Risk Over Reward

Economic Commentary: Shorting Japan

2012-01-23T20:26:00.000-08:00

Investors,

First I'll offer a quick update on the global markets and economy and then zero in on my next big bet: shorting Japanese Yen and government bonds.

The last two months have been relatively quiet for the global markets despite plenty of scary headlines. Iran threatened to close the strait of Hormuz and crude oil rallied moderately. US equities started strong on the back of better than expected employment and consumption data and were then further buoyed by good news out of Europe - Spain and Italy were more successful in their debt auctions then expected and Greece may be nearing a resolution with debt-holders for an orderly restructuring. The Euro has gradually sold off and I covered almost all of my short Euro position. I'm generally too early in covering my winning bets, but with record short interest in the Euro, the downtrend may have run its course for a while. A good line about the Euro comes from Jim Rogers; Rogers has been bearish on the Eurozone for a decade but is long the Euro at the moment because he believes that while the Eurozone will eventually collapse, it won't be this year or next.

I've talked before about Japan's coming crisis, but was reluctant to pull the trigger on a major bet because I didn't feel like I understood the timing well enough. I still don't have a clear picture of how the crisis will unfold but I believe I can structure a bet with excellent reward for the risk despite the uncertainty. I'm shorting both Japanese Yen and Japanese government bonds.
Why short Japan? First the basics - Japanese debt to GDP is around 230%, far higher than any country has ever been able to sustain in the history of the world. Social security alone accounts for 52% of the government budget. Japan has gotten away with this debt load primarily because almost all their debt is owned domestically (about 95%); the Japanese people keep buying debt that yields almost 0% for cultural reasons and because the government requires them to do so (many institutions are required to have huge holdings of government bonds). The demographic situation in Japan is rapidly worsening. The percentage of elderly Japanese is rising from 17.4% in 2000 to 25% in 2014 (versus 12.8% in the USA.) Now throw in stagnant growth in tax revenues and the fact that 25%* of tax revenues go to pay interest on the debt. This is debt that yields close to 0%! It's easy to see that if Japanese debt sells off even moderately and yields climb just slightly, the country will almost immediately have to choose between defaulting and monetizing its debt.

What could trigger yields to rise? While Japan's fundamentals have been worsening for a decade, their bonds were supported by increases in savings. The rate of savings has been gradually falling but nominal savings were increasing. The savings rate has is now on track to hit 0% and turn negative in the next few years. Another specific catalyst is that the latest data from the Japanese government suggests that Japan just experienced its first trade gap since 1963! As Japan's current account surplus vanishes, that means there's less excess capital to buy Yen denominated bonds.
So how does this crisis play out? A lot of the demand for Japanese bonds exists because the Japanese have had more than a decade of deflation. A 0.5% yield is tolerable under these conditions. Once yields start ticking higher and headlines of "Monetize or default?" start flooding Japan, at least some of the bond holders will start to sell. With every tick up in yields, the situation becomes exponentially more vicious. Even a 1% increase in long-term yields would produce an immediate cash flow crisis. Most likely, the central bank will start to purchase the bonds to keep yields down. This monetization will produce the threat of inflation, causing more bond selling, forcing more central bank purchases leading to a rapid and large devaluation of the Yen. The Japanese government would likely sell holdings of US securities to partially finance these purchases so we might see brief but sharp upward pressure on the Yen for this repatriation of government assets. Any scenario I try to envision of Japanese bond yields rising seems farfetched to me because it would be suicidal for Japan, but I'll be shorting Japanese bonds in case they choose not to monetize. In case I'm completely wrong and Japan starts to finally experience growth, this may also lead to higher bond yields so the short JGB helps to reduce the risk exposure with, I believe, a positive expectancy hedge. With long-term yields near 0, I'm getting a very cheap option on higher yields.

I should also note that a crisis in Japan will surprise many investors with its contagion effect. We rarely think of Japan as a key driver of the global economy, but Japan is the third largest economy in the world (just slightly behind China) and represents almost 9% of global GDP. Japan is also the second largest holder of US treasuries and US dollars in the world. In a crisis, they will likely become aggressive sellers to raise money.

Backpacking Through China: An Investor's Perspective

2012-01-06T04:57:00.000-08:00

Investors,

For the past two weeks I backpacked along the southern and eastern coast of China and found a very different country than I expected, simultaneously more modern and more authoritarian and culturally isolated. My tour included the wealthier and more modern areas of Guilin and Yangshuo in Guanxi, Shanghai and nearby Nanjing and Suzhou, and Beijing. I focused on trying to understand modern China from a business and investment perspective. The basic themes prevalent at every level of society and business were cultural isolation, materialism, and exploiting the outside world by any means necessary. I'm more confident than ever that China's domestic demand will grow exponentially and the Chinese people will quickly gain managerial, marketing, and engineering expertise...but this will not necessarily translate into returns to foreigners. The Chinese Communist Party (CCP) and People's Liberation Army (PLA) play a deeper role in commerce and the public markets than many suspect. The government is pursuing policies to exploit western commerce while remaining economically and culturally isolated in critical ways. China is a dazzlingly large and complex place; with 1/4 of the world's population and the largest economy within a generation, we have every reason to try to understand it.

Infrastructure and Travel Limitations
My first surprise was both the success and authoritarian nature of China's investment in infrastructure. China's highways, airports, long-distance buses, and high speed trains all put the US to shame. Shanghai's subway system was second only to Tokyo among the cities I've visited, and the regional airports and train stations were highly efficient. The authoritarian counterpoint was that China has extreme restrictions on travel for domestic citizens under the Hukou (household registration) system. ID cards and intense security are employed for all inter-city travel. Poor Chinese are basically forbidden from traveling to major cities. For much of the trip, I traveled with my friend, the brilliant UCLA MBA student Arun; he's spent a great deal of time in India and contrasted Shanghai with cities like Mumbai or Delhi where beggars fill the streets. Throughout my travels in China I encountered virtually zero begging and almost no homelessness. This reflects the travel restrictions, and quick action of the police to relocate the beggars away from prosperous areas. Putting aside the question of morality, this has helped attract foreign capital and modernize cities like Shanghai with remarkable speed.

The epitome of China's recent construction is Pudong, the new financial district in east Shanghai. Twenty years ago, Pudong was literally boggy farmland. Now it hosts a modern financial center (likely to become Asia's predominant center of finance within a decade) and some of the most impressive architecture in the world. The eastern part of Pudong consists of residential compounds for the very wealthy. I briefly stayed with my friend's family in this area and was surprised by the isolation. Within these new gated communities sits mansion after mansion with a surrounding tiny 0.5 acre yard, live-in help and paid driver; in front of many houses were two or three ultra luxury European cars. The mansions are occupied by a mix of rich Hong Kongkese, Communist Party bigwigs, foreign executives, and a few rich mainlanders. While the mansions all look gorgeous, they are poorly constructed and epitomize a theme of Chinese production; shoddy craftsmanship is considered the rule, even for luxury goods. I should note that Shanghai's gleaming modern skyline was constructed mostly by state owned companies; the holy grail of Chinese modernization is more like Singapore on steroids than western style capitalism.

Cultural Isolation and Chinese Youth
While most Chinese study English in school, the young Chinese told me that they felt it was perfunctory; the government actually discouraged serious attempts at fluency. Western English media is either censored or strongly discouraged, and most Chinese feel like English is unlikely to be useful for them. This made communication difficult; my attempts at speaking a handful of Mandarin words from my guidebook were mostly met with blank stares, probably because of my poor use of tones and the limited experience of the Chinese at hearing their language mangled by foreigners. The lack of English language is likely to be a persistent obstacle to China's international economic growth. English has become firmly entrenched as the international language of business, and China has among the lowest English fluency of any country in the world, (maybe excepting countries with mastery of other imperial languages, like Angola).

Economic inequality in China is a cliche, but I was surprised to find a stark three tier system of both income inequality and economic freedom. First are the rural (and semi-industrial) poor. The poorest farmers (more than 1/4 of the country) use primarily 18th century technology to farm small plots of land in a lifestyle that is probably not all that different from two thousand years ago. Bridging the gap to modernity are the temporary factory workers; young women in particular move to factory towns (and live in factory dorms and eat factory cafeteria food) for a few years and then return home with their saved money. These people are restricted in their movements and live in under the thumb of CCP authoritarian rule. The second tier are the educated "middle class." Generally young, well educated, ambitious, and materialistic, these people live primarily along the coast. I believe one of China's biggest problems is the perceived ceiling at the top of this class. I spoke to a twenty-something accountant working for Deloitte in Shanghai. He said that if he works hard and does a good job he can achieve a comfortable middle class lifestyle, but without family connections in the Communist Party he will hit a wall. Because of this, he and many other people like him feel that the best opportunities are outside of China; he wants to move to the US, New Zealand, or Australia. As an aside, he said that middle class Chinese don't want to move to Europe because they view it as a "sunset society." The middle class is carefully monitored but generally enjoy free movement and can easily evade authoritarian limitations like the Great Firewall and capital controls (more on this later). The third tier, a tiny proportion of the population, probably less than 0.10%, is composed of the very rich. These are Hong Kongkese, foreigners, top Party Officials, and Red Guard elite; they are functionally exempt from all authoritarian controls as long as they avoid displeasing any political leaders. At this level, political connections and wealth are easily converted from one to the other. Political "entrepreneurs" have purchased the title of provincial party secretary for as much as $500,000; the few cases we learn about are of entrepreneurs who were later convicted for corruption, usually taking several million dollars in bribes within a few years of gaining their new post.

