Friday, May 30, 2014

Profiting from Depreciation

Summary:
   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.

Yen
  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.

Cheers,
Ari

Tuesday, January 21, 2014

The view from 10,000 ft.

Investors,

   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.  

Cheers,
Ari





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.

Cheers,
Ari

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.

Cheers,
Ari

Friday, March 22, 2013

Backpacking in South America and a Global Update

Investors,

   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.  

Cheers,
Ari

Wednesday, November 7, 2012

Invest for Kids Conference 2012


Investors,

    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.

Cheers,
Ari

Friday, October 5, 2012

Whatever it takes

Investors,

   We remain in a central bank dominated market.  The German Bundesbank has given the go ahead to the European Central Bank (ECB) to buy up as many peripheral bonds as they want, and the ECB has loudly announced they stand ready to do whatever it takes to keep the European Union from falling apart.  In practice that means the ECB stands ready to buy as many Italian and Spanish bonds as investors want to sell.
   The US Federal Reserve announced similar intentions.  The Fed initiated a mortgage buying plan that entails purchasing $40 billion a month in mortgage backed securities (MBS).  About 90% of all mortgages in the US are turned into MBS and new issuance totals about $150 billion a month, although a good chunk of that is naturally amortized each month.  MBS analysts estimate this will have the Fed buying about 70% of all new US mortgages, in addition to their purchases of about 100% of all 30-year bond issuance.  

   This means that discussion of the fiscal deficit or debt to GDP ratio becomes almost silly.  The treasury issues new bonds to pay for government spending, which are then quickly bought by the Fed.  There's no legal limit to how much the Fed can buy, and now it appears there's no clear political limit either.  The point is that as much as at any time in the last few years, a bet on any asset is primarily a bet on the Fed.  If the Fed doesn't want the S&P 500 falling below 1400, they can buy up whatever assets are necessary to prop up equities.  The importance of the debt is almost entirely political.  We have a looming $600 billion "fiscal cliff" at year end, when spending cuts and tax hikes will automatically take effect without congressional action.  This leads into the need for another debt ceiling hike by April of next year; the exact timing is questionable since the treasury has some accounting slight of hand they can use to push the debt ceiling a couple months forward.  

    Many of the smartest investors I follow believe the deflationary and deleveraging pressures of the credit crisis fallout will continue to outweigh the inflationary pressure of the Fed's printing press for the foreseeable future - in other words, they think the Fed's money printing won't result in significant inflation in the next 2 years.    Additionally, the next political phase in the US is one of fiscal austerity, which is naturally deflationary.  This leaves investors in a tough spot.  It's hard to love shorting any asset when the Fed stands ready to buy with an infinite bankroll, but the fundamentals are bearish.  My positioning is unchanged with long commodity-related equity exposure and short equities in general.


   Finally, I'll leave you with some random insight from the best value investor you've never heard of.  Li Lu is a hedge fund manager and Warren Buffet's pick for one of the top 3 investors alive.  In 1989 he was a student leader of the Tiananmen Square protests in China before studying at Columbia.  Here is an interview he gave and here are notes from a lecture he gave at Columbia.  Lu makes use of traditional value investor metrics like price to earnings and price to book, but describes his role more as a journalist with insatiable curiosity who, on rare occasion, stumbles across an interesting story.  Before investing, he wants to understand the business behind the stock as thoroughly as though he owned 100% of it.  He suggests gaining a similar depth of understanding of the company's industry.  
   
Cheers,
Ari

Thursday, June 7, 2012

Europe faces reality

Investors,

   Last week, many headlines blared: "Europe finally faces reality."  There is now consensus that either the Eurozone will dissolve or Europe will finally form a true fiscal union.  Just about everyone agrees the latter is preferable, but Germany insists it will not back eurobonds or deposit insurance unless countries cede control of their budgets to a central European authority.  Most other eurozone countries (including France most importantly) are refusing to give up sovereignty.  Investors are optimistic that Eurozone leaders will quickly lay out a plan and the ECB will plug any gaps in the mean time.  To make it clear just how dire things are in Europe - both Italy and Spain will begin defaulting on debt within 4 months without additional aid.  This week, Spanish ministers began openly begging the ECB for aid for its banks, announcing that the market is refusing to finance Spanish debt. 
    I can't handicap this game and I think Europe's problems are probably fairly priced in the market.  If Eurozone leaders get their act together in time, equities will pop, otherwise they'll plummet.  There's probably no value in us betting on the outcome at this point.  I covered the last of my short euro position.
    While the world watches Europe, my concern remains the US.  Most data out of the US last week was dismal, ranging from increasing unemployment to worsening PMI indexes.  I remain very concerned that early in the next president's term we'll get fiscal tightening and the austerity will have dire effects.  Additionally, the market is now pricing in some form of additional quantitative easing, but I expect that a basic extension of "operation twist" and even large mortgage purchases will be met with an equity sell off.  Without something more aggressive, investors will rightly wonder what difference another 30 basis points in lower yields will make when 10-year notes are already at 1.6% and 30-year mortgages are at 3.8%.  Anything short of outright money printing is just "pushing on a string." 
     Back in 2008, I was convinced by my study of economic history that the collapse would likely come in two waves.  First we had a very sharp collapse followed by a sharp rebound.  Then I expected a second wave down after which equities would simply sit near their lows for an extended period, probably several years.  The first rebound happened sooner and was sharper than I expected because of the unprecedented quantitative easing.  I don't expect to time the second wave any better, but I remain confident in the general pattern.  So, I'm in no rush to get long equities in general.  Don't worry about repeating 2009's mistakes and missing the rebound.  Still, I'm a value investor, and I'm always on the lookout for specific value opportunities.  Today that means I want to find the most hated stocks so I'm looking in Europe, and in the beaten down energy sector.  My schedule as a trader and MBA student keeps me busy and makes value hunting difficult, so if anyone has any specific picks in these sectors, I welcome suggestions.  One last point - given the strong rally in treasuries and sell off in risk assets and the constant talk of Europe, it feels like the risk is for a continuation of the trend - more bad news, deflation, and "risk off."  The opposite is true.  Anyone with more than a 6 month time horizon should be far more concerned about inflation.  The market is already pricing in global recession with some small chance of global depression.  That's why investors are accepting yields of below 0% on short-term Bunds, and below 2% on 10-year Japanese, German, and US bonds.  To sleep soundly at night, we should be confident that our portfolios will withstand the surge in inflation that is very likely to start sometime in the next 5 years.    

