to win the commodity game and economies of scale is probably the #1 method of lowering the production cost.
• (Recommended) Special situation investing articles (Various sources via Old School Value): In a post dealing with reading material, Old School Value links to two useful articles on special situation investing - article 1 & article 2 (Security Analysis excerpt).
• (Highly Recommended) McElvaine Investment Management - Partners' Investment Conference, May 7 2010 (McElvaine Investement Management; h/t Pakiya Funds): Lengthy transcript detailing some history of Tim McElvaine. Good stuff.
• The end of the Bush tax cuts (Bloomberg Businessweek): The Bush tax cuts, aka 'tax cuts for the wealthy,' will arguably go down in history as one of the worst fiscal decisions by any US government. Many readers here probably won't like my thoughts on the matter (since they profit from the capital gains and dividend tax cuts that was the core element of those tax cuts) but it was a disaster for USA. On top of significantly enlarging government deficits, my opinion is that most of the benefits were recycled into dubious investments—namely residential real estate. Tax cuts that boost investment is only benefitial if the investment is in productive assets. Countries like Ireland also pursued a low-tax strategy whereby most of the investment appears to have gone into residential real estate. The only thing that makes these tax cuts not as disastrous as it may have been is the bull market in bonds. If interest rates hadn't fallen in the last decade, US government interest payments would have been far larger. In any case, my opinion isn't the only argument against these tax cuts; as the article mentions, even the proponents and architects of the tax cuts, such as Glenn Hubbard and Alan Greenspan, have admitted it was a colossal mistake... As I have speculated in the past, one the major macro trends I'm expecting is the increase in tax rates across the developed world. Taxes declined from, say, the 1960's to the 2010's but I suspect they will rise from the 2010's to, maybe, 2040's.
• Inside Las Vegas: Gary Loveman & Harrah's (Bloomberg Businessweek): Haven't read the full article but those interested in gambling, entrepreneurship, or Las Vegas may find the article worth reading when you have nothing better to do.
• S&P 500 foreign sales data (S&P via Bloomberg Businessweek): Not every company reports detailed information but here is what S&P has pieced together from reporting S&P 500 companies (click here for the report):
• Of the reporting issues, 46.6% of all sales were produced and sold outside of the United States, down from 47.9% in 2008, 45.8% in 2007, and 43.6% in 2006.
• In 2009 S&P 500 foreign sales decreased 16.0%, while domestic sales decreased 11.2%.
• European sales declined to 25.6% from 27.7% of S&P 500 foreign sales, as Asia increased to 17.6% from 13.2%. Canada representing largest single country at 7.4% is down from 9.3% in 2008.
• Information Technology continued to be the dominating sector with over 56% of its declared sales being foreign in nature; the sector represents 20.4% of all U.S. foreign sales.
• (Recommended, especially for Graham-oriented investors) [audio] Geoff Gannon interviews Jonathan Heller of Cheap Stocks (Geoff Gannon; h/t Controlled Greed): I didn't realize Gannon also did interviews...haven't listened to this fully yet but it's an interesting one.
• Amazon facing anti-trust problems? (Financial Post): One of the toughest things in an economy is to decide if businesses are selling items below-cost to drive competitors out of business, in the hope of charging a fortune in the future. What confuses matters is that consumers benefit in the short-run and it's never clear what the real strategy of the company is. It looks like Amazon is being investigated for a practice it undertook between 2007 and 2009. During that period, Amazon apparently sold e-books books at $9.99, even though it cost $12.99 to $14.99 (that's the price publishers charged everyone.) Loss leaders are common in retailing but given Amazon's size and its ability to destroy competition, this is more than a temporary loss-leader product.
• Charlie Rose interviews Wilbur Ross (Charlie Rose via Greenbackd): Thanks to Greenbackd for bringing this Wilbur Ross interview to my attention.
• The bond market survives catastrophe? (Buttonwood @ The Economist): As many may recall, the bond market was pricing in catastrophic outcomes two years ago, but managed to avoid any blow-ups. In fact, the corporate bond market has rallied so much that it is arguably over-valued relative to the stock market. Is it out of the woods or is all this just an illusion before corporate bonds return to reality? Remains to be seen.
• Wells Fargo and its drug trafficking problems (Bloomberg Markets Magazine): On top of a balance sheet loaded with toxic mortgages, one of the things Wells Fargo seems to have inherited from Wachovia is their illicit dealing with the underworld. Namely, Bloomberg is reporting that Wachovia, along with Bank of America, is a big facilitator of money earned through illegal drug trafficking. I'm sure it's very difficult to spot these transactions but it's going to be a bigger problem as we move forward. The drug war in Mexico seems to be totally out of control, with police, state and city leaders, bought off by drug lords, and only the military remaining somewhat neutral. At the rate things are unfolding, it wouldn't surprise me if the druglords infiltrate the Mexican military within 10 years. When that happens, it's all over for Mexico. Drugs will become a "normal" industry in Mexico, kind of like how poppy/opium is a big contributor to the GDP of Afghanistan. Some readers may be shocked to read that I'm in favour of legalizing drugs. Although politically impossible right now, it wouldn't surprise me if the bogus "war" on drugs ends within a decade and some loosening of drug possession, a least in liberal or libertarian-oriented states, occurs within my life. In fact, some have speculated that California may legalize marijuana and tax it, solely to alleviate some of the financial problems and to reduce spending on police, prisons, and immigration.