Young Chinese care little for politics. They share a general pessimism about the structure of Chinese society and view the Party as monolithic and unbeatable in the medium-term. In the words of one Chinese professor, "[The youth] may risk their lives to steal money, but they will not do it to attend a political demonstration." The Chinese twenty-somethings I spoke with all shrugged when asked about the long-term prospects for reform. Their focus is on advancing their own position and that means cozying up to the party or leaving China. One young Chinese professional told me that in college, talk of politics was discouraged and students were generally uninterested. The Chinese youth are conservative in other ways as well; pre-marital sex is uncommon, drug use is unheard of, and alcohol and tobacco play a very minor role. When asked about China's economy, they were optimistic, but less so than most westerners. They think a significant portion of China's recent growth has come from unsustainable government spending on infrastructure.

I ran into the "Great Firewall", China's method of controlling the internet, when I attempted to purchase a book about China for my Kindle from Amazon while in staying in Beijing. The internet connection timed out for 2 minutes. The exact rules of China's firewall are constantly changing and opaque. Basically, it slows down all internet access of sites outside China and prevents access to "distasteful" materials like pornography and any news or commentary critical of the CCP. It can be easily and legally circumvented with a proxy or virtual private network (VPN). So why does China bother if it's so easy to ignore? While anyone can easily circumvent the firewall, it plays a powerful role in controlling the media that most Chinese consume. A Chinese woman can do a search on Baidu with servers located within China and get lightning quick responses, or she can access a slow and censored google, or buy a VPN to access uncensored google. For most Chinese, they simply don't bother using anything but Baidu, because they have no reason to. It never occurs to them to do an internet search for "CCP official embezzlement" because they're never confronted with those kinds of stories in the first place. As Americans, we're frequently confronted with stories that are distasteful to the government, like say Abu Ghraib torture, without having to do a specific search for it. The Great Firewall lets the elites access whatever they want, while the vast majority of the country is content to consume the media approved by the CCP. Another effect of the slowing of external sites is that all media companies that want to produce for the Chinese market must locate their servers in China, which places them under the power of the CCP. The result is primarily self-censorship with the occasional arrest of a dissident blogger or raiding of an internet server center. A random aside, Baidu not only censors on behalf of the CCP, it sells Chinese companies the right to hide negative search results.

Party Rule and the People's Liberation Army
China is a blend of a benevolent Singaporean style autocracy, a capitalist development state like Japan, and robber-baron socialism like Russia. For national matters the Party enjoys complete central control. China is run by 9 people, the Party's "Standing Committee." These are selected from the 25 person politburo who are selected from the roughly 370 person "central committee." The People's Congress (about 2200 people) periodically rubber stamp these rulers. The Chinese state firmly retains a Leninist structure - mirroring the state at every level is the parallel but superior Party. Hu Jintao is the state president, but more powerfully he is the party secretary. The key to the CCP's control is the power to appoint and remove personnel. The CEO of every large company, the president of every major university, the chief of every police bureau, and every provincial governor serve at the pleasure of the CCP and are appointed by the completely secretive "Organization Department." The result is that all the major commercial and political organs serve state interests when so ordered. In 2009 while western governments were imploring big banks to lend, the CCP ordered Chinese banks to do so. In the west, bank lending shrunk; in China it surged 50%. “As an organization, the Party sits outside, and above the law. It should have a legal identity, in other words a person to sue, but it is not even registered as an organization.” – He Weifang, law professor.

It's critical for investors to understand that the western style boards of large Chinese companies are a facade. A party committee oversees all major strategic decisions of these companies and has final say. One striking example was in 2004 when the CEOs of China's largest 3 telecom companies were "shuffled" with no prior warning. One of the CEOs was on a roadtrip in the UK to pitch investors on an upcoming share sale when he was abruptly informed by the CCP that he was to immediately resign his current post and take control of his primary competition. It was as though the CEOs of ATT and Sprint suddenly announced they were switching places. In 2009 the exercise was repeated with 3 major airlines. Similarly, western investors need to understand that there is no independent judicial system. Judges are completely under the thumb of the CCP.
It's worth noting that the centralization of power is complete only for national matters. Provincial governments and townships enjoy tremendous freedom, largely because Beijing lacks the power to enforce their authority far beyond the city limits. In my readings, I found numerous examples of local leaders ignoring Beijing edicts from the Cultural Revolution to the present day. In general, the recalcitrant officials are not openly rebellious, rather they pay lip service to Beijing and just substantively ignore the CCP orders. On rare occasion CCP leadership will make a show of jailing or executing these leaders, usually under unrelated corruption charges. While the most egregious cases of corruption are prosecuted (e.g. Li Gang and Ma De), for the most part local officials are allowed to be corrupt as long as they stay under the radar and support the Party. Additionally, on very rare occasions there are obvious rifts within the power structure of the CCP, as when Jiang battled Hu over Shanghai corruption in 2006.

The People's Liberation Army (PLA) has one purpose - to keep the CCP in power. Another way of phrasing the same proposition is that the CCP relies on the PLA to maintain its power. The recent state and Party leaders Jiang and Hu spent an inordinate amount of time visiting military installations to maintain this support. While details are unclear, it appears that in the Tienanmen square uprising in 1989 a significant percentage of soldiers and commanders were reluctant to attack their fellow citizens (aka the treasonous protesters). The party responded by strengthening its oversight and integration with the military. The PLA has always been involved in the economy. Sometimes recruited to work on industrial projects, they have also invested in companies and stated businesses to boost their meager budget. In the 90s, the CCP ordered the PLA to divest most of its economic interests, but PLA leadership remain among the wealthiest Chinese with tendrils that reach into every industry. One American businessman who spent years working with Chinese factories told me that many of the factories he dealt with were secretly run by a single PLA gang; he learned this when investigating why factories that should have been competing with one another were instead acting as a cartel.

Contrary to this picture of a reactionary and unchanging leadership, both the Party and PLA are rapidly modernizing in their own way. The Party has started eagerly recruiting the brightest students from college and inviting star entrepreneurs to join their ranks. The PLA has become much more merit based and is working to become a modern military. In this way, the leadership has created a social safety valve by offering the ambitious but unconnected a way up the ladder, while simultaneously improving the skills of the ruling class.

History
It's worth taking a slight historical detour here. There are some themes that recur throughout China's 3000 year past that I believe are still in play. First, modern China sees itself as the descendant of Imperial dynasties that ruled the Han people (representing 92% of modern Chinese). While China actually spent about half of its history in more of a federalist system and much of its time under foreign (i.e. non-Han) rule, it's the imperial dynasties that consistently wrote China's history books and today form its political lineage. From around 50 BC, these dynasties employed a complex meritocratic system of staffing the bureaucracy. The theme of centralized power rippling outward through talented bureaucrats remains in vogue today. Second, China has never been particularly interested in international trade. In the BC era, China routinely turned away foreign trading missions, asking for only pledges of sovereignty and tribute in the form of silver. Even when it briefly ruled in the oceans around 1350 AD, China's fleets made a few trips to other countries to demand allegiance and then abandoned the routes out of a lack of interest in the resulting trade. In 1793, a British trading mission was famously told by Emperor Qianlong that China had no interest in British manufactured goods. The opium wars 50 years later were partly an attempt by Britain to eliminate the massive trade surplus China enjoyed as they exported tea and silk and imported mostly silver. I think today's economic policy reflects a similar sentiment but with a twist - whatever foreigners make that the Chinese want, they are determined to learn to produce themselves. This is of particular importance for western companies that hope to sell in China, a topic I'll delve into further in the next section.

Another theme from Chinese history is historical revisionism necessitated by the power of ideas. Most imperial dynasties burned older histories, executed the authors of non-favorable histories for treason, and ritually revised the past to make their own authority look like an obvious extension of the past. In the past century, China underwent several such revisions. For example, Mao disdained Confucius and cited the early Qin dynasty as exemplary. Today's communist party is reemphasizing Confucianism and disdains the Qin period as too authoritarian. In the mid 1800s, a group of nationalist Christians led the Taiping rebellion that resulted in a staggering 20 million dead. Mao's Great Leap forward led to a similar number of lives lost from famine. Ideas in China are powerful and the government correctly views ideas as weapons. This explains their aggressive censorship of seemingly benign intellectuals and religious leaders.

International Trade and Materialism
Arun and I paid special attention to China's brands. So far, China has produced few brands that can compete internationally (Lenovo is a rare exception). Chinese companies have excelled at cheap manufacturing, but can they move up the value creation chain and produce a Nestle or General Motors? While we saw many examples of weak Chinese branding and amateurish advertising, we also saw some examples that should make western brands concerned. China has knockoffs of Starbucks, KFC, Nike, and just about every other major international brand that appeared well executed to my untrained eye. Ultimately though, I think it matters little. Chinese demand is likely to rise so quickly that China doesn't need to find a foreign market for its brands, at least not in the next decade. It has 1/4 of the world at home. That's a lot of feet to wear Li-Ning (the local brand equivalent of Nike).

