Sunday, December 4, 2011

Economic Commentary: Eurozone crisis and Depression era politics - Ari

First I'll briefly discuss the Eurozone crisis and then delve into the possibility that the US will repeat depression era politics and fiscal policies.

The Eurozone crisis is truly in the endgame. Investors began shunning even German debt in the past two weeks and the EU leaders responded by swiftly negotiating for fiscal union. There is now a consensus that Europe must begin the formation of a fiscal union in the very near future (probably within 4 weeks) or face a self-fulfilling spiral into disintegration The big announcement three days ago of coordinated central bank intervention only prevented the collapse of several European banks this week. It basically provided unlimited overnight funding to avoid liquidity problems. It did not deal with the sovereign debt issue at all. A possible short-term bandaid that's being talked about is an $700 billion+ bailout for Italy that would include IMF funding. This would require a vote by Congress, and it looks like Republicans are unlikely to approve this. The real solution is to turn the eurozone monetary union into a fiscal union, but Germany wants to walk a fine line. They are advocating a fiscal union but say that the issuance of eurozone bonds is completely off the table. They're demanding almost unilateral control over the eurozone budgetary process, which is unacceptable to France. The ECB is currently standing firm against monetizing the debt of the profligate countries, but suggested they will be willing to step in aggressively if there is a credible plan for fiscal union in the future. I'm not an expert on European politics, but I'd guess that there's a 40% chance they'll form a meaningful fiscal union, a 35% chance the eurozone dissolves, and a 25% chance of something in between (e.g. a two-tiered euro or a couple countries leave). I've been short a small number of euros for the past two years and have scalped around the last couple weeks, but am retaining a small short position. We will likely get a major announcement within the next 10 days.

In the Great Depression, the economic consensus was for a policy of fiscal austerity. The wealthy banker Andrew Mellon advised president Herbert Hoover to, "liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people." Today economists understand that in a recession, companies and consumers deleverage, so the government must increase spending or you can get a downward spiral. To take a simple example, consider bank assets. In 2008, many banks were leveraged 40 to 1 or even 150 to 1. That means that if asset prices fell by just 2%, these banks were insolvent. When asset prices fall 1%, banks start selling assets to raise capital; this selling sends prices down further forcing more selling, which sends prices down further and so on. In the classical view of the free market system, smart buyers will step in to buy up these underpriced assets. But what if there's more forced selling than money available to buy? If the majority of investors try to sell at the same time, prices will continue collapsing until some new source of buying power enters the system. Partly because of President Hoover's fiscal austerity measures, the Great Depression became deeper and lasted longer than necessary.

Ben Bernanke learned this lesson and in fact wrote several academic papers on how the central bank should have "dropped money from a helicopter" back in 1930 to prevent the depression. Bush, Obama, Paulson, and Geithner were also determined to avoid repeating history and they launched the most ambitious fiscal stimulus projects since the New Deal. However, the political sentiment today is that we have little to show for the spending and money printing, and the excessive deficit is the biggest problem.

I see two likely political paths that both lead to bearish outcomes. The first is that the market and unemployment continue to improve through election day and Obama is re-elected. By choice or because he simply can't get Congress to pass any spending bills, government spending shrinks. This will happen automatically unless Congress reverses the automatic spending cuts that were part of the debt ceiling legislation this summer. Obama will likely resist republican pressure for even greater spending cuts and will be painted as profligate. Within a couple months of the next term, I would expect markets to be turning downward in anticipation of next recession that these spending cuts will almost inevitably create. Obama gets blamed for the worsening economy, and 4 years later we get a "tea party" style candidate who takes austerity to an extreme and creates deflationary pressure for an additional 4+ years.

The second path is that the government is unable to "juice" the economic data into election day and Obama loses. The republican led government imposes austerity which creates a recession. The negative effects of the austerity are quickly visible and the next candidate reverses course with mild "New Deal" type policies. Either way, it seems like we're going to be getting some form of fiscal austerity in the next few years that will be very bearish for the markets. Historically, the stock market has rallied strongly in the 4th year of a president's first term; the president has the ability and incentive to "juice" the markets in all sorts of ways. I wouldn't be surprised by a repeat heading into the upcoming presidential election and will be looking to buy equity puts if the rally happens.

It's worth repeating a key theme in this commentary of the last two years: company revenues, profit margins, and balance sheets are healthy; but only because of the exceptional fiscal and monetary policies. Back in 2008, the Fed made $7.7 trillion in loans to banks (the exact number was just made public recently), from which the banks profited directly by at least $13 billion. Of course, they profited much more indirectly by being able to avoid costly liquidations and continue funding their core operations. Similarly, the fiscal stimulus has mostly wound up in the coffers of large corporations. As soon as the US deficit shrinks, we'll see profit margins fall immediately, and revenue growth will likely decline after a small lag.

Friday, December 2, 2011

Blackrock (BLK) is a decent buy with high beta to equity markets - Alpha


BlackRock, Inc. (BLK) is an independent investment management firm with $3.345 trillion of assets under management (“AUM”) at September 30, 2011. BLK focuses exclusively on investment management and risk management, with no proprietary trading or other activities (like banking). BLK invests capital throughout the world and its clients include taxable, tax-exempt, and official institutions, plus retail investors and high net worth individuals. After combining with BGI in 2009, Blackrock has a platform of active (funds and managed accounts) and passive (ETF/index) products. Big competitors are Allianz (DB:ALV), State Street (STT), Franklin (BEN), Invesco (IVZ), Legg Mason (LM), and Fidelity (private).

BLK generates most of its revenues from fixed fees as a percentage of AUM; performance fees on a small asset base are much more volatile and adding or reducing revenues by 1% (so while most of this benefit flows to margins, it is variable and seen as a boost and not as core). The two largest topline drivers of BLK’s business, then, are total AUM overseen and the level of fixed fees, which varies by segment (it is higher for alternatives, lower for fixed income). Active equity, iShares, and active fixed income are the three largest product lines, accounting for 53% of total revenue. For expenses, employee compensation is by far the largest (36%), with G&A being almost half that.


Diversified investment product platform not-reliant on any asset class, fund, or region. As of December 2010, 67% or revenues are from the Americas and the rest from Europe and Asia-Pacific. The AUM base is split between equity (48%), fixed income (32%), multi-asset class (5%), alternatives (3%), and cash management (8%). The AUM mix is also split between active (38%), institutional index (43%), and ETF/iShares (19%). BLK’s strategy is to offer every type of product to clients, though its historical strength has been in fixed-income and ETFs (via BGI). As the CEO Fink noted on his recent earnings call, clients are reaching for yield and income products in the current uncertain environment, and BLK can promote existing products that meet this need.

Strong FCF generation and smart allocation of capital (though weak cash). As the chart to the left shows, BLK generates about $2.5bn of OCF with only $200-300mn of capex required. It pays a solid 4% dividend yield. One problem: currently if you add BLK’s excess cash balance of $2.92bn, its $1.40bn of investments, and deduct $4.79bn of total debt, BLK has -$0.47bn of net cash and investments. The lack of capital was driven by the recent capital drain from the BAC ownership repurchase. However, BLK is increasing its cash balance by natural cash flow generation.

BLK's Cash Flows and Dividends are Attractive

Superior management team and board. The management team headed by CEO Larry Fink is one of the best in the investment management business. No other publically traded investment management firm has anything like it. The company also has a strong board of financial experts (John Varley, Bob Diamond, Tom Montag, Deryck Maugham, Bill Demchak, etc.), unlike many other financial companies with general corporate or non-profit execs on their boards.

Valuation. Consensus forecasts for 2012 and 2013 suggest BLK will earn $12.5 and $14.4 per share in 2012 and 2013 for a 13.5x and 11.7x forward P/E. Compare BLK to peer multiples which trade in the 11x to 13x range. The FCF yield on the current price is about 4.4% based on 2010 FCF figures (OCF-capex), which is attractive when the 10-yr UST yields ~1.9% and the Barclays Aggregate yields ~2.4%. A DCF valuation suggests that BLK common stock is worth between $197 to $255 (key assumptions are revenue growth rates from 4.4%-7.0% with constant margins and equity discount rates of 9.1%-10.4% per the CAPM). The free cash flow yields on BLK are strong but its ROE at 6.4% is weak.


Active products could see outflows if they underperform peers, plus securities lending is a risk. Revenues in the active equity products can be quite volatile as AUM fluctuates. While the ETF and fixed income products are stable, the reputation risk of a real estate fund or niche equity fund blowing up could adversely affect other active products. Securities lending is akin to picking up dimes in front of a bulldozer. While BLK claims to only do this for clients and not take principal risk, investors should worry about risk controls in such a business.

