Tuesday, May 5, 2015

Monetizing Chinese A-Shares

 I wasn't expecting to write another commentary so soon, but my favorite investment has performed so well that it was required.  China is the top performing major stock index of the last year; the Shanghai Composite is up a whopping 120% since last June.  I remain long-term bullish on China but it's no longer an obvious relative value play.  Also, the A-shares of duel-listed Chinese companies are trading 32% over identical shares listed in Hong Kong.  I sold all of my A-shares.   I've re-invested 1/3 of the capital in Chinese H-shares, 1/3 into a diversified emerging market ETF, and the last 1/3 I'm putting into precious metals as I continue to anticipate continued currency depreciation globally.  
 A-shares are Chinese equities that are listed on exchanges in mainland China and denominated in Renminbi.  Many companies also issue H-shares (listed in Hong Kong), and B-shares (a class that was created for foreigners before China allowed foreign investors to purchase A-shares)  Prices between exchanges can diverge greatly because of regulatory challenges to arbitrage and tremendous buying pressure from Chinese locals.  A-shares are predominantly owned by Chinese locals, while B and H-shares are predominantly owned by foreigners.   If you're looking at broad indices of these share types though, there are other differences; many companies only list a single share class, and the A-shares tend to be smaller and less internationally focused companies.  The surge in A-shares relative to H-shares suggests that most of the buying pressure was from Chinese locals; I've seen many other statistics to back this up.  Most of the westerners I talk to have been continuously pessimistic on Chinese equities and remain so.   

 Are Chinese equities overvalued now?  Is it a bubble?  I don't think so.  First, the simple valuation metrics suggest fair value.  Chinese A-shares have a P/E ratio of 22 (vs 18 for the S&P 500) and a P/B ratio of 2.6 (vs 2.9 for the S&P 500).  The Chinese economy is growing at around 7%, vs the US' anemic 0.2% in the latest report (or closer to 2% if we ignore the last quarter).  Now, no one knows just about how much fraud is in Chinese reported earnings.  Back in 2008 I sold all my Chinese equities when I started delving into their financial statements and spotted massive fraud in minutes in every statement I examined (even with my superficial accounting skills).  One fun example was a Chinese mining company that claimed to be selling raw minerals at 5x the going market rate.  In 2009, the narrative of "you can't trust Chinese accounting" took hold and western investors have eschewed Chinese equities ever since.  While there's still lots of fraud (and I can't even try to quantify how much) the Chinese regulatory infrastructure has improved and standards are higher now.    

 From a psychological perspective, I think things are balanced to bullish.  Local Chinese citizens are speculating on margin in ways that are being compared to daytraders in the US in 1999, but that may be just the start of a trend with a long way to run.  The real estate boom is over, and the rates offered by banks on savings accounts are artificially low, so equities look attractive to the average Chinese person.  China is generating tremendous wealth that has to go somewhere.  Also, western investors missed the boat completely and remain pessimistic.  This means that if sentiment turns, there could be a flood of western money pushing Chinese equities higher.    

 What about the Chinese economy?  China is facing some huge problems but has equally massive tools at their disposal to deal with them.  They have excessive debt at the state level, too much of their financial system is corrupt and un-regulated, capital markets are underdeveloped, and their environmental problems are growing worse.  To even superficially touch on each of these would require a full essay, but I'll point out some of the highlights that explain my optimism.  China has the policy tools to stimulate growth.  While the US was "pushing on a string" and had to invent new monetary tools to encourage lending despite 0% interest rates, China has tremendous room to ease, and they've been using those tools intelligently.  Bank reserve requirement rates in China are at 18.5%, up from 7% in 2005, for example.  Additionally, while state banks are over-levered, small businesses and households are under-levered.  The Chinese government has passed a number of laws recently to encourage the formation of more small banks, bring greater transparency to the shadow banking system, more accountability to state finances, increasing lending to small businesses and decreasing lending to the largest SOEs, and new laws to accelerate the resolution of non-performing loans.  A few specific examples all from the past 18 months:  the Chinese government injected 500 billion RMB into the biggest 5 commercial banks via the Standing Lending Facility, and then another 400 billion via the CDB.  They injected 1 trillion RMB into the China Development Bank.  They cut taxes on utility companies and for manufacturing investments.  The central government passed a series of laws requiring much greater transparency in the budgeting process of local governments and forbidding municipalities from raising debt through off-balance sheet vehicles.  They are gradually opening capital markets via reduced currency controls and a wider RMB trading band; mainland Chinese mutual funds can now invest in H-Shares, and there are reduced restrictions on foreign investment in private companies.  There are a growing number of free-trade zones including Shanghai, Guangdong, Tianjin, and Fujian.  Lastly, the Chinese government is seriously cracking down on corruption - hundreds of thousands of party officials have been investigated with many senior officials arrested, including at least five members of the powerful Central Committee, and 70 executives of State Owned Enterprises.  This is just a small sample of recent reforms initiated by the Chinese government to overcome their obstacles.

Big Picture:Most assets are overvalued.  US equities and real estate are moderately overpriced; venture capital, biotech, and bonds are in or near bubble territory.  European and emerging market equities look roughly fair.  The global money supply continues expanding.  My own portfolio consists of emerging market equity, a small amount of european equity,a little commodity related equity exposure, and a small short S&P 500 position that I just initiated as a partial hedge to my long equity exposure.  I am also long a growing amount of precious metals and bitcoin.  


