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.