Competitive fee pressures, low barriers to entry, and clients internalizing asset mandates could hurt pricing and revenues. Fees in BLK’s business range from 20bps to 2/20% deals for alternative funds. In general, the barriers to entry in the investment business are low as two people in an office with a computer terminal can compete. Also, as CEO Fink mentioned in his latest conference call, a worrisome trend is that some large plan sponsors may be internalizing investment operations to bring down costs; losing $10-$50bn mandates at a time is a risk.

Merrill Lynch or Barclays may fail in their distribution and backstop roles. First, Merrill Lynch provides distribution, portfolio administration, and servicing for certain BLK products and services through its various distribution channels. Loss of market share within Merrill Lynch’s Global Wealth & Investment Management (GWIM) business could harm BLK’s operating results (distribution concentration risk). Second, Barclays has certain capital support agreements in favor of a number of cash management funds acquired in the BGI Transaction; this lasts till December 2013. Failure to meet these could cause a cash squeeze at BLK.

Concentrated control of BLK stock by the board. Approximately 28% of the BLK’s common stock is held by Barclays and PNC. Both entities have given proxy control of their ownership to the board, which now has strong corporate governance control but significantly different economic upside vectors. This could lead to agency problems and the latest proxy statement suggests executive compensation is high (the top 3 execs earned about $20 million each in 2010).


• Possible Catalysts: No clear catalyst other than strong continued revenue and earnings growth. Weak global equity market performance could be a downside catalyst.
• Market Misperception: BLK, like most asset managers, trades at a P/E discount to other firms with similar cash flows due to the perceived volatility from their AUM and revenue sources. To the extent that BLK is diversified and has many passive products, its revenue volatility could be much lower (justifying a higher premium).
• Price Movement: The stock has moved within the $140-$240 price range in the last few years after bottoming at $92 in the 2009 trough.
• Buy, Sell, and Stop-loss Points: Target = $220.0, Current price = $169.02, Undervaluation = ~23%
• Recommendation: BLK is a fair BUY because it is a large-cap stock that is misunderstood by many sell-side analysts and large buy-side institutions. The current valuation gap is barely enough to make this underappreciated “blue-chip” stock a buy - it is roughly priced below the market with a potential for 3% to 5% of alpha over the next few years. BLK is a decent security to hold in a moderately concentrated pool of 15-20 securities for the financials bucket of the portfolio, instead of highly levered broker-dealer or commercial banks. Alternatives like V or MA should also be considered.

Sunday, November 20, 2011

Economic Commentary: Debt super committee, the Euro, and Profit Margins


The Debt Super committee, 3 day countdown
When congress agreed to hike the debt ceiling, the legislation included a provision for a "debt super committee." This debt super committee has until November 23rd to find $1.3 trillion in budget cuts. It looks like they will fail. When that happens, lawmakers then have 13 months to pass new legislation to avoid the automatic sweeping spending cuts defined in the debt ceiling hike. It looks like the next election will be a tremendously important referendum on what spending to cut. However the spending cuts and/or tax hikes happen, the effect is deflationary and will directly reduce GDP. If our political leadership manages the process intelligently, it could restore confidence in America's long-term debt situation, but I wouldn't count on it.

The Euro
There is a growing consensus that the only way for the Eurozone to avoid coming unglued in the near future is for the European Central Bank (ECB) to monetize the debt of Italy, Portugal, Spain, and possibly even France. Germany currently opposes this. Most European banks are currently insolvent on a mark to market basis, and situation that is very similar to the US in late 2008 shortly before Lehman collapsed. If the sovereign debt of the weaker EU countries continues to sell off, investors will refuse to lend to European banks (which hold so much of this debt at 40 to 1 leverage on their balance sheets) and they will rapidly collapse. If the ECB monetizes the debt, this should be bearish the Euro. What's tricky for investors is figuring out what will happen to the value of the Euro if the region splinters. If Greece leaves the eurozone, could the euro rally? What about if Portugal left? I wish I knew.

Profit Margins
Corporate profit margins have been remarkably high for the last 3 years and show no sign of falling yet. It puzzles many investors how this can be when unemployment is so high. The answer is government spending. If government spending were constant, then as companies cut costs it would lead to a vicious cycle of lost revenues; after all, one company's costs are another company's sales. However, the government has been picking up the purchasing slack. Companies lay off their employees to reduce costs, but are able to maintain revenue by increasing sales to the US government. As soon the annual fiscal deficit starts shrinking, we'll see corporate profit margins fall.

Thursday, November 10, 2011

Invest for Kids conference


I had the privilege of a attending the “Invest for Kids” conference this week, where 10 of the very top hedge fund managers discussed their macro views and their favorite investments. Some of the big names included Michael Milken the “junk bond king”, Sam Zell the real estate mogul, and Thomas Russo a top global value investor. In this commentary I’ve written up their comments and investment ideas. A caveat, while these guys are the best of the best, they still do no better than coin flippers when it comes to presenting specific predictions at these conferences. My theory is that this is because their biggest advantage is their sensitivity to price; they may have a contrarian view and love real estate, but they’re still making sure they get a great price on that homebuilding stock. So, I’d suggest using the commentary that follows as a way to generate ideas, but would caution against following it blindly. In my own portfolio I’m going to try to capitalize off a few of their ideas, and I’ll highlight these investments in the commentary that follows. My thoughts in italics.

Consensus: All the speakers who discussed macro views said they believe the Eurozone crisis will be resolved one way or another and the US will avoid recession. They expect 1-2% US GDP growth over the next 18 months, and on this basis, think the equity market is fair to slightly cheap. They are therefore comfortable investing in individual undervalued value stocks. Another theme was the rebound in housing; about a year ago many of the smartest investors began to aggressively invest in real estate by buying actual properties and renting them out. Today, this opportunity has been mostly exploited, and the REITs and homebuilder stocks may already reflect the current lack of fear; but they have plenty of additional upside if the housing market continues to recover, which it will as long as the US avoid recession.

Leon Cooperman (Former CEO of Goldman Sachs Asset Management and founder of Omega Advisors)
Notes: Average stock correlation is at all time highs by a large margin. US economy will avoid recession. The Eurozone will somehow avoid meltdown, not sure how, but you can bank on it. Unemployment rate will remain very high for 3+ years possibly leading to social unrest. Free cash flow is at record highs relative to corporate bond rates. Market valuation is very, very very low relative to treasury yields. Market currently discounting 30% chance of US recession and 70% chance of 1-2% growth. He is confident we’ll get the 1-2% growth so smart value stock buys should do well.
Favorite Investments: Etrade because the market hates them since they delved into the mortgage business and got slaughtered, but their mortgage book will be fully amortized in a couple years and their core business is strong. Charming Shoppes is a clothing store with the Lane Bryant brand that he thinks is a very strong takeover target. KFN is the finance arm of KKR; they pay a 9% dividend which they have easily covered. I need to do my own dilligence, but will likely buy a small amount of Charming Shoppes, and possibly a little KFN.

Tom Russo (Founder of Gardener, Russo, and Gardener)
Notes: He’s a super long term global value investor. Likes big multinationals because:
1. Big multinational companies can choose where to reinvest capital (e.g. they can move capital from Japan to Brazil, whereas local companies can’t).
2. When local subsidiaries have cash, they either pay a taxable dividend to parent company (and shareholders) or they make loans to the parent company at artificially low rates. Better to invest in the parent.
3. Big multinationals have more transparent culture and stronger ethics.
4. Global talent pool & best practices.
Very long-term growth comes from brand + ability to redeploy capital + capacity to suffer (i.e. ability to invest long-term and bear the costs of developing a product or market).
Favorite investments: Nestle, Unilever, Pernod Ricard. Very strong brands, big multinationals, that the investment community is undervaluing because they’re based in Europe. But…they do almost all their business internationally and getting most of their growth in Asia or South America. If Europe continues to unravel and the European equity markets reach obvious "fear" levels, I'll look at these and other European multinationals for long-term value.

Barry Sternlight (Real estate mogul and founder of Starwood Capital)
Notes: Housing starts are the lowest they've been in 50 years, so we're very quickly getting rid of excess housing inventory. It's becoming cheaper to buy than to rent for the first time in 30 years. Home ownership rate is now 66%, back to the pre-bubble trend. Prices are trending up except for distressed sales.
Favorite investments: Play the housing recovery with the homebuilders TOL and NVR; TOL has high end customers and NVR has great turnover. Or, buy LOW and benefit from home improvement expenditures as well as the "renter nation" effect; renting requires more annual maintenance costs than owning. I'll probably buy a few calls on one of these stocks as a short-term "story" play. I'd guess the "housing recovery" story is half way through its life-cycle; the smartest investors got in a year ago, but most money managers aren't yet buying.