Monday, March 23, 2015

Structural Dislocations in the Volatility and Sovereign Debt Markets

   In this post I'll cover some of the biggest structural distortions visible in the market with a few ideas of how to profit from them, or at least avoid getting run over.  The bulk will be on distortions in the volatility market, which requires some technical jargon.  This post is more geared more towards the professional investor/trader than most of my "Risk over Reward" commentaries.  
Equity Index Skew
  Asian stock index volatility looks radically different from the S&P 500 because of structured products in Asia and the behavior of US investors.  There are a variety of structured products throughout Asia that aggressively sell long-term volatility, and particularly downside skew (example: "autocallables" in Japan.  These insurance products pay out less when equity markets are down, and so they result in consumers of insurance basically selling long-dated out-of-the-money puts).  The basic theme is that asian investors enhance the yield of all sorts of investment products by coupling them with a sale of long-dated volatility.  This causes the index vol curve of most Asian markets to be much flatter than the US (probably too flat), and to price in much less downside skew (probably way too little.) 
  In contrast, the US has tons of short-term call overwriting and downside put buying.  The short-term call overwriting is done to generate yield for investors like pension funds desperately trying to earn 6%+ on their portfolios; it results in a steeply upward sloping volatility curve.  Downside puts are being purchased more aggressively than ever before by banks because of new regulations (i.e. Dodd-Frank, Volcker Rule, and CCAR) that require stress testing of portfolios and limited risk taking.  Short-term and deep out-of-the-money puts help banks meet the stress testing requirements.  Insurance companies have also increased their buying of short-term puts because of the death of certain types of variable annuities, which previously required them to buy very long-dated downside protection.  
   The simplest application of this mispricing is in a simple hedging scenario.  If you want to buy protection on your portfolio, you should avoid puts on the S&P 500, because S&P put skew is currently overpriced relative to other sources of downside protection.  Instead, consider replacing some of your equity exposure with an out of the money call.  That way you dodge the overpriced puts and benefit from the cheap call skew.  A picture of the put/call skew ratio is attached.  The high number associated with the S&P 500 reflects the fact that the market is pricing puts with much greater skew than calls, unlike in the Nikkei and Hang Seng where the premium on puts is small to almost non-existent.

  Options on crude oil are trading with an implied volatility of 45 (taking the average of Brent and WTI 1-year option implied vol).  The market is pricing in a substantial chance that crude oil will soon trade below $30.  I've had some recent discussions with analysts who have convinced me that $30 crude is indeed a possible (albeit unlikely outcome) and that crude could potentially stay there for at least a couple years.  While $30 is well below replacement cost, banks can force the oil companies to keep pumping oil to generate cash to pay off the debt that financed the wells.  In other words, crude oil supply may drop surprisingly slowly in response to low prices.  This isn't a comment on crude's direction, but on its probability distribution.  
  In contrast, the options market is pricing  the volatility of the energy large caps (represented by the ETF XLE) at only 20 vol, and even smaller E&P companies at only 50.  Many of the E&P companies will go bankrupt with oil below $40 and are worth much more than where they're trading if oil rebounds above $70; they're a heavily levered bet on the price of oil, but the options market isn't reflecting that.  The simple trade is to sell volatility on crude oil futures and buy vol on energy companies (both E&P and broader large-cap).  The more sophisticated version is to do the same, but also buy the debt of these companies (especially E&P which are severely discounted) and short the equity as well.  The latter trade looks like owning delta hedged convertible debt against crude vol.  
Sovereign Debt
  We all know about how central bank buying has artificially suppressed interest rates, but only recently have investors become totally complacent about the negative nominal interest rates that a good chunk of the developed world is now exhibiting.  The following countries are all being paid by investors to borrow money for 2 years, i.e. they have negative nominal interest rates: Germany, France, Belgium, Austria, Sweden, Czech Republic, Switzerland, Finland, Netherlands, Austria, and Denmark. In many spots, the market is offering staggering reward for relatively low risk to the investor.  For example, shorting Japanese debt (or buying vol on it) may fail as a trade, but you can structure it to offer you 5:1 or better.  Instruments like the LIBOR-OIS spread and equity puts contingent on a currency move offer similar payoffs.  One very specific trade that I like is buying equity puts contingent on higher interest rates. The pricing of this trade depends on the implied correlation between bonds and equity.  The biggest player in this market are pension funds who need to hedge the risk of equity falling while bonds rise (in which scenario the present value of their liabilities increases and they face a funding shortfall), and so these behemoths sell down the implied correlation between equity and bonds to artificially low levels.  By taking the other side of the trade (betting that bonds and equity will move down together), we can buy puts at highly subsidized prices.  Currently, the implied correlation is so low that you can save roughly 70% of the premium on the puts.  
  The pattern of interest rate suppression and volatility selling by investors may continue, but it provides a fantastic opportunity to construct asymmetric trades with great reward for minimal risk. Unfortunately, the best trades require the use of OTC derivatives, so they're out of reach for most of our personal accounts.  

Big Picture
  Most assets are overvalued.  US equities and real estate are moderately overpriced; venture capital, biotech, and bonds are in or near bubble territory.  European and emerging market equity looks roughly fair.  I'll provide a more detailed look at each of these areas in my next letter.


Thursday, January 22, 2015

The Crude Collapse


   The last 6 months have seen a collapse in commodity prices (particularly crude oil), a strengthening dollar (and collapsing Yen), and generally flat equity prices with rising volatility.  In this commentary I'll focus on crude and then discuss the big picture.