The problem facing western brands trying to access China is one of regulation and price. On one popular shopping street in Suzhou, I saw a Nike store, Li-Ning, and then a tout selling fake Nike. The real Nike shoes cost about $160, Li-Ning was $60, and the fake Nikes (of lower quality) were $20. Most western luxury brands actually cost much more in China than in the US and Europe, despite being manufactured in China. One common reason is that the companies have export-only licenses so the goods must be exported out of China and then re-imported back in and face tariffs. Alternatively, KFC is omnipresent in China and faces no premium since there's no export involved. As investors, we need to distinguish between western brands that effectively do business locally (like KFC), and western brands that must import some element of the business (like Coach). At best the latter group will face an uneven playing field and at worse they could be forbidden from selling in China at any time. Foreign companies need a license to sell within China and this license is viewed as a privilege and can be revoked on a whim.
China has adopted a policy of requiring foreign corporations to form local partnerships. I spoke to a senior executive at Ford who explained that lately the Chinese have been demanding not only partnership in the ownership structure, but also in the high-skilled labor; Ford is required to locate a major engineering office in China if they want to continue to do business there. Unabashedly (and I'd argue very intelligently), China is aggressively studying the technological and managerial expertise of the companies that do business there. The Chinese government understands the idea of "smiley curve." In a product's life cycle, there is a lot of value created in the design and engineering phase, only a little during manufacturing, and a lot during marketing and retail. For example, of a $30 pair of headphones sold in the US, only about $3 stays in China. China wants a bigger piece and has the policies in place to get it. What does that mean for Ford? While I think that Chinese demand will grow fast enough to provide plenty of sales to both Ford and local brands, it ultimately depends on what line the Chinese government chooses to pursue. If they decide it's in China's interest, the government will not hesitate to withdraw the permits that currently allow foreign brands to sell within China.

The Chinese clearly intend to exploit western companies for profit, expertise, and as corporate police. One example of the latter comes from Macau (also spelled Macao), a small island south of China that was originally a Portuguese colony and is now a special economic zone of China. Macau has been a crime ridden center of gambling, organized crime, prostitution, and money laundering for much of the last century. One man, Stanley Ho, had a legal monopoly on casinos. Recently, the Macau government (with Chinese encouragement) invited a half dozen US casinos to establish operations in Macau. These casinos, including Wynn resorts, have their global operations scrutinized by the Nevada gaming board. They have to play by the same rules in Macau as they do in the US. As a result, they have a clear incentive to report unfair and illegal activity of their local competitors to the authorities and to establish infrastructure that rewards a clean gaming economy.

A key question concerning China's future is if they can generate the domestic demand to reduce their reliance on exports. I find it impossible to understand how anyone who has visited China could doubt that the answer is a resounding Yes. The Chinese are arguably the most materialistic people in the world today. The middle class Chinese are incredibly aspirational and consumption driven. They desperately want to improve their quality of life and understand that education and hard work are the way to get there. Contrary to the communalism imposed by the government, individual Chinese are entrepreneurial spirited. Everyone I spoke to supported the idea that most people in China are looking to improve their economic status quickly, either from temporary factory worker to skilled labor, or from mid-level auditor to investment fund manager. In Shanghai, conspicuous consumption abounded from knockoff Rolexes to genuine European luxury cars. The religious practices in China support this materialism. In the words of one young Chinese professional, the Chinese Buddhists are not really religious but just come to temple on rare occasion to pray for wealth or good test scores. This was in line with my observations at the Buddhist temples; the "prayers" available for purchase (ribbons or wood carvings with text) were for wealth, good test scores, a job promotion, or having a male child. While some books suggest that as many as 80% of Chinese are a member of one religion or another, the Chinese people I spoke with thought the real number was a small fraction of that. In China's early history Confucianism may have been an obstacle to economic growth since Confucius disdained merchants and trade. The Confucianism of China today ignores these tenets and emphasizes the ideals of a harmonious society and respect for authority.

The Environment and New Construction
I was apprehensive about traveling to Beijing after reading stories of air so polluted that it made breathing difficult. In 2006, blue skies were a distant memory and on most days, you couldn't see more than a few hundred yards because of the thick smog. Remarkably, Beijing is less polluted today despite a doubling of cars on the road. In the government's 11th five year plan, released in 2007, the Chinese government fully acknowledged their environmental catastrophe. They publicly accepted that the pollution was reducing GDP by as much as 3% a year, killing tens of thousands of people a year, and reducing the expected lifespan of the general population. As a result, the government enacted some of the most vigorous environmental controls in the world. These included car emission regulations that are more restrictive than in the US and regulations and subsidies to put modern pollution scrubbing technology on factories and power plants. It's hard to overemphasize this point. The Chinese environment is still a mess, but they are devoting tremendous resources to cleaning up; China builds about 50% of the world's solar and wind plants and is investing $1 trillion over the next decade in renewable energy. The environment is a national priority at every level, from the top of the CCP to the average entrepreneur. Local officials are now judged on both environmental and economic metrics. While Beijing air remains significantly more polluted than Manhattan, the results were clear. On my last day in China, I was able to enjoy Beijing with clear blue skies. An obvious place to look for investment opportunities in China is in companies that produce "green technology."

My friend Arun and I debated whether China will face a hard landing in the next 4 years (I think so, Arun disagrees). I'd need another few pages to delve into the macroeconomics, but one turning point for China is clear. At least the current wave of real estate and construction spending is over. The Chinese government recognizes this and recently announced the construction of 30 million low income homes in the next five years. Critics argue that the "home" in question is sometimes as small as 150 square feet and little more than a berth for temporary laborers. Also, provinces are counting projects already underway as part of the new home construction figure, but it's still a massive undertaking. The goal is to support the construction and real estate markets while providing political cover for the CCP in case unemployment rises and GDP growth slows. Investors need to keep a close eye on such projects. The initial boom in infrastructure was largely productive; China needed highways and high speed rail. The next round may consist mostly of bad loans for "bridges to nowhere."

Conclusions
Learning about China will be a lifelong endeavor as I chase a quickly evolving target. I don't pretend to understand China, but this trip and the associated conversations and readings have given me a rough sketch. First, China may claim to be the oldest surviving civilization, but it is a young and materialistic economy; it will continue the process of industrialization, urbanization, and especially, rapid growth in consumption. Second, China is authoritarian and savvy; the government is using their power to exploit western technology, expertise, and capital; success in China (or selling to China) requires dealing with the CCP. Third, the Chinese are incredibly aspirational and will work hard to advance in life; I believe they will likely reshape the nepotistic CCP structure around them (especially if the USA keeps stupidly denying visas to their best and brightest). China will continue its expansion as a global economic power. They will inevitably grow from the manufactures of the world to also challenge the west as engineers, designers, and marketers. The key question is: will they choose to isolate themselves or will they gradually integrate? Will the government focus on import replacement and continue to "protect" the population from foreign goods and media, or will they globalize?

The advantages of investing in a company like Ford that is based outside China, is that they have much stronger corporate governance and are subject to western laws. The string of recent Chinese accounting frauds is just the tip of the iceberg; investors in Chinese companies will be in for a bumpy ride for the next generation or longer as they find no legal system to protect them and few sympathetic ears in government. However, China may continue to block imports by restricting permits, employing tariffs, and giving home grown companies special advantages; if so, foreign companies that are attempting to sell to China may end up as poor investments. I haven't come to a satisfying conclusion yet, but I think the answer lies in carefully investing alongside mainland Chinese. For example, as the majority investor in the mezzanine debt in a state owned company, you are likely to find yourself defrauded. If you own 2% of the senior debt or equity of the same company, you are investing alongside the Chinese and the company's management will have a tough time singling out your investment for "special" treatment. If this analysis seems too paranoid, it's worth looking at other historical precedents. Large US companies routinely defrauded British investors in the 19th century through dilution of equity and subordination of debt among even less subtle methods.
China's booming economy and sheer size will offer tremendous opportunities for investment over the next generation. With some smart decisions and a careful approach, we can profit from what may end up being the single most important secular trend of our lifetimes - the rise of China.

Cheers,
Ari

Aside from my own observations and discussions with Chinese locals and expert foreigners, I am indebted to three books. "The Party" by Richard MicGregor is a phenomenal look at the modern Chinese political structure. "China: A History" by John Keay is a great overview of ancient China. "Postcards From Tomorrow Square" by James Fallows is a short collection of essays with some revealing anecdotes about Chinese culture.

Economic Commentary: Eurozone crisis and Depression era politics

2011-12-04T13:38:00.000-08:00

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.

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

2011-12-02T19:41:00.000-08:00

BUSINESS DESCRIPTION

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.

INVESTMENT MERITS

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.

INVESTMENT RISKS

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).

RECOMMENDATION AND PRICE TARGET

• 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.

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

2011-11-20T03:06:00.000-08:00

Investors,

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.

Invest for Kids conference

2011-11-10T17:45:00.000-08:00

Investors,

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.

Economic Commentary: Occupy Wall St

2011-10-28T19:15:00.001-07:00

Investors,

60 years ago a wealthy man owned and operated a factory and made 20x what his workers made. Today, the wealthy man got wealthy by lying about the value of derivatives and made 100x the earnings of the workers in the pension fund he fleeced. The Occupy Wall St movement reflects disillusionment and anger; beyond that there are few shared goals. However, it plays a critical role in the 70 year boom-bust cycle we're experiencing now. In this commentary I'll discuss the movement, where we are in the boom-bust cycle, and some political views. First, a very brief rehash of the recent news and market action.