John Keeley (Keeley Asset Management)
Notes: Looks for value in special opportunities, especially spin offs and Savings and Loan conversions. Spinoffs trade cheap initially because the new stock I s not in an index, institutions sell it, individuals sell it, and it has no street analysis to start. They are very attractive because they are in a focused industry which makes them easy to acquire and they have newly energized management. S&Ls will run into the arms of regional banks. Regulations makes them wait 3 years, at which point market value generally jumps from 1x book to 1.5-2.0x book value.
Favorite investment: ITT (post-spinoff), and TBNK because he thinks it will be acquired in the next year at a 40-90% premium. The S&L conversion looks like a cheap option; I'm pessimistic on the finance industry and banks in general, but if the interest rate environment starts to normalize, deposits should become valuable again so bricks and mortar S&Ls should have value.

Michael Milken
Notes: The financial world doesn't learn from the past. Sovereign debt has been horrible credit for 3 thousand years. In ancient Greece, the temple of Delos had to take an 80% haircut on debt on loans to several city-states. Greece has been in default 50% of the time since 1829. Modern capital markets were born in 1974 with the death of the "nifty fifty"; As inventors realized that "buy and hold" wouldn't necessarily produce consistent profits with minimal risk, they became interested in investing with money managers. "The world is moving east." In 2030, 60% of 20-34 year olds will be living in Asia. 40% of American women are now obese vs 2% in China and Japan. This costs the US $1 trillion a year in additional healthcare costs. In Asia, 15% of income is spent on supplemental education for children; in the US, it's 2%. There's a stupid belief that loans to real estate are naturally high quality; simply false. Regional real estate markets frequently go bust. In general, no one knows which way interest are going, no one.

Sam Zell (Real estate mogul and international investor. Chair of Equity Group Investments)
Notes: Demographics will drive successful investing. The emerging markets haven’t yet had their aspiration killed by the “roman disease” of entitlement. Brazil is growing fast, big enough to have good economies of scale. Great natural resources including self-sufficiency in food and energy. For private investment in emerging markets, you need a local partner or you’ll be taken advantage of. Ask yourself, where is capital most needed and look to invest there.
Favorite Investments: Look at Brazilian companies that service a fast growing, aspirational middle class. No specific examples given.

Richard Perry (Head of Perry Capital)
Notes: US Banks fund loans with deposits; loans are generally 95% of deposits. Italian banks lend 120%+ of deposits.
Favorite Investments: Likes preferred securities of the GSEs (Fannie and Freddie). Guaranteed fees are likely to be raised and the health of the US housing market depends on the GSEs. They offer very asymmetric risk/reward. Also likes RBS tier 1 securities because he thinks dividends will soon be "turned on."

Barry Rosenstein (Founder of JANA Partners)
Notes: Likes approaching investing as if he were still doing hostile takeovers in the 80s. Looks for situations where incompetent management is failing to release shareholder value.
Favorite Investment: McGraw-Hill. “Sleepy family business” that’s a conglomerate with 4 totally different businesses under its umbrella: education, S&P licensing, S&P ratings, and finance. Educational division is poorly run and appropriately has low valuations. S&P licensing is phenomenal and would get a very aggressive valuation if spun off. S&P ratings will do better than people think, risk from lawsuits and additional regulation is not terrible. He’s begun the activist process and management is open to spinoffs, stock buybacks, and cost cutting.

Marc Lasry (Avenue Capital)
Favorite Investment: GM is cheap and currently trading at 1x EBITDA (vs 4x for peers). Why? Because the government owns 1/3 of the equity. They have basically no debt. While I shudder to own company that represents such corruption and incompetence, it may indeed be a great contrarian investment. I need to do a little digging but will likely buy a little.

Michael Elrad (GEM Realty)
Notes: Less than 10 class A malls will be built in America in the next decade (there are currently about 500). Old tenants were books and music, new tenants are clothing stores; the malls do fine even if their tenants do poorly. They have very long-term leases, so a couple years of turmoil in rents isn't a threat.
Favorite Investment: Macerich (MAC). There are basically 4 companies that own 80% of the class A malls in America. Macerich is one of them and trades slightly cheap to its peers.

Saturday, October 8, 2011

Why I Do Not Short Markets and Securities - Alpha

After getting 29% returns on my short financials portfolio in 2008 (with no longs!), I eventually decided to stop shorting (I shorted Greece and the big Euro banks early in 2010, losing some money, but recently those trades have done well). In late July 2011 I made a call on the S&P dropping due to Euro bank fragility and a friend sent me this image of the market's return after the call.

A Lucky Call, or Obvious in Hindsight - "S&P500 Will Drop From August On"

My call worked out but I have a few reasons for no longer shorting. It boils down to...

SHORTING IS VERY DIFFERENT THAN GOING LONG. Superficially, the two are similar. You calculate the intrinsic value of an asset and then compare it to the market price. For a long, you buy the asset; for a short, you sell it. The biggest differences are time, risk/return profiles, and psychology. Also shorting is always speculation, but long investing can be speculation or investing (by the classic Graham/Buffett definition).

In long investing, time is your friend. When an asset's price stays low (or falls), you can keep buying it and "clip the coupons" of interest, dividends, etc. You want it to fall lower and can be patient. At an extreme, you want the price to fall below ST earnings or cash/book value per share. In contrast, when a short goes against you, your lender can crush you by forcing you out of your position or raising the collateral margin or borrow rate. Also, good news comes gradually and in a planned way but bad news comes in random and unpredictable bursts. This makes the timing of shorting very hard. If you're right on the fundamentals and wrong on timing, you lose big bucks and many nights of sleep.

2) THE RISK/REWARD FOR SHORTS SUCKS: For longs, your theoretical return is infinite but your loss is capped. You can lose what you pay but get a 10x-20x return. Shorting is the opposite. At most you can make 100% (2x) if the stock goes bankrupt; but you can lose an infinite amount if the stock rises for a while and the market stays irrational longer than you can stay solvent.

As numerous bubbles in the last 20 years (Tech bubble, housing bubble, sovereign debt bubble) and last 50 years (emerging markets bubble, S&L bank bubble, commercial paper bubble, etc.) have shown, markets can be irrational for long periods of time. Mr. Market is often right but sometimes a complete doofus. So as a short speculator, you need to have flair for timing and trading, whereas this is less important (not unimportant) for long investing. (NOTE: Two books I suggest you read about bubbles: Kindelberger, "Manias, Panics, and Crashes" and Hunter and Kaufmann's "Asset Price Bubbles.")
My thesis is that most value investors have long-term mentalities and so do not have the trading prowess to be short. This is fundamental. Temperamentally, you need conviction, emotional stability, and contrarian staying power to be a good long investor. These are bad qualities for a short speculator, who needs to be nimble and trade around positions a lot. A short speculator needs a high tolerance for pain and needs to wait through pauses or the market manipulation of management.

In sum, there are brilliant short speculators out there like Andrew Lahde and Jim Chanos (see the article below). However, the number of people that can go long and short smartly over time are rare (Steinhardt and Soros were legends in doing both, and Dr. Michael Burry comes to mind, but even he prefers the asymmetric outcomes of longs). Also, by shorting you can create stress for your own investor LPs (e.g. Burry and Julian Robertson) and even have a public reputation of profiting off of misery (as George Soros, John Paulson, and others saw).

My bottom line: Know your temperament and create a method that respects it. It's very hard to be both long and short. The Tiger Cubs follow the AW Jones model of a hedged 40% net portfolio with a book of longs balancing their shorts - this is one smart way to do it. A better strategy is to be long only and then switch to bonds and cash when timing requires it.

APPENDIX I: Eric Savitz's Notes from Chanos' Appearance at the Stanford Director's Conference on Jue 24, 2008

Chanos, the president of Kynikos Associates, which has $6 billion invested in bearish bets on the stock market, gave a talk at the Stanford Directors’ College, an annual symposium at Stanford Law School for the directors of public companies.

Chanos provided some insights on what he does, areas of the market where he sees opportunity to short stocks, and how directors ought to react when the find short interest in their stocks rising.

Here are a few bullet points from the talk:

** Chanos noted jokingly that he doesn’t often get invited to talk to corporate directors - and that when he does, “there tends to be a battery of lawyers in the room and a stenographer.” More seriously, he said part of his goal was to make it clear that shorts are neither “the evil omnipotent financial geniuses the market thinks we are on down days or the village idiots the market thinks we are on up days.”