Crude Oil   
  Oil's price has been falling primarily because US crude production has been skyrocketing, for fundamental and sustainable reasons.  New technologies developed over the last 15 years have increased US crude oil production from 5 million barrels per day in 2008 to 9 million barrels per day currently, and likely over 10 million per day within a year.  The US is now the world's largest energy producer, and that appears unlikely to change any time soon.  There has been a huge amount of new well drilling in the US over the last few years; while many of these projects will be unprofitable at current low prices, much of the cost is sunk and unrecoverable, so the companies will recover as much cash as they can by drilling.
  But none of that is new, so why did the price crash in the last 5 months?  There were a few timely triggers.  First is the abatement of geopolitical risk.  Turmoil in Iraq and Libya, as well as tensions with Russia and Iran have not substantially affected production.  The market was pricing in a substantial geopolitical risk premium to the price of crude, and much of this has now been removed.
  Second is global recessionary fears.  The global rate of growth has slowed and investors are pessimistic.  Weaker global growth means less demand for crude.
   Third is OPEC.  The market expected OPEC to cut production at their meeting at the end of November, and instead they held steady.  There is speculation that this was due to internal politics - that Saudi Arabia wanted to put pressure on Venezuela and Russia who more desperately need the higher oil revenues that come with higher prices.  Another hypothesis is that Saudi Arabia wanted prices to fall far enough to completely shut down research into alternatives and new exploration.  However, it may be that Saudi Arabia simply felt that cutting production wouldn't raise the price enough to justify the drop in their sales volume.
   Crude prices today are unsustainably low unless the world falls into a global depression.  The marginal cost of developing a barrel of crude at today's production levels is about $70 per barrel.  But...the glut of recently finished and nearly finished wells means that the price could stay depressed for at least a couple years while we work off the excess supply.  I think buying crude oil futures out 3 to 5 years forward is an attractive bet, but it's not a crazy mispricing by the market. 
   The market is still trying to decipher how oil related equities should be affected.  Many oil companies will go out of business, while others are probably trading at excessive discounts.  I don't have a sense if the sector as a whole is cheap or rich, and I lack the expertise in the sector to try to identify the winners and the losers.  Some smart stock pickers will make a lot of money in this sector over the next couple years though.  There are also lots of interesting and hard to calculate second order effects.  For example, the Canadian banking sector will be hit hard by the drop in investment banking activity that was previously supported by tar sands projects.  
   While cheaper energy is unambiguously a major boon to GDP growth, its effect on markets is more subtle.  Energy is over-represented in US equity and debt markets relative to its role in the economy, because the energy sector is mostly composed of large and publicly listed companies.  So while the economy as a whole will benefit from cheaper energy, specific equity and debt markets may not because the companies in that particular index will see their profits fall.  Below is a graph that shows the relative weight of energy in various indexes.  Those indexes with the largest percentage of energy have been hit the hardest by the crude price decline.  
  Thinking globally, countries that are large net importers of oil (like China, Japan, South Korea, and Germany), stand to benefit the most from the price drop.

Big Picture:
 Global interest rates remain near all-time historic lows and artificially suppressed.  Additionally, credit markets are pricing in almost no default risk.  Between these two factors, bonds are very unattractive investments today.  
  US equities are substantially overpriced, to the point that their expected real returns over the next 7 years are near zero.  Global developed market equity (Europe and Japan) are a little overpriced, and emerging market equity is about fair (which is very cheap in relation to the US).   
  The US unemployment rate is now at 5.6%.  While there's no magical number, 5% is often referred to as "full employment."  This suggests there is very little slack left in the labor market.  However, wage growth has been slow and we have not yet seen evidence of inflationary pressure.

Mea Culpa and Positioning: 
  In my last commentary 6 months ago, I suggested positioning for inflation and highlighted the rampant global money printing.  Instead of inflationary pressure, we've seen strong disinflationary or even deflationary pressures globally that may continue for the next 6 to 12 months.  My basic perspective is unchanged - the massive money printing will eventually create inflationary pressure, and we continue to see slack in the labor market shrinking. The market is pricing in very little risk of inflation, and very few people are worried about it.  That doesn't tell us whether it will happen or not, but it does suggest that at the first hint of inflation, we'll see an exaggerated response by the market since many participants will be caught out of position.  I continue to favor gold, silver, bitcoin, emerging market equity, short Yen, and commodity related exposure.  If crude oil falls any further, I will likely buy futures settling in 2020.  
  Wealth inequality is a hot button political topic, but it's also of critical interest to investors today.  One reason the Federal Reserve has been able to quadruple the money supply without triggering rampant inflation is because the newly printed money has ended up in the pockets of the very wealthy.  The very wealthy aren't spending the extra cash, rather they're investing it and bidding up equity, bond, and real estate prices.  If more of the newly minted cash finds its way to lower and middle class households, a much larger percentage will be spent on consummables and services, which will create upward pressure on prices and then wages.


Friday, May 30, 2014

Profiting from Depreciation

   The global supply of base money is growing at a ferocious pace.  The US is tapering (still expanding the money supply, but at a slowing pace), and the velocity of money is likely to pick up causing broad money measures to continue expanding.   More dramatically, the rest of the world has joined in our money printing efforts, with the central banks of UK, ECB, Japan, and Switzerland aggressively increasing the size of their balance sheets.  Productivity is growing far slower than the money creation, so we're seeing currency depreciation that is likely to accelerate.  If all the major currencies depreciate simultaneously, exchange rates won't necessarily move.  Rather the prices of real assets (like commodities and real estate) generally increase. Slack in the labor market is shrinking, so the price increases in real assets may spread more generally and produce moderate inflation. 
    The big challenge is that the money printing has already pushed up the price of assets that provide yield to very "optimistic" levels.  The cap rates on real estate (basically a measure of yield) are low, reflecting both the low interest rate environment and the minimal risk premium.  The pricing for companies that provide commodities is similar.  This makes it difficult to get excited about buying a lot of the traditional depreciation/inflation hedges.  Investing is 1/3 about making the right prediction, but 2/3 buying at the right price. 
   My best guess is that moderate inflation is about 18 months away, but the market will begin positioning for it sooner.  I suggest purchasing a basket of assets that do well under stagflation regimes (low growth, moderate inflation), as well as under pure currency depreciation scenarios.  This includes a focus on precious metals, with smaller allocations to REITs with pricing power (like hotels), the equity of companies that benefit directly from rising commodity prices (miners, farmers, drillers, wildcatters, energy servicing companies etc), pure commodities, and maybe a little Bitcoin.  Insofar as you hold equities, it's smart to focus on emerging market economies; EM equities are trading much cheaper than the US and those countries will likely benefit disproportionately from continued money printing.  Probably the clearest advice is what not to own.  Fixed income of all types will do poorly.  