Recent News and Market Action:
Eurozone political leaders announced a new resolution; it's far from a solution to the Euro problem, but a legitimate strong step in the right direction. They've organized an orderly default of Greece (that will not legally be called default to avoid triggering Credit Default Swaps), an increase in the EFSF bailout facility to a trillion euros, a plan to recapitalize banks, and additional austerity measures. It reduces the risk of a catastrophic disorderly default, and so the market rallied strongly on the news. Equities were oversold at the start of the month, so the anticipation and realization of this good news led to a whopping 14% rally. I just sold my long crude oil position for a 13% gain, probably far too early but I am again uncomfortable being long any risk assets. If the market continues to rally I will scale into a larger short equity position. Global economic releases have been generally bad suggesting a global recession is still the base case.

The 70 year boom-bust cycle:
Historically, developed markets experience 70 year credit booms followed by major busts. The basic pattern is that the boom begins with real growth in productivity, this kindles "animal spirits" and encourages entrepreneurship, investment, and easier credit. Over time the general public becomes giddy with the pace of development; politicians reduce regulation which leads to booming profits, especially in the financial sector. Eventually the credit gets too easy and rational greed becomes stupid greed and we get a bubble. When the ponzi scheme of easy credit reaches its pinnacle, the bubble collapses and we go through a painful deleveraging process. Excessive debt can be eliminated in 2 basic ways - you can pay it off with profits (or taxes in the case of national debt) or you can forgive the debt in bankruptcy court or a similar restructuring. When a credit bubble is unwinding, profits and tax revenues are shrinking, so option #1 is impossible. So far, the government has tried to shuffle the debt to parties more able to bear it and to push the debt into the distant future when hopefully tax revenues will be higher. There are also plans for additional debt forgiveness for homeowners and students.

The role of social unrest:
You may recall in mid 2009 that I questioned why we didn't see more social unrest. In my studies of history, every major credit crisis has resulted in significant social upheaval. I wasn't expecting revolution in the USA, but isolated riots could be expected. At the time, this influenced my belief that the "bust" portion of the cycle had much further to go. I continue to believe that until we see major social unrest and the average american swear off equity investing, that the "bust" portion of the cycle is not complete. Right now we're seeing the early stages of a major social movement. The mainstream media continually understates the size of the demonstrations, but they are large and growing. What can we expect in the future? This is a difficult question because early stage social movements are chaotic beasts. I am very curious as to how the social will eventually be converted to the political. President Obama seems to be trying to co-opt the movement, but he has proven he lacks the stomach to confront special interests. The ultimate outcome of the anger will likely be sweeping regulatory reform. Economists and politicians currently believe that the "too big to fail" banks must be kept gigantic; they believe that there are inherent economies of scale in banking and that smaller banks will either be uncompetitive or simply reunite like the Ma Bell telephone companies. If this view holds, the only option is to more thoroughly socialize the banking system. Banks will likely be separated into retail banks with government backing and implicit subsidies that remain huge, and investment banks that will effectively be forced to shrink in size as they lose the implicit government support. The result will likely be that the finance sector in general becomes smaller and much less profitable, both at the corporate and individual level. As investments, the financial sector is likely to underperform the broad market over the next twenty years.

The politics:
A frequent criticism of the Occupy Wall St movement is that it has no cohesive goals. This is a valid criticism - the movement includes both socialists and libertarians - its members call for more government redistribution of wealth and better health care and support for unions - and the exact opposite. The greatest theme that resonates with me, and I believe will eventually resonate with the middle class, is one of fairness. I am a tremendous champion of capitalism. The problem today is that the government is supporting crony capitalism. Small banks recently had their fees and taxes hiked to pay to support a handful of "too big to fail" banks. Incompetent CEOs are receiving $10+ million dollar golden parachutes even as their companies are saved from bankruptcy with taxpayer money. Companies like General Electric have an entire branch devoted to lobbying government for customized tax loopholes; these loopholes make it nearly impossible for smaller companies that can't afford similar lobbying to compete. This isn't a question of wage inequality or liberal vs conservative politics. This is a question of integrity. It appears to many observers (myself included), that government regulation is actually entrenching corrupt business practices. Businesses are then forced to either compete with their own lobbyists and unethical financial schemes or to resign themselves to shrinking profits or even bankruptcy. Citigroup CEO Charles Prince said, "When the music's playing, you've got to dance." In today's oligopolistic industries which include the banking sector, ratings agencies, and even software, our only hope is for the government to turn off the music and stop encouraging the unethical behavior.

Back in 2009 I tried to do my part and voiced support for a "Tobin Tax": http://www.riskoverreward.com/2009/11/in-support-of-tobin-tax-vega.html

Cheers,
Ari

Why I Do Not Short Markets and Securities - Alpha

2011-10-08T17:23:00.000-07:00

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).

1) TIME IS YOUR ENEMY WHEN YOU SHORT: 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.

3) PERSONAL AND MARKET PSYCHOLOGY: 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: http://www.scioncapital.com/PDFs/Scion%202006%204Q%20RMBS%20CDS%20Primer%20and%20FAQ.pdf

2008 Scion Letter: http://www.scioncapital.com/PDFs/Scion%202008%201Q.pdf

Michael Lewis on Burry (background): http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt-201004?printable=true

Economic Commentary: Deflationary Wave - Ari Paul

2011-09-28T07:51:00.000-07:00

Investors,

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.

Cheers,
Ari

Economic Commentary: Eurocrisis - Ari Paul

2011-08-11T13:52:00.000-07:00

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.

QE3 and debt ceiling - Ari Paul

2011-07-29T16:30:00.000-07:00

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.

Economic Commentary: New Trends by Ari Paul

2011-07-01T15:49:00.001-07:00

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.

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

2011-06-15T15:09:00.000-07:00

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.

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

2011-06-13T10:03:00.000-07:00

A. SUMMARY
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).

B. BUSINESS, INDUSTRY, & COMPETITION
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.

C. FINANCIALS & VALUATION
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.

D. PEOPLE
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
patents).

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).

E. 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
2010).

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:
http://www.riskoverreward.com/2010/01/how-to-invest-in-china-miracle-where.html

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:
http://seekingalpha.com/article/256768-where-is-the-chinese-real-estate-bubble
http://www.washingtonpost.com/blogs/post-partisan/post/is-chinas-real-estate-bubble-about-to-burst/2011/03/04/AF8qvV0D_blog.html

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.

F. SUPPORTING DATA
Recent 10-K: http://www.sec.gov/Archives/edgar/data/1353970/000107997310000463/cxdc_10k.htm
Recent 10-Q: http://www.sec.gov/Archives/edgar/data/1353970/000107997311000389/cxdc_10q.htm
Last Investor Conference Call:
http://webcast.mz-ir.com/publico.aspx?codplataforma=2545
Last Investor Presentation:
http://cxdc.irpage.net/tl_files/upload/PDF/CXDC_May_2011_PPT_Final.pdf

G. CATALYSTS
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:
http://www.nytimes.com/2011/06/10/business/10norris.html?_r=1&hpw=&pagewanted=print

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.

Grantham's Bear Case - Ari Paul

2011-05-19T15:02:00.000-07:00

Investors,

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.

Criticisms:

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?

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

2011-05-15T13:14:00.001-07:00

Investors,

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.

Cheers,

Ari

The Segmented Market by Ari Paul

2011-04-26T05:04:00.000-07:00

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: 
http://www.scribd.com/doc/53945184/SegmentedMarketROR

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.”

Understanding Value Creation in Real Estate--by Uncle Sherman (Guest)

2011-04-22T11:09:00.000-07:00

In November of 2007, Isthismar, a Dubai based investor, bought 280 Park Avenue, a two tower 1.2 million square foot Class-A office building in Manhattan. They paid $1.2 billion for the building, or around $1,000 per square foot, a new record for a property of this size. A few months later, Isthismar flipped the building to Broadway Partners, a New York-based real estate investment company for $1.35 billion, a small profit. Broadway held the building until this March, when they announced that they were in over their heads and needed a bail-out.

The story is a familiar trope of the last recession—over-funded investors get caught up in a manic market and overpay. “Investors” isn’t really the right term though, since buying without any regard for real estate fundamentals is speculation rather than investment. But how do we know they overpaid? Is this just smarmy 20-20 hindsight? And what are “fundamentals” after all?

Real Estate Fundamentals

Owning real estate as an investment is like owning a car rental business (with very long-lived cars). You lend your car to someone who pays you to borrow it. That’s it. The value of your real estate is the value of the payments you can get when you lend it to someone. Of course many home owners and even some “professionals” don’t pay attention to lending or rental rates. Home owners often estimate value by how much pleasure they’ll get out of a home, or how much they believe they can get when they sell it. “Professionals” sometimes buy buildings for braggadocio, brand image or for the fees they get for investing money. There is nothing wrong with buying on those principles (unless you’ve promised your investors you’d do otherwise), but betting on what the next guy will pay instead of the cash income you’ll get for renting is the definition of speculation.

Real estate investment, as opposed to speculation, is the purchase of a property based on its income potential. Property income has two parts: “yield” or “current income”, meaning the income you expect to receive while owning the property, and “appreciation,” the increase in capitalized value of the expected future income, which you’ll get when you sell the property.