** Kynikos has 5 investment partners with a combined 160 years of experience, and 20 investment professionals in all. Chanos notes that the firm has “no opinions on interest rates, or drilling offshore, or the dollar, or the Fed.” Instead, he says, “we are just looking at companies, the only place we feel we can add value.” And he adds that they “delve into companies more than you would ever want to know.”

** Chanos notes that there is a basic asymmetry in the financial markets; he notes that the short side is not simply the mirror image of going long. While he says they evaluate companies much like any securities analyst might, he says there is a distinct difference. Chanos notes that the daily “hum and drum” of Wall Street, where “the constant backdrop is positive.” He says that Wall Stret is “a giant positive reinforcement machine.” Chanos notes that his firm is short about 50 U.S. stocks and another 50 international stocks, and that every morning at least 10-20 of those have had estimates raises, or CNBC appearances by the CEO, or takeover rumors, or some other factor pushing stocks higher. “It’s the Muzak of the investment business,” he says, though “most of it has no informational content long term.”

** Chanos notes that people tend to prefer positive reinforcement; short-sellers, he observes, are constantly told “you are wrong.” The number of people who can take the heat and succeed professionally on the short side, he said to the assembled group of directors, “would fit at a couple of tables.”

** Chanos outlined some of the broad themes he follows in seeking out short candidates. One of those is “booms that go bust,” or more specifically, credit-driven asset bubbles. Examples include the telecom boom of the late 1990s and the commercial real-estate boom and bust that created the S&L crisis in the 1980s. (He says we could see another one in debt from private equity deals.)

** Another theme: technological obsolescence. “This is a very fruitful area,” he says. In recent years, he says, “the digitization of of many businesses has destroyed a lot of companies.” Chanos says he’s been actively looking for companies where the distribution of analog products had been digitized. He cites video rentals, music retailing and newspapers as a few areas where he has had successful short positions in recent years. Chanos says he’s currently short cable and satellite stocks on the theory that video will be the next area to be disintermediated. At times of great technological advancement, he says, there are often more losers than winners.

** Yet another theme: growth by acquisition, and its cousin, questionable accounting. Chanos says that most large acquisitions destroy shareholder value, rather than enhancing it. He also sees the potential for accounting mischief when companies take large charges and reserves related to M&A, allowing things to look better than they are.

** Another red flag, he says is the use of “irregular accounting.” He points to Enron as a prime example of the use of “mark to model” accounting, rather than “mark to market.” Another example, he says, was the use of “gain on sale” accounting at sub-prime lenders like the Money Store in the mid-to-late 90s. One more example he cited involved Tyco’s ADT home security unit. He says ADT at one point was buying up subscribers from other security providers for about $900 each, at a time when others were only willing to pay $600 per sub. He says the sellers turned around and paid ADT $200 in fees which were booked as revenue; the result was a net cost of $700, and at the same time, a magic way to turn capital into earnings. “Make sure your companies are not turning capital into earnings,” he told the directors. “The market will be fooled by that for a while, but then the lawsuits start flowing.”

** Chanos advised the directors to ask management for a concrete explanation when there is a short position building at a company where they sit on the board. “I guarantee you the CEO and CFO know why,” he says.

** Chanos said he’s often asked why financial frauds continue to occur, despite the installation of new rules like Sarbanes-Oxley. He notes two decade-old surveys that found a shocking number of CFOs that had been asked at one time in their careers to falsify financial results. A July 1998 Business Week CFO survey, he says, found 55% had been asked to falsify documents but refused to do; 12% said that had been asked and agreed to. A similar survey in 1999 by CFO magazine found 45% of CFOs had been asked by the CEO to falsify financial results. “There is a lot of hanky-panky going on in corporate America, gang,” he said. “And it continues to this day. There is always incentive to shade the truth, to make things appear rosier than they are.”

APPENDIX II: Dr. Burry explains his CDS short thesis of mortgage securities in two investor letters.

2006 Scion Letter:

2008 Scion Letter:

Michael Lewis on Burry (background):

Wednesday, September 28, 2011

Economic Commentary: Deflationary Wave - Ari Paul


A synopsis:
-Commodity complex down big, equities trading weakly in a range, treasuries on their highs
- Eurozone remains a slow motion crash despite the pro-active ECB
-Political deadlock in the US is a growing economic liability
-Consumer balance sheets remain just a couple paychecks from bankruptcy
-The long-term investment positions are long Brazil, Turkey, India, and China, neutral the US, and short the Eurozone. Shorter term this is probably priced in. The clearest part of the puzzle to me is the long emerging markets piece, but I'm not buying until I see more of the crisis priced in.
-The Fed's latest action "Operation Twist" is selling shorter dated treasury notes to buy longer dated treasury bonds. This caused the curve to "flatten", meaning long-term interest rates fell sharply. They hope this will support housing prices and encourage investment.

The trend in the market over the past month has been towards "risk off" and positioning for deflation. Copper has fallen about 25% and the commodity complex as a whole is down about 8%. Gold is at about $1650, down $250 from its highs. Silver fell more than 25%, turning my october silver puts into a nicely profitable trade. Equities have been trading in a broad range from around 1110 to 1121 in the S&P 500. This comes as more investors are accepting that we are either in a recession or very soon will be.

Europe remains a slow motion catastrophe; the European Central Bank has been incredibly proactive in coordinating aid to preempt each mini-crisis so we're seeing muted volatility. George Soros says a breakup of the EU is inevitable, but it's possible it could be done in an orderly way. He suggests that a disorderly breakup would cause economic calamity as all the Eurozone banks would be immediately bankrupt.

The markets generally like political deadlock. Usually, the less the government does, the better the stock market will fair. Today however, the "drama queen" congress is causing consternation. Most investors and economists agree that reducing spending in the short-term as the tea party demands is a recipe for disaster. The immediate effect of a reduction in government spending is lower employment and lower capacity utilization (i.e. more idle factories). Our best hope to get out of this mess is to combine an intelligent and productive increase in short-term spending with a credible commitment to decrease entitlements in 5-10 years. That was the idea behind the debt ceiling resolution, but as with all the bills coming out of congress in the past 4 years, it was so muddled and ambiguous that the market is skeptical it will meet either goal.

While the balance sheets of big companies remain healthy, the consumer balance sheet is basically holding steady just shy of bankruptcy. Take student loans for example (see attached graph). Student debt has been growing rapidly for the last 6 years and now stands at clearly unsustainable levels. The default rate on student debt rose from 7% to 8.8% in the past year. Unless the unemployment rate comes down soon, we're likely to see that number climb annually as each graduating class fights with recent graduates and the newly unemployed over the same small pool of jobs.

Over the last 3 years, emerging markets have done a tremendous amount of "catching up" to the developed world in terms of GDP growth but this isn't fully priced into the relative market valuations. If the US falls into deep recession these markets may again get hit very hard, but we want to be looking at these countries from the perspective of aggressive long term buyers. I'll write a much longer piece on this soon.

My positions: Small short S&P 500 position, small long crude oil position. Small short EUR/USD, very small short JPY/USD, very small long positions in a few equities including IPI. I covered my silver puts because they will be expiring soon but am considering buying more puts further out. My opinion on gold/silver remains unchanged - its a bubble and I'm unlikely to be able to spot the top with any confidence. Gold may have peaked or it may peak at $10,000, but in 10 years it will be lower than it is today. I really like crude oil as a long-term buy, but if we fall into global recession in the next year, it could get hit hard. I expect to gradually scale into a larger position if crude falls significantly. Around $75 is a long-term floor for crude (meaning it's highly unlikely that we spend more than a year below there). Even in a severe global recession, global crude demand is unlikely to drop much and at this point, I believe little to no growth is priced into crude.


Thursday, August 11, 2011

Economic Commentary: Eurocrisis - Ari Paul

Just as the world was breathing a sigh of relief over the resolution of the US debt ceiling issue, the Eurozone entered full blown crisis. A quick rehash of the fundamentals: Greece and to a lesser extent Ireland, Italy, Ireland, Portugal, and Spain, run excessive fiscal deficits and have much lower labor productivity than Germany. Generally this would be resolved through currency devaluation, but as members of the EU, they're stuck with the Euro and have monetary policy imposed on them by the European Central Bank (ECB). In 2010 the focus was Greece, and a few months ago that crisis seemed to have been averted with a nearly unlimited lending facility to Greece.