The Growing Money Supply:
The central banks of the world are in full out money printing mode.  The US led the way beginning in 2008 and ultimately produced a staggering 5x increase in the base money supply, but Europe and Japan have been ramping up their own efforts.  While the US federal reserve is "tapering", this simply means they're printing money at a slower rate than before, but they're still printing, and as I'll discuss shortly, the US money supply is likely to continue growing quickly.  Central banks are printing money faster than productivity is growing, which means the value of currencies will depreciate in real terms.  We usually think of the value of a currency as an exchange rate, but what if all currencies are depreciating together?  You get price increases in real assets.  Whether that turns into general inflation depends on whether labor can demand wage increases, and that depends on the amount of slack in the labor market.  Economists are debating that last point at length, but the debate centers around a pretty narrow range.  Is "hidden" unemployment an extra 1% or 3%?  The slack in question is really minimal compared to the upward pressure on demand from the flood of cash, and global GDP growth will continue eroding whatever slack remains in the coming year.  
   Distinguishing between inflation and global currency depreciation is tricky.  The former is a self-sustaining cycle that must eventually include wage increases and rising consumer demand.  If there's enough slack in the labor market, it's possible to get global currency depreciation without inflation.  In an inflationary scenario, "useful" assets like housing and crude oil are more likely outperform.  In the depreciation without inflation scenario, currency alternatives like gold will likely outperform.  Whether depreciation will turn into inflation requires a complicated and contentious discussion of the amount of slack in the global economy. 

Monetary Basics:
Back in 2008, market watchers noted that the Fed Balance sheet had ballooned from $800 billion to $2,200 billion dollars, and it has continued rising to over $4,000 billion.  Economics 101 tells us that Price x Quantity = Money Supply x Velocity of Money.  The equation tells us that if the money supply increases and neither velocity nor productivity changes, then prices must rise.  In even simpler terms, if there's more money chasing the same goods, prices will rise.  
  So why didn't prices increase threefold in 2008?  The velocity of money collapsed.  People hoarded their cash and used earnings to pay down debt instead of invest or consume.  Similarly, banks hoarded their capital instead of making loans.  None of this was surprising in 2008, or 2009, or even 2010.  But now in 2014 with the economy humming along with moderate growth, it's surprising that the velocity of money remains at recession levels.  There's a lot of debate on exactly why this is, mostly centered around a reduction in the size of the "shadow banking" system.  The bigger question is when will velocity normalize and what "normal" means.  I don't have good answers for you here, except that the rise in asset prices, expected low real yields, decreasing labor slack, and increasing money printing out of the weaker parts of the global financial system (ECB and Japan), will likely push up the money multipliers sooner rather than later.  

Bonds Moving With Stocks:
People often think of bonds and stocks as moving in opposite directions, but this has only been true for about 1/3 of the time over the last 50 years.  When we're in a deflationary environment (or a high real growth environment), the correlation is negative, as it has been for the last 12 years.  But when inflation is the focus, the correlation is positive, as it was from 1970 to 2000.  The last 5 years have had the most negative bond/stock correlations of all time, and I think that will soon reverse.  Here is a chart of the stock/bond correlation using 5-year rolling returns.  Being short bonds is currently a crowded trade, but the fundamentals are correct.  Interest rates are near all time lows and at the end of a generational cycle.  

What To Buy
  I've written in the past that gold is a mediocre inflation hedge.  The best predictor of gold returns is not inflation, but real returns.  When other assets offer opportunity, investors prefer them.  When other assets look ugly, investors are content keep their wealth in gold.  Quantitative easing has pushed every asset class to at least fair value if not far above fair, and with interest rates suppressed globally, real returns are likely to be very low over the next decade.  This makes gold an attractive inflation hedge in the current economic regime. I haven't kept a close eye on the commodity markets over the past year, so I'm wary of offering specific recommendations.  Personally I've bought a basket with an emphasis on natural gas, for similar reasons to what I wrote two years ago.  For investments of longer than a year, I generally prefer investing in companies that profit from commodities rather than in commodities themselves.  Equity investment provides a "tailwind"; even if commodities remain at current prices, the companies can earn a reasonable return and their equity may still appreciate at 5%+ a year.  Second, while you can buy physical gold and store it, it's not feasible to do this for things like crude oil or corn.  Owning commodity futures for more than a year incurs roll costs and unfavorable tax treatment, and ETFs are forced to roll their holdings and get taken advantage of by traders.  With all that said, I think that US equity markets are generally overpriced, so I'm also including some pure commodities in my basket.  
   A speculative candidate for addition to your portfolio is bitcoin.  Bitcoin is a cryptographic method of transferring value.  There's debate as to whether it's best thought of as a currency, commodity, or simply a method of transaction like Visa.  Regardless, it supports a fascinating variety of new technologies that may become integrated into the real economy in all sorts of interesting ways.  The biggest names in Venture Capital like Andreessen Horowitz as well as major players like Richard Branson and Li-Kashing are pouring money into bitcoin related start-ups.  It's inherently deflationary by nature as well, so investors may like allocating some portion of their wealth to it as a hedge against currency depreciation and inflation.  To be clear, bitcoin is not an investment, it's speculation.  It could easily collapse to worthlessness in the near future.  But...I think it's a smart addition as a small part of your portfolio, and I think it has the potential to achieve 5x returns in the near future.