Cheers,
Ari

Wednesday, May 16, 2012

Economic Commentary: A political and possibly a monetary turning point

Investors,

   The big news of the last few weeks has been out of Europe.   For the past 4 years we've had loose monetary and fiscal policy in the US and relatively tight monetary and fiscal policy in Europe.  I believe that is about to switch.  Now is a good time to identify attractive European equities and European assets that will benefit from increased spending in the near future.
- France just elected the Socialist Francois Hollande; I think he's a moderate at heart but will reverse the relatively extreme austerity that Sarkozy was championing.
- In the past week, Greece roiled markets as voters gave support to parties that are declaring all debt agreements void.
- The unsustainable debt and unemployment situations in Spain and Italy have led to increasing bond yields and growing concern, highlighted by a major bank bailout in Spain announced last week.
- Germany's bundesbank may finally be throwing in the towel on inflation and we may get another major money printing operation from the ECB soon.

  First on Hollande - the markets view him as a big question mark. He's advocating "growth" policies as opposed to Sarkozy's austerity, but no one knows the specifics.  My own take is that Hollande is really a moderate and will not make any radical changes.  Analysts are suggesting that his election and that of Greece mark a political turning point.  Voters are rejecting austerity programs that are ostensibly in the service of foreign debt holders.  However, France has no printing press.  Hollande can increase government spending, but I doubt this will have much of an impact.  French banks have little in the way of excess reserves, so just about every euro that Hollande spends will effectively cause a decrease in private sector spending of a similar amount since banks will have to buy the additional sovereign debt instead of lending; in contrast, banks in the US have lots of cash sitting under the mattress so an increase in government spending would likely increase total consumption.  Hollande might want to be profligate, but in the short-term it won't matter since France's total consumption will change little.  The key is the pressure Hollande is likely to put on the ECB to print Euros.  More on this shortly.
    I don't know what will happen with Greece, but at this point if they leave the Eurozone or default on the bulk of their debt it will be neither shocking nor particularly important to global markets.  Greece's stock market is down 90% from its highs and much of their sovereign debt has already been written off by investors.  The focus is rightly on Spain.
    Last week the Bank of Spain announced a partial nationalization of the large institution "Bankia."  The announcement included a rough outline for a plan requiring all Spanish banks to set aside more reserves, which will further reduce lending to the private sector.  I've said it before and I'll say it again - austerity has never succeeded in getting a country out of a deflationary recession in the history of the world.  Spain will either slide into crisis, or the EU will have to embark on a radical change in direction with a money printing scheme.  With Spanish youth unemployment at 55%, I'll be surprised if we don't see major social turmoil in the next year. 
    The ECB created a trillion euros as part of the ongoing peripheral Eurozone bailout...and it's clear that was no where near enough.  Spain needs more money ASAP and France will likely be demanding easing soon.  Murmurings from Germany's bundesbank suggest they will soon give in and allow further monetization of the sovereign debt.  Back in 2008, the US Federal Reserve doubled the money supply and yet deflationary forces were stronger than the money printing.  I don't know which force will prevail in the coming year in Europe, but the looser monetary policy will likely generate a bid in real assets.  I continue to favor energy commodities and related equities.  
  

    My positions are unchanged - very small short euro position, short yen, I'm continuing to gradually ease into a long-term short treasury note position, and I'm long energy related equities.  With the exception of the small euro positions, I'm viewing these positions on a 3-10 year time frame.  I want to increase my energy equity investments so if you have any particular ideas or analysis, I'd love to see it.  I also want to invest in European assets - they're incredibly unpopular and the wave of fiscal and monetary easing will provide a tailwind - and would appreciate suggestions.

Cheers,
Ari