Now the market is "attacking" Italy and Spain by refusing to buy its bonds. As bond yields sharply increased over the last few weeks, economists did the math and saw that Italy and Spain could not afford to finance its debt at the new, higher yields. Since European banks hold tremendous amounts of Spanish and Italian debt, speculators presumed that they were suddenly insolvent as well. The situation closely resembled the week that led up to the collapse of Lehman Brothers in 2008. The ECB quickly intervened to buy Spanish and Italian bonds, temporarily halting the crisis. Ultimately however, this is a problem of productivity and leverage, not solvency. When we say that the "EU" bailed out Greece, we really mean Germany, since Germany (and to a lesser extent France) is the local powerhouse with a current account surplus and a balance sheet to handle the additional debt. However, Germany and France can't afford to bail out all the PIIGS. Investors have already begun doing the math that if we shift all EU debt to Germany and France, both have perilously high debt to GDP ratios.

For the past two years I've been skeptical of the US economic recovery, but my bullish friends could point to the reasonably robust GDP growth. It turns out the data they were relying on was simply wrong. The BEA released a massive second revision (detailed breakdown here) of the GDP over the past few years. Under the new data, the economy has yet to recover to its 2007 highs. The data coming out from most corners of the globe suggests slowing growth. Two months ago most economists were predicting accelerating global growth. Now the talk is of a high likelihood of global recession within the next 6 months.

The key factor working in the global economy's favor is that central bankers appear very pro-active. Switzerland, Japan, and the ECB have begun serious money printing operations and China is easing its monetary policy. Somewhat ironically, the US' Federal Reserve has been the laggard and provided little evidence of a third round of quantitative easing in their latest communication.
With the talk of global slowdown, all risk assets have been selling off sharply and treasuries have rallied. My purchase of silver puts appears very poorly timed as silver has been dragged up with gold. Gold is rallying as people purchase it to hedge their losing equity positions as well as on speculation that the money printing will cause inflation.

My best guess of how this plays out remains unchanged from 2008. Equities will remain weak for at least the next 2 years and unlike in 2009, they will not recover swiftly. Rather, they will stay at depressed levels for several additional years as "mom and pop" swear off the equity market.

Friday, July 29, 2011

QE3 and debt ceiling - Ari Paul

A month ago, Bernanke hinted at a possible third round of quantitative easing in response to weak employment and manufacturing data. It's just a hint for now but he appears more open to the idea than most pundits expected. It was this hint that sent gold and silver flying and provided broad support to most risk assets.

With QE1 and QE2, the Federal Reserve was the effective buyer of 95%+ of new mortgages and 100%+ of new treasury issuance; this kept interest rates low and prevented further declines in housing prices. The fed purchased these massive quantities of securities directly from the big banks at prices above market value, thus generating quick profits for the financial sector at the expense of taxpayers. The flood of cash also helped prop up commodity prices and trickled into just about every risk asset on the planet.

Most pundits believe a third round of quantitative easing is unlikely for political reasons, but most (myself included) were saying the same thing about QE2. A month ago, Bernanke hinted at a possible third round of quantitative easing in response to weak employment and manufacturing data. It's just a hint for now but he appears more open to the idea than most pundits expected. It was this hint that sent gold and silver flying and provided broad support to most risk assets.

The second key theme has been the US debt ceiling. I believe the risk of the US entering a state of actual default to be exceptionally low, but the market is hoping for a sustainable solution in the next few days. A good primer on the issue can be found here. The assumption, probably accurate, is that a solution that produces a sustainable long-term budget will result in a significant short-term equity rally. However, spending cuts and tax increases directly reduce GDP. To illustrate the point - an immediate reduction in government spending of 10% would induce an immediate recession. Admittedly, any plan will reduce spending gradually, spread over a long time period. Bulls can also argue that the greater certainty and confidence in US finances will promote corporate spending and hiring (a practical version of Ricardian Equivalence). Many business leaders have taken to bullhorns lately to explain that they are hoarding cash because they are worried about the unsustainable deficit; perhaps a resolution will loosen their purse-strings.

Friday, July 1, 2011

Economic Commentary: New Trends by Ari Paul

The last two weeks have presented a number of critical turning points. First, treasury securities may have finally ended their interminable bull run. Several treasury auctions "tailed" meaning that the government had to sell the treasuries at a significant discount to market value to complete the sale. This coincided with the end of QE2. It sounds too obvious that when the Fed stops purchasing treasury securities we get treasury weakness, but this caught many bond traders off guard. For the past two years I've patiently waited to short treasury securities, always thinking the time was near but not yet at hand. I'm far from certain that treasuries have topped out, since I remain skeptical about US economic fundamentals; If we get a severe recession in the next two years, treasuries may revisit their highs. However, I think shorting treasuries is now an attractive risk/reward proposition as a long-term bet.

The second theme has been gold and silver weakness. Contrary to popular belief, gold does not closely track inflation. Rather, it can be viewed as a hedge against negative real rates of return. When market participants see investments they like (positive real rates of return), they don't want to waste their capital holding an inert metal. When inflation is outpacing the return on capital, investors are content to hide their money under their mattress in the form of gold. Economic strength causes equities to rally, treasuries to sell off, inflation to increase, but gold price to fall. To beat a dead horse, the inflation that comes from a stronger economy does not produce positive gold returns. I own silver puts that settle in 4 months.

Equities have been very strong over the last week. Some of that is likely from end of quarter rebalancing and the (temporary) resolution of the Greek crisis with an apparent bailout agreement. We're likely to get some good corporate earnings announcements in July which could provide further strength. The same basic dynamic that has been in place for the past two years remains in force: corporations are healthy and possibly undervalued from a bottom up analysis, but the world economy remains in a "ponzi" state. The Eurozone, Japan, China, and US financial situations remain unsustainable and can be counted on to provide additional crises.

Long-term, the fundamentals of crude oil remain very bullish. Shorter term, there are many crosswinds. The IEA announced they will release 60 million barrels of crude oil; to put that number in perspective, the world consumes roughly 85 million barrels of crude a day. OPEC is struggling to maintain cohesion as Saudi Arabia is increasing production unilaterally after a failed OPEC meeting. The other OPEC members may move to tighten production to offset Saudi Arabia and such a headline would temporarily be very bullish for crude; I say temporarily because most OPEC members can't afford to reduce production since they need the cash flow. If you expect the global economic recovery to continue unabated, buying crude oil is a good bet and it will likely outperform equities. I'm hoping we get a dip to the $83-88 range before I buy.

Agricultural commodities have been very weak on the back of bearish crop reports. Basically, the weather for the previous two years was crummy and this year it's a lot better. I still like the long-term bullish agg story, but a safer way to play it at this point is via fertilizer producers.

Wednesday, June 15, 2011

Economic Commentary: Weak Data and the End of QE2 - Ari Paul

Equities fell about 6% over the past two weeks primarily because of very weak employment data; the nasdaq generated a never before seen series of 9 lower highs and lower lows to start the month.. Some other issues weighing on the markets include continued problems with Greece (they need and will likely receive a comprehensive bailout), a downgrade by Moody's of key Eurozone banks, and tightening credit globally. The ECB suggested they are likely to hike interest rates next month, South Korea hiked rates, and China is tightening credit. QE2 ends this month and has some investors nervous about who will buy US debt now that the Federal Reserve is done buying. Treasury prices have been strong because of the deflationary fears that accompany tightening credit and the weak economic data, but that could change quickly.

High Yield debt has sold off significantly, which is often a precursor of equity weakness. However, the put/call ratio is very high (often a contrarian indicator), and the VIX (a measure of the volatility expected by options markets) has remained low. Overall, this suggests to me that many market participants are pessimistic but are not expecting a wild sell off. Hedge funds are generally bearish, which can have a contrarian effect.

Crude oil has fallen with equities and the strong dollar; OPEC was expected to increase production but could not reach consensus; Saudi Arabia said they may increase production unilaterally.

Chinese equities have been weak for the past 9 months. This is partly because of fears of a Chinese credit or real estate bubble, and partly because many Chinese companies have been uncovered as a frauds, sometimes in very high profile cases. For example, John Paulson, manager of the one of the largest hedge funds in the world, lost $235 million in two days in his investment in Sino-Forest. A shortseller released research that the company was massively overstating assets...and the company neglected to deny the harmful claims. It was primarily this fear of fraud that kept me out of the Chinese market for the past two years. If the Chinese stock market continues to sell off, this will likely reflect more "spring cleaning" of built up problems, and will eventually represent an exceptional opportunity for value investors. I'm starting to hunt for gems.

Overall, I remain relatively flat and patient. If crude oil sells off another 4-8%, I may buy some as a longer term play. I am also likely to buy puts on gold and silver over the next couple of days; if deflationary fears continue to gather over the next couple months, gold and silver could get hit hard.