Your Thoughts?
  I generally lack the time these days to delve into specific assets in great detail.  Do you like a particular commodity, company, or equity index as a depreciation/inflation hedge?  I'd love to hear from you.

  The trade I've recommended most strongly in the last 3 years was shorting the Yen, and that's worked out very nicely.  The easiest money is already captured so I've cut my position to 25% of the original size.  The long-term fundamentals continue to support shorting the Yen and I expect to leave on the remaining position for another 5 years or so.  The basic reasoning that I put forward back in January of 2012 remains sound.


Tuesday, January 21, 2014

The view from 10,000 ft.


   While short-term forecasts are near impossible, and medium-term is hard and requires a lot of luck, long-term forecasting is easier because market values generally head towards "fair" and mean reversion operates at a lot of levels.  The best long-term forecaster that I'm aware of is Jeremy Grantham, partner at GMO.  Grantham produces 7 and 10-year forecasts based on fundamental relationships and the assumption that over a long time frame, asset classes will revert to intrinsic value.  His current forecast suggests that US equity real returns over the next 7-years will be negative; he thinks US equities are currently 75% overvalued.
   He updates the forecasts quarterly to account for changes in things like GDP and investment levels, but most importantly, to account for changes in asset prices.  In 1999 he predicted that equity returns over the next 10 years would be zero, a staggering contrarian prediction at the time.  After the tech bubble burst, he became moderately bullish in 2002 before again predicting negative long-term equity returns in 2007.  He was then bullish again in 2009 before becoming bearish in 2012.  He also correctly forecast the outperformance of commodities and emerging market equity in the 2000s.  This is not to suggest that his timing is perfect; he became skeptical of equities in 1997, 3 years too early.  He seems to have little skill in picking the turning point, but is excellent in identifying when we're far above or below the "trend line" to which we will eventually revert.  
   The bulk of his work is to simply ignore the narratives of the pundits, and focus on some very basic metrics that ultimately drive returns.  For equities, long-term returns come down to revenue and profit margins (which determine net profits), leverage (which converts profits to return to equity), and the earnings multiple (which converts earnings per share to a stock price.)  Revenue generally trends upwards with the economy, and the rest is strongly mean reverting.  While we can't know what the mean reverting level is exactly, we can be sure that, for example, profit margins won't climb and climb until breaking 100%, and the P/E ratio must ultimately relate to real interest rates.  
   This simple analysis is just the starting point however, because things do fundamentally change over time.  For example, the top quartile of venture capital funds earned annualized returns of over 40% from 1990 to 2000.  That's likely a decade that will never be repeated for venture capital, because it was a new, underpopulated asset class investing in a new, underinvested industry.  Today venture capital is crowded with ten times the capital chasing a similar number of opportunities. 
  Long-term secular environments are also critical.  We're now 5 years into a period of financial repression with artificially low real interest rates.  The further the government pushes real interest rates below equilibrium, the higher asset prices may get above fair value.  
   Grantham thinks the biggest cause of excess market volatility and mispricing is faulty extrapolation.  Investors assume that trends will continue indefinitely, instead of identifying short-term aberrations for what they are.  For example, investors consistently overprice "growth" stocks, despite research showing that future earnings of growth and value stocks are actually the same; in other words, the prior revenue growth rate has no predictive value for future revenue growth rates.  This is why mindlessly buying stocks with low price to earnings ratios has outperformed most professional investors over the last 90 years.  Right now, the biggest false extrapolation is profit margins.  It depends on the measure you use, but profit margins are about 35% too high.  This means that if absolutely nothing else changes with the economy or corporate fundamentals and valuations, we should expect net profits to fall 35% and stock prices to fall 35%.  Of course the adjustment is unlikely to happen instantly, so the market may adjust to lower profit margins over time while other inputs into stock valuation provide support (e.g. stocks may lose 35% from lower margins but gain an offsetting 35% from revenue growth over the next 4 years).  
    Here is a link to an article about GMO's methodology (which they recently updated), and Grantham's latest quarterly letter:  http://www.gmo.com/websitecontent/GMO_QtlyLetter_ALL_3Q2013.pdf.  You have to register to read it, but it's a quick and painless process and well worth it.  I've attached their latest 7-year forecast.
   It's worth noting that the forecasts are in real (aka inflation adjusted) terms.  So, if we expect inflation to average 3% over the next decade, this forecast then predicts small positive nominal returns for US equities.  As you can see, none of the asset classes look attractive.  Even top performing timber is projected to return a modest 6%.  This is a result of "financial repression" and the major run-up in all asset prices over the last 4 years.

   So where should we have our money?  Grantham's forecast suggests that neither emerging market equities nor commodities are undervalued, but both areas look far more attractive than US equities.  I've been tip-toing in to emerging market equity, particularly China.  I've also been continuing to scale into commodity-linked equities.  I was a little early getting long natural gas related equities in 2012, but those are now paying off nicely, and I think the sector has a long way to run.  I'd also suggest looking at the mining and agriculture sectors.  My concern is that the credit situation in China leads to a mini-panic and sell-off in both emerging market equity and commodities across the board.  If that happens, I think both asset classes will represent a phenomenal buying opportunity.  