Like any other investment, real estate is risky. You may not be able to lease out your building, or if you do, your lessee may not pay their rent. You might also face non-leasing risks, such as capital risks (problems with the building’s structure), environmental risks, political risks (direct expropriation, an increase in taxes, or a modification of legal use which makes an expected income stream infeasible), technological risks (new technology or change in social habits which render your building obsolete), financing risk (not being able to refinance or repay your loan), and many others. As a result, good real estate investors approach acquisitions not only thinking about the income they’ll get with a property, but the riskiness of that income. After all, the 11% yield you’re buying on a property isn’t worth a whole lot if you stop receiving it when the tenant goes bankrupt in the second year you own the building.

Pricing Real Estate

Real estate investors think about the value of a building both in terms of what income you’d get if you owned it today (a “static” analysis), and what income you’d expect if you owned it a number of years into the future (a “dynamic” analysis).

A static analysis is useful to compare a property against other projects and opportunities with similar risk profiles. The most important number investors use to understand an investment on a static basis is a capitalization rate, or cap rate. Cap rates are the inverse of price/earnings multiples with stocks, although in real estate the convention is to divide “Net Operating Income” or “NOI” into a property’s price. Like earnings, NOI is composed of income (rents, other income) minus expenses (real estate taxes, insurance, property management, and any utilities and maintenance costs that can’t be passed through to tenants). Unlike earnings, NOI may or may not include capital expenditures on the building, depending on the property type. NOI never includes debt service.

Cap rates represent the cash yield in the first year of the investment and don’t take into account future expectations or changes in the asset or income stream. A higher cap rate represents a larger amount of income per the price paid, but if the property is openly marketed, a higher cap rate also suggests that the property’s income stream is riskier than similarly sized income streams of more expensive properties.

Here’s an example. Let’s say I can buy a condo for $100,000 and rent it out for $11,000 a year. Let’s say that all my expenses on the condo are $1,000. My cap rate is $10,000 divided by $100,000 or 10%. Now assume that at the same time I buy my condo, you buy a condo down the hall for $90,000. If you get $9,000 of income, you’re buying at the same cap rate as me, and the market considers your condo and my condo to be similarly risky. But if you get $10,000 of income, you’re buying at a higher cap rate and the market believes your property is more risky than mine. Why? If investors are willing to accept a 10% yield (as I did on my property), and your property receives $10,000 income, and if investors believe your and my properties are equally risky, someone would bid up the price to $100,000. If they do not, then you are paying less for a higher but more risky income stream, hence the higher cap rate.

This example assumes there is market liquidity and market knowledge, and that investors are rationally seeking to optimize the risk-return profile of their investments. These assumptions are not always true, but most real estate investors know what cap rates their competitors are paying for properties, so they are at least aware when they are breaking away from the pack. Breaking away from the pack isn’t necessarily stupid either—the best money is made taking mispriced risks that others won’t.

As opposed to a static analysis, a dynamic analysis of real estate evaluates the estimated income stream over a multi-year horizon using a traditional discount cash flow model. In addition to considering rent changes, vacancy, sales expenses, capital expenditures, and leverage, investors also have to consider changes in interest rates. Over the long term, cap rates are driven by interest rates; the various real estate asset types each have a different spread over “riskless” treasuries. That’s because if cap rates get too close to treasuries, investors can (in principal) shift their money out of real estate and into government bonds, driving cap rates up until the risk/return profile makes sense. Again, this idea assumes more liquidity than probably exists in real estate, and it doesn’t take into account the asset allocation models which drive so many institutional investors today. As a result, cap rates changes may get dislocated from treasuries in the short term, creating investment or sales opportunities. But in the long term, as Ben Graham says, the market is a weighing machine, and cap rates return to proper risk-associated levels.

Common Investor Mistakes

Understanding and modeling real estate income streams or risks is worthy of books, to say nothing of a blog post. There are two points however which non-real estate investors often miss entirely in evaluating real estate investments but which are critical to profitability.

The first is capital expenditures, which for buildings in good repair consist of leasing commissions and tenant improvements (TIs). Buildings with higher capital expenditure requirements relative to their cost (office buildings and restaurants, as opposed to industrial warehouse buildings) suffer disproportionately during periods of high turnover because their cost structure is more variable relative to rollover risk. Although investors across asset classes may conservatively underwrite expected capital expenditures into their purchase price, investors with high cap-ex buildings pay a larger cost for being wrong. This problem is particularly true with TIs.

In most real estate asset types, a building owner gives a tenant a TI allowance to “finish” shell space to the tenant’s preferred specifications. These improvements generally include carpet, painting, or even new walls, among other items. The TI allowance can be given as a cash payment toward contractors, or as a loan amortized into the tenant’s lease. The amount of TIs depends on the market conditions and the product type. In both strong and weak leasing markets, tenants request improvements.

Although they are considered “capital improvements” and can be added to a building’s basis, TIs generally don’t outlast a tenant. This is a critical point--since each new tenant demands new TIs, the more frequently tenants move in and out of a space, the more a landlord has to spend on capital expenditures. The idea seems obvious, but it is often lost in acquisition underwriting, which often models “down” scenarios with low rents rather than with high turnover. In weaker leasing markets where it is harder to fill space and where tenants default more frequently, owners must pay TIs more frequently to keep the space filled, and more generously to attract tenants away from competitive space. And during a down market, an owner must foot this bill while accepting a lower lease rate. As a result, while higher TI asset classes may look as good on paper and perform as well in “up” markets, they are much more risky in down markets.

The second issue that non-sophisticated investors often overlook is the impact of changing interest rates on real estate investments. Interest rates hit the bottom line in a number of ways. First, depending on rates at any time, a significant percentage of commercial real estate loans float at variable rates, and interest rate changes quickly hit the bottom line through debt service. Second, even if owners have the cash to cover mortgage payments, they may incur a “technical default” if their coverage ratio reaches a certain level. A technical default may require acceleration, imposition or other fee consequences. Third, as mentioned above, interest rates ultimately drive cap rates, which play a more significant role in asset value than any other factor.

Buying at a 5% cap rate for example, which many real estate investors are doing today, is risky business. Ten year treasuries historically yield around 5%, and real estate, depending on the asset type, is considered a minimum of 150-200 basis points riskier than treasuries. The tables below are simplified as they do not include traditional deducts for vacancy, sales costs and a number of other items, however they still demonstrate the disproportionate impact of interest and cap rates versus rental increases. Notice that if treasuries go back up to 5% and cap rates go up to 7% or 8%, you don’t even make a 5% return unless you get 5% annual net operating income increases and hold for a minimum of 7-10 years. If interest rates go up to 7% or 8% and cap rates hit 9% or 10%, it’s almost impossible to make your money back unless you hold for 7 to 10 years, even if rents increase at 8%-9% annually for that entire time. Given that current interest rates cannot go lower and that inflation seems poised to strike, buying at a low cap rate seems to have a one-sided risk reward profile.

This is likely the discovery that Broadway Partners made in 280 Park Avenue, which reportedly sold at a cap rate below 4%. When you buy at a historically low cap rate, and cap rates rise even slightly, there is almost no way to escape losing money. Isthismar was equally culpable for speculating, but they managed to flip the building before they got in trouble.

In future posting, I will cover other overlooked phenomena of real estate investing.

IRR Returns
Buying at a	5%	cap

			Going out Cap
		6%	7%	8%	9%	10%	11%	12%
Annual NOI Inflation	2%	1%	-4%	-7%	-11%	-13%	-15%	-17%
	3%	1%	-3%	-7%	-10%	-13%	-15%	-17%
	4%	2%	-3%	-6%	-9%	-12%	-14%	-16%
3 Year Hold	5%	3%	-2%	-6%	-9%	-12%	-14%	-16%
	6%	3%	-1%	-5%	-8%	-11%	-13%	-15%
	7%	4%	-1%	-5%	-8%	-10%	-13%	-15%
	8%	5%	0%	-4%	-7%	-10%	-12%	-14%
	9%	5%	0%	-3%	-7%	-9%	-12%	-14%
	10%	6%	1%	-3%	-6%	-9%	-11%	-13%

		6%	7%	8%	9%	10%	11%	12%
	2%	3%	1%	-1%	-3%	-5%	-6%	-8%
	3%	4%	1%	-1%	-3%	-4%	-6%	-7%
	4%	5%	2%	0%	-2%	-3%	-5%	-6%
5 Year Hold	5%	6%	3%	1%	-1%	-3%	-4%	-5%
	6%	7%	4%	2%	0%	-2%	-3%	-5%
	7%	7%	5%	2%	0%	-1%	-3%	-4%
	8%	8%	5%	3%	1%	-1%	-2%	-3%
	9%	9%	6%	4%	2%	0%	-1%	-3%
	10%	10%	7%	5%	3%	1%	-1%	-2%

		6%	7%	8%	9%	10%	11%	12%
	2%	5%	3%	1%	0%	-1%	-2%	-3%
	3%	5%	4%	2%	1%	0%	-1%	-2%
	4%	6%	4%	3%	2%	0%	-1%	-1%
7 Year Hold	5%	7%	5%	4%	2%	1%	0%	-1%
	6%	8%	6%	5%	3%	2%	1%	0%
	7%	9%	7%	5%	4%	3%	2%	1%
	8%	10%	8%	6%	5%	4%	3%	2%
	9%	10%	9%	7%	6%	4%	3%	3%
	10%	11%	9%	8%	6%	5%	4%	3%

		6%	7%	8%	9%	10%	11%	12%
	2%	5%	4%	3%	2%	2%	1%	1%
	3%	6%	5%	4%	3%	3%	2%	1%
	4%	7%	6%	5%	4%	3%	3%	2%
10 Year Hold	5%	8%	7%	6%	5%	4%	4%	3%
	6%	9%	8%	7%	6%	5%	5%	4%
	7%	10%	9%	8%	7%	6%	5%	5%
	8%	11%	10%	9%	8%	7%	6%	6%
	9%	12%	10%	9%	9%	8%	7%	7%
	10%	13%	11%	10%	9%	9%	8%	7%

Inflation vs the end of QE2 - Ari Paul

2011-04-07T19:27:00.000-07:00

Over the last two years commodity prices have rallied 101% (measured by the GSCI index), while inflation in consumer goods has been an anemic 5%. The simplest explanation for that contrast is excess capacity. When there's plenty of factory capacity and high unemployment, a rise in input prices isn't fully passed on to consumers. This effect is so pronounced because commodity prices make up a surprisingly small component of many products. For example, the actual cotton is usually just 15-30% of the price of a finished cotton dress. The rest is labor, manufacturing, transportation, administration, etc.