Monday, June 13, 2011

China XD Plastics - CXDC - A good buy when the world hates Chinese stocks? - Alpha

China XD Plastics (CXDC) is a microcap company selling plastics to car
manufacturers for parts like bumpers, door panels, and dashboards.
While it is traded on NASDAQ and has a legal domicile in Nevada (this
is not an ADR), the company's assets, operations, and sales are mainly
in northeastern China, based out of Harbin. The cheapness and
“growthiness” of the stock are self-evident and easy to quantify
(growing sales/OI/NI at about 40-80%, lots of cash and a healthy
balance sheet, PE of about 3.5); however, like hell and blind dating,
the risks are evident but much harder to quantify (but at this price,
a moderately diversified investor could deal with the uncertainty).

1. Products - CXDC makes specialty plastics for the Chinese automotive industry:
Its plastics are used for exteriors (automobile bumpers, rear- and
side- view mirrors, license plate), interiors (door panels, dashboard,
steering wheel, glove compartment and safety belt components), and
functional components (air conditioner casing, heating and ventilation
casing, engine covers, and air ducts). Over 30 automobile brands
manufactured in China, including Audi, Red Flag, Volkswagen and Mazda,
use CXDC parts.

2. The Chinese car and car plastics industry is booming along with the
Chinese economy:
In 2009, 13.8 million cars were sold in China, which increased by 45%
from the previous year (and from a base of 5.7mn in 2005, for a CAGR
of ~26%). It is estimated that the Chinese car market will grow by 15%
annually in the coming years, and the PRC government has a 5-year plan
to encourage car sales. Each car requires 100 kg to 150 kg of modified
plastic, which means that by 2010 the demand for modified plastic in
the Chinese car industry will be approximately 1.8 million tons (MT)
annually (3.2 MT for 2013). Harbin Xinda’s existing facility has an
annual production capacity of 100,000 MT. Installed annual capacity
of 165,000 MT in 2011, with 80% of the capacity contracted in 2011 and
plans to grow it by 30% for the two years after. However, car sales
growth can't continue forever (see the Risks section). The Chinese
economy (GDP) continues to grow at a 8-9% annualized rate, if you
believe their national statistics (if so, I have some mansions along
the 3 Gorges to sell you).

3. The competition is mostly one big German company:
BASF, the German company, has 65% of the market share (by sales) and a
local competitor has 16%. CXDC has a 6% market share. CXDC claims
that its edge over BASF is greater design flexibility for customer’s
individual requirements and that on average its formulation cost of
the products is 10-30% lower. For the local competitors, CXDC claims
it has the largest inventory of products certifications and the
largest number of variety of products to be offered to customers. I
haven't been able to verify this and so am treating the company like a
commodity manufacturer with a slight price edge against BASF.

1. CXDC is a growth company by sales, OI/NI, and FCF measures:
Like the Chinese car industry, CXDC's financials look like
radioactive, supergrowth mushrooms. From 2008 to 2009, sales went
from $75.8mn to $135.7mn, operating income from $9mn to $17.6mn, and
net income from $8.2mn to $4.1mn. Why the NI drop? The company
issued some warrants with preferred stock and revalued the warrants to
create a $12.2mn one-time non-cash “loss” (see Note 15 in the 10-K).
So annual sales were up 79% and OI about 100%. FCF went from -$16.9mn
to $3.3 mn. The Q1 2011 10-Q paints a similar picture. First quarter
2011 sales were $76.1mn ($50mn the year before), with OI and NI coming
in at $14.6mn and $11.9mn (compared to $8.4 mn and $13.1 mn). The NI
fell because CXDC started paying a standard Chinese tax rate of about
20%, whereas it had an exemption before to pay basically no taxes
(management in a conference call estimate that 20% would be the rate
going forward) – also the derivatives the previous year added to NI.
The operation margin went up from 17% to 19% from Q1 2010 to 2011
(gross margins have consistently been between 24-26%). 2011 revenue
guidance is $280-310mn with non-GAAP net income guidance of $48-51mn.
But can you eat it?

2. CXDC has a healthy balance sheet and healthy ROE:
CXDC has total assets of $184.5 with total liabilities of $66.9mn
($27.5 are ST loans from banks, with ~$20mn being deferred tax
liabilities). Current assets are at $135.8mn, with ~$31mn in cash and
~$27mn in accounts receivable. The Q1 ROE was 10.1% (the 2009 ROE
would be complicated due to the derivatives transaction and a
preferred dividend). Also total stockholders equity has grown the
last 8 quarters (from $104mn to $118mn just from Q1 2010 to 2011), so
it's a healthy check that the earnings are real (just as cash on hand
is the other check).

3. This growth stock is cheap... deep value cheap:
The expected 2011 and 2012 EPS is $1.01 and $1.18 respectively. The
6/9/2011 price is $3.59. So the 2011 and 2012 PE are 3.6 and 3.0.
Put another way, the enterprise value (EV = equity market cap + ST
debt FV + preferred & warrants - cash) now is ~$175mn and the non-GAAP
net income guidance is $48-51mn. The 2011 FCF I estimate to be about
$37-40mn, given a continuation of the Q1 earnings rate and historical
D&A and capex figures (keep in mind that capex is high at about $13mn
as management spends to grow capacity-maintenance capex is harder to
calculate). So the current FCF yield is about 23%. Auto suppliers
(when solvent) generally trade at 11-13x earnings. However I give a
2/3 discount to Chinese companies (my rule of thumb – see Risks
below). So 11 x $1.18 x 0.67 = $8.7 per share expected intrinsic
value for a 1-year hold (a range of $6 to $12).

A two-stage DCF for the company gives it a value of $8 to $14.50, given
my assumptions of ke = (11% to 15%) and g = (15% to 25%) - the model
has many other conservative assumptions.

1) It's a one man show but his team seems solid:
CXDC has 396 employees with 87 as temps. It's basically the Jie Han
show, as he co-founded it in 2004 and is now the CEO and Chairman. He
was previously in the nylon business, associated with the Harbin Xinda
Nylon Factory, which he founded in 1985. He has some political clout
as a deputy to the Harbin Municipal People’s Congress (prob. a bad
thing for foreign investors, but it depends on his probity).
Han has three lieutenants: Taylor Zhang as CFO, American educated,
former CFO of Advanced Battery Technologies, Inc (Nasdaq: ABAT);
Qingwei Ma as General Manager of Harbin Xinda since it was founded in
2004; and Junjie Ma as CTO (a polymer materials engineer with a few

2) The board is sterling and should be a good check:
The board includes: Yong Jin, a professor at Tsinghua University and
an academician of the Chinese Academy of Engineering; he knows the
ChemE and has more than 30 patent applications; Lawrence W. Leighton,
an international investment banker (Princeton and HBS, positions at
Bear Sterns, JPMorgan Chase Bank and recently as the CEO of the U.S.
investment bank of Credit Agricole, the major French Bank) – he is the
independent director on the audit committee and has his reputation on
the line for their veracity; and Cosimo J. Patti, a former banker who
is now an Arbitrator for the SEC and National Association of
Securities Dealers.
The 2 Westerners on the board and the Western-educated CFO should be
a decent fraud antidote as their reputations are on the hook; but this
is still a Chinese company so fraud is always a risk (see Risks).

1) Concentration risk (suppliers and a distributor):
Raw materials such as polypropylene, ABS and nylon come from 2
petrochemical suppliers (each providing about 50%). While management
claims they can get these from many suppliers, they claim to only have
chosen 2 to increase volume buying discounts. No way to verify this.
Also a rise in oil prices will cause these input prices to rise, but
again I have not found a way to model this on COGS. Sales through one
major distributor was 83% and 81% for 2008 and 2009, but the company
had no single customer above 10% of sales. CXDC has been getting
better, as the 2011 10-Q notes that “sales to three major distributors
accounted for approximately 60% of the Company’s sales for the three
months ended March 31, 2011, with each distributor individually
accounting for 33%, 14% and 13%, respectively” (it was 90% for Q1

2) Macro risks of China:
The PRC government could confiscate all assets, war or civil unrest
could break out, the management could perpetrate fraud or transfer
assets to itself (weak foreign investor protection and high agency
costs), etc. This isn't boilerplate – these are real risks in China.
Because of them, I have a rule of thumb that Chinese stocks should be
valued at 2/3 to ½ their American counterparts. See my general
discussion here:

3) Real estate bubble knock-off risks:
China is probably at some stage of a RE bubble, though Jim Chanos
thinks it's deep and late while Willem Buiter at Citi thinks it's very
early and “rational” because RE is a better place for Chinese savers
to store consumer savings than in banks that give them interest rates
much lower than inflation (you can refer to numerous reports on this
bubble). If the Chinese economy and home prices stumble, car sales
are bound to fall (and hence CXDC's sales). Past correlations between
house and auto sales are probably not reliable (both markets are so
new), so quantifying revenue impacts in a worst-case scenario is hard
(but that nasty tail risk still exists). See here for more
information and links:

4) Internal control risks and an auditor tiff:
In November 2009 CXDC fired its auditor Bagell Joseph Levine &
Company, LLC and hired Moore Stephens in Hong Kong. I investigated
this smoke and couldn't find any fire behind it (See the consolidated
2008 statements, with the auditor's opinion, and the company's
response and in the November 4, 2009 Current Report on Form 8-K). In
the 2009 10-K, CXDC admits its internal controls are weak and its
trying to strengthen them by hiring E&Y to bump up controls through
2010. I have no insight into how strong or weak the controls are (put
this into the “China fraud risk” box). Even 10-Ks are just marketing
documents that have been put under some scrutiny of human (not divine)
auditors and lawyers; each investor should be vigilant and exercise
her own judgment.