Sunday, November 17, 2013

Economic Commentary: Healthcare

  I attended a healthcare conference on Friday and learned a few things, but I'll start with a personal anecdote. I recently had my annual physical and received the itemized bill. The standard battery of blood tests cost $1300 as part of the Northwestern university medical system. My physician asked me to retake two of the tests because of lab errors. I'm on a high deductible plan and so I was curious if I could get the same tests done less expensively elsewhere. The exact same tests were offered at numerous labs around Chicago for $130. Why would any individual or any insurance company agree to pay 10x more than necessary for routine blood tests? How can such an enormous pricing disparity persist?

The Current State
   US healthcare spending is about double that of comparable countries with similar outcomes. A little bit of this difference comes from superfluous procedures and tests, higher medical liability insurance premiums, and hospital emergency room procedures. But the vast bulk of the disparity comes from higher prices on the same medications and procedures.

  The trillion dollar question is why do the same procedures and medication cost 2x-5x as much in the US as in other developed countries? 

Prices are higher here primarily for two reasons:
   1. Prices are not transparent.  This is, I believe, by far the biggest issue. A hospital in the US often charges literally 30 different prices for the same procedure to different constituents, and these prices are not public. Every insurance company receives a separate price, as do medicaid and medicare patients and the uninsured. This lack of transparency means there's no price competition. Consumers usually have no idea in advance what they will be charged for a procedure and so they can't comparison shop. This means that not only is there no competition between providers on price, but there isn't even any substitution. With price transparency, consumers would go to hospital A for the services it provides most efficiently and hospital B for the services in which it specializes, which would yield a lower effective cost of service, even if the prices themselves didn't change at all. In most comparable countries, there's some government entity that can see all prices and is able to purchase the healthcare from the most efficient providers in each category. This is also true with pharmaceutical drugs. In the US, two pharmacies within a 10 mile radius will offer the same drug at a 400% price disparity. The disparity persists because consumers don't know, and don't care. Which brings us to #2.

 2. No one pays directly. No one is simultaneously both incentivized and capable of being an intelligent purchaser of healthcare in the US. Consumers are mostly on low deductible plans or medicaid and medicare, and so most don't care about the prices they're being charged. Insurance companies are somewhat incentivized to negotiate for lower prices, but in many cases they can pass their costs on to consumers, and they're stymied in their ability to negotiate by consumers' preference for broad coverage networks. Insurance companies can't limit their coverage to just the most efficient providers, because consumers will buy other insurance plans that give them access to a broader network.

The Future
   The key trend in healthcare is towards choice. It's not clear if and when pricing information will become more transparent, but many other aspects of healthcare are becoming shoppable. There are now both public and private systems for rating doctors and hospitals and much more performance data is being collected by the government. This has created opportunity for startups that help hospitals improve their performance figures (like a company that is installing RFID sensors into soap dispensers to insure that all physicians wash their hands), as well as by 3rd party medical providers that now have the data to convince consumers they're better. The CEO of One Medical Group spoke at the conference; their tag line is, "The doctor's office reinvented." They provide more convenient care (e.g. offering consultations by skype to patients that would rather not trek into the office) that also provide cost savings (e.g. by encouraging earlier patient-physician contact, they catch problems earlier when they're cheaper to fix.) The battery of new data allows One Medical Group to provide a strong pitch to patients that the quality of care they provide is better than that of traditional, much larger institutions.

 The presenters at the conference all believed that sudden, radical change was unlikely. Rather they expected increasingly large cracks in the traditional healthcare model, cracks that will be filled by startups that treat healthcare like consumer electronics.


http://jama.jamanetwork.com/article.aspx?articleID=1769890 http://dpeaflcio.org/the-u-s-health-care-system-an-international-perspective/ http://www.commonwealthfund.org/~/media/Files/Publications/Issue%20Brief/2012/May/1595_Squires_explaining_high_hlt_care_spending_intl_brief.pdf http://www.pbs.org/newshour/rundown/2012/10/health-costs-how-the-us-compares-with-other-countries.html http://www.huffingtonpost.com/2013/10/03/health-care-costs-_n_3998425.html

Tuesday, June 11, 2013

The Tepper Rally and the End of the 30 year Bond Bull Market

   From November of last year through May 22nd, equities crawled higher, slowly but consistently for a whopping 26% rally.  The last few days of the move were nicknamed the "Tepper" rally, because hedge fund titan David Tepper went on CNBC to explain why he was bullish.  The doubters were concerned that as the Fed tapers quantitative easing over the next year, the reduction in easy money may prove fatal to equities and possibly most other assets.  The Fed is currently buying $85 billion a month in treasury and mortgage securities and investors wonder how much of the equity rally was because of this buying and if it ends, will the equity rally reverse?
   Tepper explained that while the Fed will be reducing its stimulus, the size of the fiscal deficit is shrinking even faster.  The fiscal deficit has fallen from about a peak of $1.4 trillion in 2009 to $1 trillion in 2012.  Next year was previously projected to fall slightly to $850 billion but the latest estimates put it at closer to $600 billion.  This $400 billion reduction in the deficit from 2012 to 2013 comes primarily from an increase in taxes from higher personal income and corporate profitability.  
   From a basic value investing perspective, the market appears roughly fairly valued.  I think the greatest risk to equity performance is currently Japan.  Japan is the world's third largest economy and if it faces a crisis, the contagion effect will be drastic.  
   Bill Gross is the founder of PIMCO, the word's largest bond fund with $2 trillion in assets under management.  Gross recently said that he thinks the 30 year treasury bull market finally ended this April.  Over the last month we've seen a sharp increase in treasury shields, but they're still quite low in any sort of historical context.  Over the last 50 years, 10-year yields have averaged about 6.6% and they're currently 2.2%.  That 6.6% number is probably a bad anchor since it included the severe inflation of the late 70s and represents the period with the highest consistent GDP growth that humanity has ever seen.  Still, 2.2% 10-year yields are unsustainably low in any sort of growth environment.  
 Gross predicts that while the Bull market ended this April, the Bear market won't start for another 3 to 4 years.  He suggests a generally range bound market in treasuries in the mean time, albeit with higher volatility.  I think Gross is likely right.