Still, over time input prices impact consumer prices and we're starting to see a stronger impact. The CEO of Wal-Mart recently stated that he expects CPI to rise sharply by June as commodity price increases and a tightening labor market in China are finally felt by US consumers.

Competing against this inflationary pressure is the end of quantitative easing in June. As part of the QE2 program, the federal reserve was scheduled to purchase $600 billion in government bonds. Some fed hawks are suggesting the Fed may stop $100 billion short. While I think that is unlikely, the statements suggest that there is currently no QE3 planned. If you believe, as I do, that quantitative easing has been the primary driver of rising asset prices and improving corporate fundamentals, than the end of quantitative easing is potentially both bearish and deflationary.

Europe just raised interest rates to 1.25% and China raised its benchmark 1-year rate for the 4th time in 6 months to 6.31%. This increases the political pressure on the US to tighten.

So, we have the inflationary pressure as rising commodity prices are finally passed on to consumers, but the possible end of the quantitative easing program in June. If these were the only factors, I would quickly emphasize the end of QE2 and be confident in a deflationary outlook, but it's not quite that simple. There's increasing recognition that US debt is a ponzi scheme, and that's not hyperbole. Paul Volcker and Michael Bloomberg recently pointed out that if the US were valued as a company, its net worth would be negative $35 trillion due to the present value of medicaid and medicare liabilities. Bill Gross, the co-manager of the largest bond fund in the world PIMCO, noted that the Fed is currently buying 70% of all US treasury issuance, compared to 10% normally. If the Fed stops buying, who will replace them? If no one steps up to the plate with an appetite for at least $600 billion in additional treasury purchases a year, the Fed will have no choice but to continue buying.

Finally, there's growing political pressure by the republicans for fiscal spending cuts. The current spending bill is held up for a trivial difference of $30 billion, but Representative Paul Ryan is pushing a bill that would potentially cut $6.2 trillion over 10 years. Ryan's bill is unworkable and might not even save any money (most of the savings push healthcare payments to states and emergency rooms), but it reflects the political winds. Still, it's almost never a good idea to bet on politicians exercising political restraint.

In conclusion, we have to balance rising input costs, the likely end of QE2, and a more fiscally conservative political environment. The simplest change is that CPI is likely to do much better relative to commodity price increases than it has in the past. I have no great confidence in how this will play out, and I'm mostly unwinding my trade of the last two years: long commodities vs short equities. My current positions are slightly short US equities, slightly long natural gas producers, slightly short the Euro, and short the Yen.

Japan - Ari Paul

2011-03-15T07:33:00.000-07:00

Investors,

The devastation of the tsunami in Japan is estimated to cost $200 billion to repair, and possibly as much as $1 trillion. I haven't been able to get a clear read on the risk of nuclear disaster, but a release of radiation over a 50 mile radius is a significant risk. The Japanese government is evacuating people in a 10 mile radius and telling people in a 20 mile radius to remain indoors. Many foreign companies have been evacuating people in a 70 mile radius.

In reaction, Japanese stocks fell 16% over the last two days, Japanese treasury yields rose marginally, and the Yen strengthened by about 2%.

From an investment perspective, my first thought was that this could be the catalyst that leads Japanese treasuries and Yen to sell off. So why were treasuries steady and the Yen so strong? After a major disaster, a great deal of money needs to be repatriated to pay for repairs. For example, the Japanese Government may need to sell treasuries to raise funds for rebuilding. This means that foreign currency must be converted into Yen, which can send the Yen climbing. After the Kobe earthquake in 1995, the Yen rallied by about 15% over the next two months, before then falling 40% over the next 3 years.

Will Japanese sovereign yields rise? They really can't rise much because every 1% increase in treasury yields will require 25% of all tax revenues to cover the increased interest costs. Japan's central bank has absolutely no choice but to neutralize a yield increase with monetization.

Pundits have talked about a debt/currency crisis in Japan for a decade now and I began discussing it two years ago, but we are now truly in the end game. I believe the pressure to monetize the debt will outweigh the effect of repatriation. I am reasonably confident that the Yen will be significantly weaker vs the dollar over the next five years. I am initiating a small short Yen position in my portfolio and will short more Yen if it rallies another 5%. The Yen is likely to be extremely volatile, so any bet should be small enough that you can hold on through the turbulence.

Observations from Street Markets - Alpha

2011-03-12T17:50:00.000-08:00

From Bogota to La Paz, I've been through more than a dozen cities with street markets, from permanent concrete stalls to wooden booths and tables in a plaza.

Some observations:

1) Markets are omnipresent and part of human society everywhere. People want to buy, sell, and trade goods and services, from food items to clothes, gadgets, and dead llama fetuses (strange to see iPads selling next to dead llama babies and fetuses). I think the desire to trade comes from the primate desire to be social and engage in reciprocal relations (see the work by evol. biologists, like Trivers). Open and free markets are a natural, sociological phenomenon. Anti-free market voices are delusional ideologues (with some truth when they attack crony big company capitalism).

2) You can bargain for anything, esp. if you buy in bulk or the seller is having a bad day and wants to make a quick sale (and you pay in exact cash). All negotiations are contextual, but there are some basic rules (important to know your BATNA and the other side's goals/constraints).

3) Sellers need to develop market niches: I've seen dumb sellers selling the same thing in 7 stalls next to each other. Smart ones differentiate on price, service, or retail presentation/orderliness. Even smarter ones find small niches, selling only jeans, candles, paper goods, etc. Getting the right retail mix to minimize your customers' transaction costs is hard (if you're too narrow, buyers need to go to other places and so may prefer an omni-mart).

4) Niche clusters are part of markets: For example, all the optical stores are near each other, as are all the jeans stores, the pharmacy stores, etc. Clustering is normal and in some ways reduces transaction costs (easy for buyers to compare sellers on different criteria). But there's also an element of dumb herding to it. I think it makes more sense for wholesaling or professional services than basic retail.

Beta Isn't Risk: A look at CAPM and APT - Ari Paul

2011-03-08T04:52:00.000-08:00

In this issue:

1) The Capital Asset Pricing Model (CAPM)
2) Beta Isn't Risk
3) Arbitrage Pricing Theory (APT)
4) "It is better to be roughly right than precisely wrong."

For a PDF version of this newsletter, please look here: 
http://www.scribd.com/doc/50196867/RoRBeta
    

The Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) are financial paradigms that shape portfolio construction and the way professionals think about the market, but they provide a very dangerous conception of risk. I'll provide a basic introduction to the theories before exploring their most serious flaw.

1) The Capital Asset Pricing Model (CAPM)

  The Capital Asset Pricing Model (CAPM) is a cornerstone of the way financial professionals think about the market .  While CAPM is a great academic theory, it’s dangerous to rely on it for investment decisions or to judge a portfolio’s performance.  CAPM assumes that market participants can expect to earn returns in excess of the risk-free rate only by taking on systematic (non-diversifiable) risk.  With this assumption, the expected return of any asset is entirely dependent on its Beta to the market portfolio.

There's a lot of jargon in this description, so let me try to state it more plainly. Investors shouldn't care about company specific risk (like the death of a CEO), because they can completely diversify that risk away by holding a portfolio with a bunch of companies. Since they can effectively get rid of company specific (non-systematic) risk, the market won't reward investors for taking it on. CAPM suggests that the market will only reward you for taking on risk that is impossible to diversify away; that's the risk that's left over when you build a portfolio with hundreds of companies and it's called systematic risk, AKA Beta.

   Beta is just a measure of how a security generally moves with the market.  A slight oversimplification: if a stock has a Beta of 2, we’d expect that if the market is up 1% on a given day, the stock will be up 2%.  Buying a lower Beta security will add less risk to your portfolio than a higher Beta security.

   Alpha is the leftover return after we account for Beta.  If the market is up 1% and that stock is up 3%, CAPM suggests that 2% of the stock’s return came from systematic risk and 1% was “extra”.  That extra return is frequently thought to be a portfolio manager’s skill.  This is a valuable framework because it demonstrates that a manager can always juice their returns in an up market by simply increasing their Beta.  If the stock market is up 8% in a year, a manager who uses leverage or buys high beta stocks will very likely produce a better than 8% return.  However, if they double their returns with this method, they are also doubling the risk to their investors.  A manager should not be rewarded for simply using leverage.  If instead, a portfolio has a beta of 1 and produces double the returns of the market, CAPM suggests that the manager is exceptionally skilled.