5) Current expansion could pose growth risks:
The company plans to grow capacity at about 30% annually for the next
few years. So capex is high and growth expansion always poses margin
and sales risks. Capacity growth doesn't mean sales or profits growth
will inevitably follow.

6) Micro-cap, illiquid float, penny stock risks, and high price volatility:
Since management/insiders own about 68% of the company, only about 32%
floats and the 10-day average volume is about 1.6% (250K out of a 15mn
float, with 48mn shares outstanding). Because the share price is
currently below $5, the SEC could subject the company to its penny
stock regs, and some institutional investors may not be able to buy
it. Also the stock's price volatility is very high over the last 2
years, from a $2 low in mid-2009 to a $11.15 high later that year.
Few investors can deal with this sort of roller coaster.

Recent 10-K:
Recent 10-Q:
Last Investor Conference Call:
Last Investor Presentation:

1) Corporate buyback plan - On April 7, 2011, the Company’s board of
directors approved the repurchase by the Company of up to $10 million
of its shares of common stock through May 31, 2012.

2) Completion of new capacity upgrade and continued high sales and
profit growth.

3) Management incentive agreement – if you read it closely, it seems
that management has an incentive to keep the stock price low in 2011
and then have it rise over the next three years (perverse).

4) Mr. Market sorts through “China Frauds” and revalues “China
Bargains” (one quick survey I took of other investors is that Chinese
stock prices, for ADRs and listed in the US, are hitting bottoms as
investors shy away from fraud and China macro risk... so a few pearls
are being sold as beads). Sino-Forest Corp. is just one example of a
potential China fraud, with high uncertainty:

5) The best catalyst would be for a value investor to take a $10-20mn
position and then sit on the board or be a board observer; either a
proactive activist or a PE investor may end up doing this.

UPDATE - Summer 2011: Morgan Stanley Private Equity Asia took a large position in CXDC - this should be a credible outside party to monitor management and control agency costs.

Thursday, May 19, 2011

Grantham's Bear Case - Ari Paul


Shortly after I posted Siegel's bullish narrative last week, a friend (thanks Alejandro) sent me a recent essay by Jeremy Grantham that serves as the perfect counterpoint to Siegel's bullish narrative. Grantham runs GMO and manages about $110 billion in assets. He is known for his long-term approach to predicting asset returns (latest 7 year forecast) and his bearishness over much of the last decade. In the essay (part 1 here, part 2 here), Grantham argues that the entirety of Jeremy Siegel's bull case is really just a 200 year hydrocarbon bubble. Grantham believes that global GDP growth has been above trend for two centuries because of the discovery of incredibly cheap energy...and that the age of cheap energy is over.

Grantham's argument:
The recent boom in commodity prices has reversed the downward trend of the last century. Even as the population increased more than fourfold over the past one hundred years, commodities produced negative returns because we were discovering and innovating even faster than we were consuming. The recent supply fundamentals suggest we're entering a new era. Productivity growth in agriculture has fallen from 3.5% a year to 1.5% a year. Growth in the oil supply has nearly stagnated and the average cost per barrel has more than doubled in real terms in the last 10 years, after staying roughly steady for 60 years. Every extra barrel of oil, ounce of copper, and bushel of wheat is becoming exponentially more expensive.

Economists generally believe that every $10 increase in the price of oil reduces US GDP growth by about 0.25%. The demand for oil by emerging economies (especially China), continues to rise at a dramatic rate, while supply growth stagnates. What will keep oil from climbing over $140 and eliminating US GDP growth? Optimists hope for sudden innovation in alternatives like solar or wind, but any transition will require at least 10 years to have a meaningful impact, and probably more like 20 years.

Grantham also focuses on the impossibility of sustained compound growth. As a colorful example, he asks us to imagine what would have happened if the Ancient Egyptians started with a cubic meter of physical wealth (say gold) and compounded it at a rate of 4.5% a year. How much would they have today? Their gold would completely fill more than one thousand solar systems. His point - if our demand for resources rises at all with our growth in GDP, then indefinite compound growth is impossible, and will catch up to us sooner than most realize.
Speaking practically, Grantham believes that bets on resource production and resource efficiency will pay off over the long-term. However, over the next 18 months he thinks there is a significant risk of commodity prices falling sharply because of a "blip" in Chinese growth, better weather, and the end of QE2.

To paraphrase Warren Buffett, it's never paid to bet against American ingenuity. Malthus predicted that we'd all die from famine because the world couldn't support a population of more than a billion people. Today we have nearly 7 billion with less famine than in Malthus' time. Who knows what innovations and discoveries tomorrow will bring?

Sunday, May 15, 2011

Economic Commentary: Siegel's Bullish Argument - by Ari Paul


I returned to my alma mater, Upenn, for my 5th reunion this weekend. I had the pleasure of attending a lecture by Jeremy Siegel. Siegel is a Wharton professor, the author of "Stocks for the Long Run", and the leading researcher of the returns of asset classes. He made a convincing argument that stocks are currently fair to undervalued and explained why the market never overshot as far to the downside as many bears expected in 2009.
The cornerstone of Siegel's research is the above graph. Invested over 200 years, a $1 investment in gold would be worth just $4.02 today (adjusted for inflation). A $1 investment in treasury bonds would be worth $1,530. A $1 investment in equities would be worth $700,000. While the equity returns are overstated because Siegel does not adjust for taxes or trading costs, the basic conclusion is valid. Perhaps more impressive is the consistency of the returns. The average annual real equity return has been 6.7% (after inflation) over the past 200 years. It has also been between 6 and 7.5% over any 50 year period you look at.

He recently extended the study to look at 16 countries with 100 years of data. While equity returns had a bit more range (from 3% to 9%), the difference between equities and bonds was remarkably consistent. Countries with an average real equity return of 3% had treasury returns near 0; countries with a 9% equity return had treasury returns of about 5%.

So, are stocks cheap? According to Siegel's 200 year logarithmic stock chart, stocks are currently slightly below trend. He also discussed the traditional P/E metric and said that the average is 15. In a low interest rate environment like we have now, 18-20 is more common. The current PE of the market is about 13, suggesting the market is perhaps 35% undervalued (more on this later). Siegel suggested that many stocks in China are remarkably cheap; the top 10 dividend paying Chinese stocks have a yield of over 5%, PE ratios of <13, and expected growth of 12% a year.

The role of interest rates also explain why the market failed to overshoot to the downside as much as prominent bears like Jeremy Grantham and Cliff Asness expected. In the 1970s and great depression, P/E ratios fell below 8. In March of 2009, they bottomed around 10. Siegel argues that in the 1970s and 30s, long-term interest rates on government debt provided a much more attractive alternative. When interest rates are 6%+, investors are much more willing to dump stocks. With the incredibly low interest rates in 2009, pension funds were unwilling to reduce their stock holdings; if they locked in a return of 3% in bonds, they would effectively be admitting to insolvency since they require a higher a return to meet liabilities.

As for future returns, Siegel is optimistic for structural reasons as well. His research suggests that long-term stock returns depend on long-term GDP growth, and long-term GDP growth depends on productivity growth. While short-term GDP growth is calculated as consumption + investment + government spending, long-term GDP growth depends almost entirely on productivity growth. Productivity growth depends on the number of people in a position to innovate and their ability to communicate. For example, before WW2, women were generally not part of the research and entrepreneurial community in the US. When we double the number of potential innovators, we more than double the rate of innovation because of network effects.

Today, technology allows a professor at Wharton to collaborate easily with a professor at South China University. The number of global innovators and their ability to collaborate is growing at fantastic speeds, which should lead to rapid increases in productivity, which will support strong global GDP growth and thus strong global stock returns.