Friday, March 22, 2013

Backpacking in South America and a Global Update


   I spent January and February backpacking through Argentina, Chile, Peru, and Ecuador.  I wish I could write an analysis of the economies and societies as detailed as I did for China last year here, but I didn't gain comparable insight.  There are a few key themes worth briefly discussing, and a few specifics that I think you'll find interesting.  I'll then delve into a update on global markets.

South America: Most of South America is export driven with a focus on raw commodities.  China provides much of the marginal demand for commodities ranging from cattle to iron, so several South American countries are nearly a levered play on China.  Much of the continent faced intermittent civil war until just 35 years ago, so social institutions are weak and corruption is rampant.  
  Argentina is in the midst of a currency crisis, which will likely become a fiscal and political crisis in the next two years.  Wealthy Argentines are pulling their money out of the country as fast as they can circumvent the capital controls in place, and I wouldn't suggest fighting the smart herd.  One funny anecdote that highlights Argentine problems - the magazine ''The Economist'' publishes a ''Big Mac'' index, comparing the prices of McDonald's Big Mac across countries as a half-serious inflation index.  The government of Argentina ordered McDonald's to lower the price of its Big Mac in Argentina to make inflation appear lower.  McDonald's responded by lowering the price, but hiding the item from the menu.  If you walk into a McDonald's in Buenos Aires, you won't see the Big Mac advertised, but can request it and get a half-price meal.
  From a social perspective, Chile has a strong work ethic and social fabric, but is overly dependent on copper (42% of exports), and has a stifling bureaucracy; crossing the border from Mendoza into Santiago by bus required a 4 hour layover at border security where I had to stand in 3 separate lines to get various documents stamped.  Domestic service industries are nascent at best.  Peru and Ecuador lack the social institutions and infrastructure to support fast economic growth in the near future.  Of the four countries I visited, I'm most optimistic about Chile in the medium and long-term.
   Finally, one random point of interest about global real estate - I met an Argentine entrepreneur/investor named Jose who made the point that between 1965 and today, the population of the world doubled with plenty of population growth in the US, and even in Western Europe, so obviously there was strong demand for new homes and offices.  Today, the population of the western world is stagnant, and in many places shrinking.  Instead of a growing pie, we now have a shrinking pie in many areas.  For every new "hot spot" development, blocks of other homes must become abandoned.  Any time you see an underpopulated area that you think will prove a good investment, you need to ask yourself, where will the people come from to fill it and what other area must become underpopulated?  Real estate is fundamentally local, so there will certainly be areas of high growth and great returns to investment, but the secular trend is for stagnant demand.   Housing trends of the last century were supported by relatively consistent population growth that has now ended.  This argument even applies to much of the Eastern world.  China's population has stagnated and Japan is shrinking.  World population growth is coming almost entirely from India and Africa.  

Global Update: I recommended shorting the Yen in early 2012 and it's come down around 17%, with half that move coming in the last few months.  This is a big move for a currency and this trade has become a little crowded from a short-term technical perspective...but I still love the position and think it has a long ways to run.  I discussed the logic here; since then Japan has gained a new central bank head who was brought on specifically to print money and induce inflation.  This may end up looking like the best and most obvious trade of 2013 and 2014; I suggest selling on any pullbacks if you're not already in the trade.  
   Equities have continued their "stealth rally", a series of small winning days that have largely left the retail investor behind and many professionals too as people wait for significant but nonexistent dips to buy.  Retail investors stepped up their investments in mutual funds in the last three months, chasing recent moves as always, but more buying pressure has come as corporations buy back their own stock with cash on hand or newly issued debt.  It's perfectly sensible for companies to pursue these buybacks, but it has historically anticipated periods of poor equity returns for the market as a whole going forward.  
   The federal reserve is knee deep in the fourth round of quantitative easing with $85 billion in purchases of mortgage securities and treasury bonds each month.  I think they'll likely end the MBS purchases within the next 6 months since Fed officials have acknowledged they're ineffective; the MBS buying is just turned into profit for a handful of lenders and big banks and is having little effect on mortgage rates.  How long Fed bond purchases continue is anyone's guess.
   Finally, there's currently a bank run going on in Cyprus, which creates a risk that Cyprus could leave the Eurozone and set a bad precedent for the PIGS.  The problem is that the ECB/EU organizations are reluctant to simply write a blank check to solve the problem, and Cyprus' debt is so great relative to its GDP that the only way to cover it may be to seize individual deposits from banks.  Still, the total problem is just $13 billion, a trivial sum in the scheme of Eurozone problems; this will likely be easily resolved soon, but there's a small risk that it will be the straw that breaks the overburdened camel's back.  
Ending corruption:  I promised Jose that I would ask for the input of my brightest friends and colleagues on ending Argentine corruption and that of other South American countries.  Jose has done his own research and estimates that the Argentine government accepts about $3 billion in bribes annually to dole out state construction contracts and similar projects.  This creates massive dislocations and inefficiencies.  Jose is looking for ways to make a difference, and exploring ideas like creating a Wikileaks type site to expose the corruption of individual politicians.  Some other ideas include creating an agreement with global financial institutions (either imposed from above like the Basel accords or as a voluntary organization), to stop funneling dirty money out of Argentina.  If politicians had no way to get sums larger than $1 million out of the country without anyone noticing, bribe taking would be greatly reduced.  We're looking for creative and practical ideas.  