 E(R) = expected return on the security

 E(Rm) = expected return on the market

 Rf = risk-free rate

= alpha

 B = Beta

2) Beta Isn't Risk

 The problem with CAPM is that it’s entirely based on old data.  Beta is used as a proxy for risk, but it’s not; it’s a measure of how the equity moved relative to the market in the past.  Much of the time a company with a volatile past has a risky future, but we’re not investing blind.  We have the opportunity to analyze a potential investment and judge its future riskiness for ourselves.  Sometimes the factors that made a company risky in the past, like a specific lawsuit or labor dispute, are no longer applicable.  This logical fact is backed up by extensive research. 

   The economists Eugene Fama and Kenneth French performed exhaustive statistical analysis from 1963 to 1990 that demonstrated that Beta (i.e. historical volatility) was not a predictor of future performance ("The Cross-Section of Expected Stock Returns" Journal of Finance 67, 1992, pp 427-465).   Fama stated, “over the last 50 years, knowing the volatility of an equity doesn't tell you much about the stock's return."  If Beta is risk, than this means there is no consistent relationship between risk and reward.  I think the better explanation is that Beta is simply a poor measure of risk.  

   The emphasis on Alpha and Beta confuses historical regression for actual risk and return.  Perhaps even more perniciously, it assumes the market portfolio as the benchmark.  Imagine a hedge fund manager who bought a collection of tech stocks in 1999.  Over the next 3 years, the Nasdaq collapsed more than 80%.  If his portfolio only fell 60%, he might claim that the loss was entirely due to Beta, and that he was actually a skilled Alpha generator since his portfolio outperformed the market.  However, he made the decision to buy a collection of overvalued stocks.  CAPM implicitly excuses the fund manager from having to judge whether the market as a whole is overvalued.  

    Some fund managers have a specific market mandate - for example, a manager of a tech mutual fund is always supposed to be roughly 100% long technology stocks.  For that manager, alpha and beta are a decent measure of performance since the manager has little discretion over his general market exposure.  Most fund managers, however, can choose to be 100% long equities today and flat equities tomorrow. They are responsible for both the general positioning of their portfolios as well as the performance of their individual stock picks.  A big part of their jobs is choosing the benchmark.

3) Arbitrage Pricing Theory (APT)

  Arbitrage Pricing Theory (APT) is another popular measure for forecasting equity returns.  APT defines an equity’s expected return by its exposure to a series of factors.  The specific factors are left open for discussion, but generally include macroeconomic data like GDP, inflation, and yield curve changes.  

E(r) = expected return on the security

Rf = risk-free rate

B = Beta

RP = risk factor premium

   This equation formalizes the idea that a company’s return comes from its exposure to specific risks.  The theory’s name comes from the assumption that asset prices must obey the equation, otherwise, investors would buy the asset and sell short a synthetic portfolio with the same exposure to the specific risks and gain an arbitrage profit...so the theory goes.  Like in CAPM, the higher the risk, the higher the expected return.  The difference is that where CAPM defines the only risk as being the Beta to the market, APT let’s the user define just about any risk they want.  Unfortunately, this added freedom isn’t all that helpful.

   Every input into this equation (except maybe the risk-free rate) will always be subjective.  The very concept of a risk premium for a stocks’ sensitivity to inflation is debatable.  APT practitioners generally data mine the last 30 years to identify key factors, but the importance of factors is always changing.  Second, we’re stuck with the same problem as in CAPM - we’re using historical Betas that will likely be inaccurate going forward.  A company may have had little sensitivity to GDP in the past when it solely produced fast food, but now that it has grown into a conglomerate, it may be far more sensitive.

4) "It is better to be roughly right than precisely wrong."

- John Maynard Keynes

     No one ever got a Nobel Prize for saying, "it's complicated."  Economists are incentivized to produce elegant equations.  Financial professionals seek formulas to simplify their chaotic world and convince their risk managers and investors that they know what they're doing.  A theme of the "Risk over Reward" team for the last 2 years has been that a great source of risk is the oversimplification of risk.  

     In pursuing elegant simplicity, both CAPM and APT ignore economic reality when calculating risk.  They confuse the volatility of historic stock returns with future business risk.  For short-term traders, CAPM and APT are valuable tools in predicting how the market will act.  The theories identify past patterns and have additional predictive power simply because they are so widely accepted.  However, for investors and economists, they are misleading and harmful metrics.

Sacrifices in Early Colombia and Thoughts on Economic Development - Alpha

2011-02-11T20:39:00.000-08:00

The early Colombian indigenous societies had many practices that we would consider economically ludicrous today, such as:
-Human sacrifice to show status (killing talent for ego);
-Burying wealth with dead owners (destroying assets for ego);
-Treating women as chattel (male primate foolishness carried over into homo sapiens).

These are actually practices common to all "backward" societies, but I'm shocked about how variants of them exist today when people claim that increasing wealth (economic prosperity, GDP per capita, the level of the bottom quartile) is a paramount social goal.

From Egypt to Venezuela, the major problem of the world today isn't technology or scarcity, but governance. I would argue that we have the technological, institutional, and cultural know-how to bring many poor countries to the level of Singapore or South Korea in two generations, but bad leaders hinder their own countries.

Let me focus on 3 low-hanging fruit, easy investments that governments can make:

1) Bolstering K-12 education, basic literacy, numeracy, and computer/tech fluency. I think we can replace hundreds of thousands of bad and mediocre teachers with a few good teachers "broadcasted" with software and made interactive with games. MIT's OpenCourseware project and Khan Academy are the very beginning of a massive revolution...

2) Putting a strong focus on government transparency, anti-corruption laws with teeth (see Singapore), and putting most government services on the internet. Most countries don't have identity cards tied to the internet. Besides doing banking and communicating, what about voting, getting EVERY permit, and complete budget transparency? Sorry, even the US or Singapore don't do this!

3) Empowering women through equal education, preferences, and affirmative action. In the US, women are now better educated, but having kids puts them back. Like Sweden, the US needs a much better maternal (and paternal!) support system. Other "developed" countries, like Japan, have backward, 18th century views toward women.

Generally, the US is the best place in the world for entrepreneurship, STEM (science, tech, engineering, and math)innovation, and higher education. However, for social policies on education, clean government, and empowering women, Singapore, Finland, & Sweden are more interesting.

The Early History of Venture Capital and Silicon Valley - Alpha

2011-02-02T22:08:00.000-08:00

I'm getting set to publish a book titled: "A History of Silicon Valley (1900-2010)" with Piero Scaruffi. Below is an excerpt from the book on the early history of venture capital. For more information about the book, plus some great resources about Silicon Valley, see:

www.svhistory.com

Origins of Modern Venture Capital, 1900-1945
Benno Schmidt of J.H. Whitney claimed he and his partners put together “risk capital” and “our business is the adventure” to first describe the industry as “private venture capital” in 1946. Schmidt claimed they shortened “adventure capital” to “venture capital.” However, the first documented use of the words “venture capital” can be traced to 1920, when the Industrial Securities Committee submitted a report on it: “The enlistment of venture capital is necessary for the development and growth of the country, as well as for the safety of all investment securities.” These investors saw venture capital as part of a traditional portfolio for large investors, as an investment in “business in the experimental stages.”

Prior to 1920, a few wealthy families, such as the Phipps, the Rockefellers, and Whitneys, informally invested in new ventures. They were amateurs. Yet as the stock market took off in the 1920s, these individuals switched their investment allocations to the public markets, and venture funds declined. When the markets crashed from 1929-1931, wealthy individuals shunned all risky investments and delegated more to institutions.

A number of other factors led to a paucity of venture investing from 1931 to 1946. First, as tax rates rose through the 1930s and 1940s, especially due to higher tax brackets for the rich and interpretations of rules by the IRS, wealthy families shunned venture investing. Second, as power shifted from individuals to institutions, the new “institutional investors” found that state fiduciary rules limited their investing to only securities on approved lists, usually the safest bonds and preferred stock. This combined with the natural risk aversion of institutional investors, leading to the decline of venture funding. Third, the public’s distrust of investment bankers, the difficulty of getting transitional funding for a growing venture due to the new securities laws of 1933 and 1934, and bankers’ reluctance to take risk impeded the growth of venture capital. Fourth, the excess profits tax that Congress raised in 1933 penalized young companies more than established ones, since their rates of return were highly variable and the tax would hit them in their peak years. Fifth, inventors and entrepreneurs had little bargaining power with holders of capital after the depression, and so many chose to bootstrap their own companies or join larger corporations.

During those lean years, most venture funding was being done by large corporations and the US government. Corporations could expense their venture creation as “R&D costs,” and could raise the large amounts of capital that some new ventures needed. Generally, the US government avoided venture funding, and New Deal programs funneled capital to large projects like the TVA. Government banking agencies like the Reconstruction Finance Corporation (RFC) could not finance risk ventures (though the RFC made loans to some small businesses). Rather, most government venture capital came during World War II, as government, industry, and universities formed a research network, and subcontracting programs for federal procurement encouraged technology transfer to small firms. One example is the development of synthetic rubber production from scratch, where $700 million was invested in 51 plants over two years. Most importantly, many state governments started giving institutional investors more leeway to finance risky investments, often dropping approved investment lists for a “prudent man rule,” a discretionary standard. Also, a tax code change in 1942 gave capital gains a more favorable treatment. Finally, the GI Bill after WWII put millions of Americans in college, educating a generation of technologists and entrepreneurs, while increasing funding for research in pure science many times over.