Now for the criticisms of these arguments -
Siegel naively trusts earnings. While the earnings of non-financial US companies are of high quality today, the earnings of Chinese companies are certainly not. A significant percentage of Chinese stocks that are listed on US exchanges directly or through ADRs are reporting fraudulent financial data. If the PE ratios of Chinese stocks were really 12, they would be great buys, but the real PE is higher. They may still be great buys, but we need to dig deeper.

Second, Siegel makes a compelling argument that the low interest rate environment of 2009 is what generated the high valuation levels (relative to what bears expected). He also acknowledged that interest rates are likely to rise significantly (he guesses 3%) over the next 2 years. That means that while stocks may have been a great buy in 2009, they are not any longer as the market will (and possibly is already) anticipating the future higher interest rates. Given his own methodology and interest rate assumptions, fair in the S&P 500 is 1320 to 1530 (versus a current value of 1337.


Tuesday, April 26, 2011

The Segmented Market by Ari Paul

In this issue:
1) The Retail Investor
2) Long Equity Managers
3) Fundamental Hedge Funds
4) Short-term Equity Traders
5) Quants

For a PDF version of this newsletter, please look here:
Dear Friends, Colleagues, and Investors,

From the “Invisible Hand” to the “Rational Actor”, the “Electronic Herd”, or just the monolithic “Market”, we tend to think of asset prices as being driven by a uniform force. In reality, there are many different types of investors and traders who push and pull prices in myriad ways. The battle between these actors creates inefficiencies and profitable opportunities. I’ll discuss the most important market players and how their actions create distinct waves in asset prices. A rough estimate of the relative trading volumes:

1) The Retail Investor
The backbone of the stock market is the passive retail investor. Many people buy stock every year without giving much thought to valuation. Through the employer’s 401k, pension fund, or by consistent mutual fund purchases, these investors provide a relatively steady tailwind to the market. When the economy is doing well and they are optimistic, they invest more. During severe recessions they may produce net withdrawals. Even when their money is professionally managed by someone with great discretion, it tends to be invested in a way that is 100% long the market, and very diversified.

When these investors pour money into the market, the result is an indiscriminate rally that will lead to the overvaluation of some weak companies that are simply getting swept along. This causes the market truism, “a rising tide lifts all boats.” Over a 5+year horizon, their contributions will be influenced by the public attitude towards stocks and bonds in general. For example, for 20 years after the great depression, the American Public believed that stocks were inherently risky and unsuitable for most investors. Over a 10+ year horizon, contributions are also greatly influenced by demographics. As more Americans near retirement age, net investment into the stock market as a percentage of income will decrease. It’s also worth noting that passive investors are still relatively geographically isolated; American investors drive American stock market prices, and German investors drive German prices.

Over the long term, the valuation of a large country’s stock market is primarily determined by passive investors. To take advantage of opportunities created by the passive investor, we want to identify when they make poor choices. The simplest example is the passive investor’s exaggerated response to crisis. During a major war, recession, or natural disaster, public sentiment is likely to become extremely pessimistic. If the market has already sold off by as much as you think appropriate for the actual risks, it’s time to prepare for a contrarian trade. Similarly, we know that a young country with a growing economy will have a tremendous tailwind from a continuous flow of new earnings into the equity market. In the absence of a crisis, stock prices are likely to continue to rise regardless of valuation. As long as valuations are not obviously too high, we can ride the tailwind.

2) Long Equity Managers
These professionals consist of mutual fund managers and some pension and hedge fund managers. They focus on picking sectors that will outperform the market and individual companies that will outperform the sector. These managers usually have a 6 to 18 month investing horizon and they dominate the market in that time frame. They are driven by “ideas.” For example, a well respected analyst might put out a research report arguing that solar energy stocks are dramatically undervalued for various reasons. As this idea percolates through the market, fund managers overweight solar stocks in their portfolio. They tend to look for “pure plays”, stocks that are most directly tied to the investment thesis. They follow the dictum that it's better to fail conventionally than to succeed unconventionally, so they avoid “ugly” stocks, like those of companies embroiled in lawsuits.

It’s relatively easy to take advantage of these investors because their motivations are so clear. It’s sometimes possible to jump on a popular investment thesis near the beginning, but at the very least, you can avoid sectors that have already been pushed to bubble valuations. Because the fund managers look for “pure plays”, simple stocks are usually overvalued relative to more complex conglomerates. Conglomerates take more time to analyze and have less exposure to the trend, but frequently provide better value. Finally, these investors avoid “ugly” stocks because they don’t want to have to explain to their investors why they lost money on an obviously bad company. Ugly companies frequently provide the very best value investments for this reason. To borrow an example from the bond world, after Enron went bust in 2004, Seth Klarman of Baupost Group studied the company intensely and bought up a large portion of its bonds for 15 cents on the dollar. At the time he believed they were worth about 35 cents on the dollar and they paid off closer to 50. Most money managers didn’t want to risk losing money connected to one of the greatest stock scandal stories of all time; they were afraid to look stupid.

3) Fundamental Hedge Funds
The next economic actor at bat is the hedge fund that trades equities with a 1 month to 1 year time frame. Various hedge funds focus on long-short equity portfolios, predicting and trading around earnings announcements, medium-term technical analysis, and business cycle investing. The key feature of these funds is the timeframe, because they vary greatly in methodology and psychology. They are generally pretty efficient and rational in their investing process, but occasionally they fail spectacularly in ways that can be exploited.

In October of 2008, shares of the car maker Volkswagen soared 286%, making it briefly the largest company in the world. Many hedge funds had sold Volkswagen shares short because the company seemed generally weak and its stock overvalued. It was widely known that Porsche owned over 40% of Volkswagen shares, but Porsche had vehemently claimed they had no interest in acquiring more. Suddenly Porsche revealed they had secretly gained control of about 75% of Volkswagen, which meant that some shortsellers would be unable to find shares to cover their shorts. There was a stampede for the exits and as shortseller after shortseller bought back the stock, the price rose to the stratosphere. At that point, even hedge fund managers who wanted to remain short could not, because they were margin called and forced to buy Volkswagen shares. While equity hedge funds with a medium-term outlook are generally rational, extraordinary events can force them to create wildly mispriced valuations that we can trade against.

4) Short-term Equity Traders
Over a 1 minute to 1 month time frame, we have short-term equity traders. These traders are responsible for creating what we think of as the “efficient market.” They trade equities immediately after public announcements, natural disasters, economic releases, and even weather updates. When rumors float that a large hedge fund is getting margin called, these equity traders will fly like vultures over its corpse and take advantage of the resulting mispricing. Short-term equity traders try to anticipate the actions of the longer term equity managers and hop on “idea” trends at the very start. They ride the ebb and flow of bigger players’ orders.
These traders don’t frequently make “mistakes” that we can exploit as investors, but we have the advantage of a longer time frame. While they are rational at what they do, their disinterest in holding positions longer term means they leave a lot of money on the table. For example, after a subtle but strongly bullish announcement from a company, these traders will immediately buy a company’s stock, but if the stock price stalls, they may sell the stock out in an hour or a day. We can buy the stock from them and enjoy the gains over the next few months or years.

5) Quants
The last player in the equity game are “black box” hedges funds or “quants", and they represent about 70% of the trading volume. These traders program computer algorithms to trade in a time frame measured in microseconds to minutes. They immediately exploit simple arbitrages and use complex models to try to predict the actions of other market participants and jump ahead of them. For example, a computer program will notice that every 5 seconds, there is a purchase of 1000 shares of Microsoft stock. The program will purchase 10,000 shares and then sell the shares to the original purchaser every 5 seconds at a higher price. The quants make many basic mistakes. They overweight simple historical data and frequently fail to consider changing circumstances. For example, their programmers will estimate the impact of a good GDP number on stocks by looking at the impact of GDP reports over the last 10 years. However, they will likely fail to consider more subtle variables like current valuation levels, market sentiment, open stock option interest etc. Every once in a while, quants make eggregious, even comical errors. For example, during the “flash crash” of May 6th, 2010, quants sold the stocks of several large companies at $0.01.

It’s difficult to exploit quants unless you have access to similar technology. Even when the quants make eggregious mistakes, they are generally protected by the exchanges; the NYSE cancelled the trades in which the quants sold stock at $0.01. We can at least be mindful of their market impact. While quants are frequently thought of as “liquidity providers” in that they are constantly making markets and trade great volume, they become “liquidity takers” when the market is strongly trending. This means that a market with a high volume of quant trading is much more likely to experience a “flash crash.”