Wednesday, November 7, 2012

Invest for Kids Conference 2012


    I had the privilege of attending the “Invest for Kids 2012” conference today, where a dozen of the most talented hedge fund managers and financial analysts discussed their macro views and their favorite investments.  My thoughts in italics.

Frank Brosens of Taconic Capital Advisors
  Favorite Investment: GM.  Sales are up 40% over the last 2 years, with stock price stagnant.  With the election out of the way, the treasury will now sell their 32% stake, at which point management will pay out $20 billion of stale cash to shareholders.  Fantastic new management recently took the reigns.  Next year is the peak of the "refresh" cycle with many new products coming to market, which boosts sales and margins.  And, they're introducing many new trucks, which are particularly high margin.  There's general pent up demand for autos, with the average car age now at 11 years, vs 9 in 2008.  Even with valuation at current low levels, the stock price could rise 200% based purely on growing revenues, higher margins, and better cash allocation.
   Last year Marc Lasry pitched GM at the Invest for Kids conference; I was interested but skeptical and didn't pull the trigger.  Now I'm convinced.  I like the near-term catalysts and GM's sales in the last year are very supportive of a higher valuation.

Nelson Peltz of Trian Fund
  Focus on the income statement - if you find $1 on the balance sheet, it's worth $1, but that same $1 on the income statement is recurring so it's worth $10+.  
  Favorite Investment: Danone.  Food companies are currently trading at a 15% premium to the S&P 500 instead of their traditional 30%.  Danone is a health and wellness food company with most of its revenue from yogurt, water, and infant nutrition.  50% of revenue from emerging markets.  Free cash flow yield of 7%.  Trading at 9x forward looking.  Forecast 50% stock price appreciation over 2 years.  

Kyle Bass of Hayman Capital Management
   The US is monetizing our entire fiscal deficit every year.  Japan is monetizing 2/3 of theirs.  It's kind of a joke listening to central bankers talk monetary policy.  They're monetizing all the debt, plain and simple.
   Favorite Thesis:  Japan is on the brink of collapse.  We've passed the Rubicon. They sell more adult diapers than children's diapers.  The ultra rich are starting to pull their money out.  Starting to see net redemptions from Japanese pensions.  The currency will collapse.
   I fully believe in this thesis, but timing has always been the issue.  I think we've likely crossed the tipping point and collapse is likely any time now, but it's unlikely to take more than 3 years.

Ari Levy of Lakeview Investment Group
  Favorite short:  IOC interoil company is a fraud.  They've somehow gained an enterprise value of $3 billion through an incredible marketing effort, despite having basically nothing of value.  They own land in Papua New Guinea that probably does not produce meaningful oil or gas.  They routinely lie to investors about those assets.  6 companies have explored and given up on the exact same land.  
  This is a good short in theory, but the short interest is 23%.  That's a recipe for a short squeeze.
Steven Romick of First Pacific Advisors
  Real GDP growth has been collapsing for 40 years.  It was 5.5% in the 1940s, 3.5% in the 80s, and now it's 2%, and to get the shrinking growth, we're having to use more and more debt.  
   Favorite Pick:  Renault - cyclical exposure to unpopular Europe, but 50% of sales outside of western europe.  Buy Renault and sell Nissan and Volvo against it and you're getting a free stub.  Renault could sell off its assets and buy back all its stock and you'd be getting the core operating business for free.

Alex Klabin of Senator Investment Group
   Favorite pick: Rayonier.  It's a big timber player in the US and also makes high end fiber products.  They produce 35% of the global supply of certain fiber products; great margins.  Because of growth, the company will soon have to end their REIT structure for regulatory reasons, which will likely entail spinning off the fiber business.  The whole business is being priced as commodity timber with a low valuation, so spinoff should unlock value.  He expected EBITDA will go up 50% over 2 years.  Sees 30-60% stock upside over that time period.

Steve Mandel of Lone Pine Capital
  Favorite Pick:  Verisign (VRSN).  Registry operator.  Gets paid $8 per domain name.  6% annual growth in domain names.  They sign a contract with ICANN that gets confirmed by the department of commerce that dictates the prices they can charge.  Likely to continue being able to hike prices by 40% every 6 years.  Trading cheap given the certainty of cash flows.

Sam Zell, Real Estate Mogul
  Must be a contrarian, and the confidence to do that comes from finding deep value with bottom up analysis.  
   Current macro environment is terrible and uncertain.  Doesn't see value in equities or real estate.
  Volatility is underpriced.  Bet on black swan events.

Kelly Cardwell of Central Square Management
   Favorite Pick:  NXST - broadcaster pure play.  Being unfairly lumped together with newspapers.  They're a major content creator with good asset allocation.  They've cleaned up their balance sheet in the last 2 years and are prepared to make accretive acquisitions.

Jim Grant author of Grant's Interest Rate Observer
   Interest rates are cyclical, and despite the 31 year bull market, it won't last forever.  
   Favorite Picks:  Buy gold.  It's a moratorium on the market's faith in central bankers and fiat money.  Buy Metlife insurance equity.  Smart management (hedged against the falling interest rate yields), trading below tangible book value, powerful brand, diversified sales.