The Venture Pioneers of 1946
Five important venture organizations were started after World War II, around 1946, as businessmen and government officials realized the importance of venture funding. The organizations were J.H. Whitney and Company, Rockefeller Brothers and Company (later Venrock), the American Research and Development Corporation (ARD), and two in Silicon Valley, Industrial Capital Corp. and Pacific Coast Enterprises. These were daring experiments, as conventional wisdom was that the US would fall back into a depression after WWII ended. This is why US government bond yields were so low around 1945, and most investors clung to government bonds yielding a little above 2%. Venture capital investors, however, were bolder and willing to take more risk for a potential higher return.

J.H. Whitney & Company was founded by John Hay “Jock” Whitney and his partner Benno Schmidt in February 1946, after Whitney wrote a $5 million check to capitalize the firm. Whitney had been investing since the 1930s, founding Pioneer Pictures in 1933 and acquiring a 15% interest in Technicolor Corporation with his cousin Cornelius Vanderbilt Whitney. Benno Schmidt was working at the State Department in 1946 when one day he got a call from Whitney, one of the wealthiest men in the country. Whitney wanted to stake a new firm with $5 million to finance young companies in new industries. Schmidt told Whitney that he had no business experience whatsoever. Whitney replied: “I’m not looking for somebody who has a lot of business experience. I’m looking for someone who has had a lot of experience with life.” Schmidt signed on and became a partner for 52 years, until 1992.

Schmidt and Whitney did good deals. An early deal of the new firm was buying Spencer Chemicals after World War II and converting its munitions plant into a fertilizer facility (the $250,000 of initial equity was eventually worth over $10 million). Whitney’s most famous investment was in Florida Foods Corporation. The company developed an innovative method for delivering nutrition to American soldiers, which later came to be known as Minute Maid orange juice and was sold to The Coca-Cola Company in 1960. Eventually, J.H. Whitney & Company left the venture capital space to become a buyout firm.

Rockefeller Brothers Co. had its roots in the 1930s, when Laurence S. Rockefeller (1910-2004) pioneered early-stage financing by investing in the entrepreneurs of Eastern Airlines and McDonnell Aircraft. Over the years, the family’s investment interests included the fields of aviation, aerospace, electronics, high temperature physics, composite materials, optics, lasers, data processing, thermionics and nuclear power. Beginning in August 1969, the VC firm Venrock was founded to continue the family’s heritage of investment and building entrepreneur-backed companies, beginning with its investment in Intel, based on the advice of Arthur Rock. Venrock still existed in 2010, having invested $2.5 billion in 442 companies resulting in 125 IPOs and 128 M&A exits over its 41 year life.

These early family venture funds share a few goals: achieving high returns on an initial investment to get favorable capital gains tax treatment (versus the higher-tax burden from dividends and interest from established companies); creating a more effective way to finance new ventures from their entrepreneurial friends and associates; and pushing an ideological view of free market capitalism over state-sponsored socialism. All three goals came together with a sense of noblesse oblige, as the rich felt they needed to lead the way back for a prosperous economy and free enterprise system. The most important firm founded in 1946, however, was not a family venture capital firm.

The Father of Venture Capital: Georges Doriot of ARD
Non-family venture models essentially began with the American Research and Development Corp. (ARD), founded by Georges Doriot, who many believe was the “Father of Venture Capital.” Before WWII, Doriot was a banker at Kuhn, Loeb & Company, the premier investment bank of its time (along with JP Morgan & Co.). Doriot then became a Harvard Business School professor, where he formed close bonds with many students and taught an eccentric business philosophy (rather than mutable facts or fancy theories) in his Manufacturing Class. Note that Doriot was also an uber-capitalist and elitist, as shown by a speech he gave in 1934 where he denounced FDR’s popular and socialist New Deal programs as “one thing that has done more harm to the morals of the nation” and that “those who pay the taxes have more right to govern than those who don’t.”

During WWII, Doriot partnered with Ralph Flanders, Merrill Griswold, and Karl Compton (a former President of MIT) to encourage private sector investments in new products for the war effort. He even joined a private company, Enterprise Associates, which raised $300,000 from twenty stockholders to finance the final stages of promising research projects and looking for entrepreneurs and ideas to finance. Doriot was pulled even further into the war when he became the head of the Military Planning Division in the Office of the Quartermaster General of the US Army, where his role was putting together teams to develop technologies and get ideas made into products and weapons for the battlefield (one example is the food ration bars for soldiers on the line, packages containing meat, biscuits, a powder-made drink, a sweet, gum, and cigarettes).

After WWII, members of previous committees that Doriot sat on formed the American Research and Development Corporation (ARD) on June 6, 1946, as a Massachusetts corporation. ARD raised $3.5 million through a public equity offering (a mistake, as we shall see), of which $1.8 million came from nine institutional investors like MIT, Penn, and the Rice Institute. ARD’s significance lay in that it was the first institutional venture capital firm that raised capital from sources other than wealthy families although it had several notable investment successes as well. One of the incorporators, Ralph Flanders, gave a speech in 1945 to the National Association of Security Commissioners explaining the need for “new methods of applying development capital” and that the nation could not “depend safely for an indefinite time on the expansion of our big industries alone.” Hence ARD sought to bring together cash-poor entrepreneurs with great ideas and an institutional investor community that had become too risk averse.

ARD’s investment record was typical of the economics of many venture firms. A few failed (Island Packers, tuna fish packing), a few made modest amounts of money (Tracer Labs), and one investment made the fund (Digital Equipment, a chip manufacturer). ARD’s criteria was “taking calculated risks in select [growth] companies”, with guidelines such as projects having passed the test tube stage, with patent or IP protection, and an “attractive opportunity for eventual profits.” Doriot also thought entrepreneurs were more important than ideas and joked in the 1949 annual report that “An average idea in the hands of an able man is worth much more than an outstanding idea in the possession of person with only average ability.” ARD raised $4 million more in 1949, and Doriot found that selecting companies was the easy part and that the “hardest task [was] to help a company through its growth pains.”

Doriot had an interesting business philosophy. He felt the study of a company was not the study of a dead body, but rather of things and relationships which were alive and constantly changing. For him, business was “the study of men and men’s work, of their hopes and aspirations… a study of determination of successive goals and of victorious competitive drive towards them.” Doriot also fostered an entrepreneur’s paranoia that “someone somewhere is making a product that will make your product obsolete.” He pushed managers to delegate down, grow slowly, and examine small decisions which could lead to vital errors. In the end, he felt work was a part of living, that work was not just an activity necessary for existence but also a worthwhile part of existence.

ARD and Doriot went through hard times, as by 1953 venture investing was not fashionable again. By 1954 the number of proposals fell and the company made no investments. Also, the SEC created problems by examining and questioning the valuation of the underlying portfolio companies (a speculative endeavor). The stock price slumped below the net asset value that the accountants had valued the company’s assets per share.

ARD’s greatest investment was . . .

See www.svhistory.com for more!

Betting Size: Kelly Criterion and Portfolio Variance - Ari Paul

2011-01-22T10:03:00.000-08:00

In this issue:

1) Kelly Criterion 
2) Portfolio Variance
3) Rules of Thumb
4) Don't Diversify with Dutch Tulip Bulbs

Dear Friends, Colleagues, and Investors,

After identifying a variety of attractive investments, how much of our capital should we risk? Should we use leverage or hold cash in reserve? Should we invest all our money in our best idea or diversify broadly, even if that means devoting money to less attractive investments?

1) The Kelly Criterion
The scientist John Kelly created a simple formula that describes the optimal strategy for non-correlated bets.  Before delving into the formula, let's look at a simple example.  Let's say that you're going to make a series of 100 bets on a coin flip.  The coin is weighted and thus lands on heads 60% of the time.  You have $100.  How much should you bet each time?  It’s tempting to think that you should bet your entire bankroll every time to maximize your expected returns, but this is incorrect.  While betting your bankroll does indeed maximize your expected value for any individual bet, it ignores the fact that you have a limited bankroll, and once you lose it, you also lose the opportunity to make future profitable bets.  If you bet your entire bankroll each time, you will likely go bankrupt by the fourth bet, so you'll miss out on future advantageous bets.
   
   Here's the Kelly Criterion formula:

where:

f* is the fraction of the current bankroll to wager;
b is the net odds received on the wager (that is, odds are usually quoted as "b to 1")
p is the probability of winning;
q is the probability of losing, which is 1 − p.

The most intuitive way to think about Kelly’s approach is to consider the outcome of a full “set” of bets. Let’s imagine that we bet our entire bankroll on that 60% weighted coin. If we bet 10 times, we can expect to double our portfolio 6 times, but then we will go bankrupt. If instead we only bet 20% of our portfolio, our bankroll will grow by a factor of 1.2 when we win, and shrink by a factor of 0.8 when we lose. The growth looks like this: 1.2*1.2*1.2*1.2*1.2*1.2*0.8*0.8*0.8*0.8 for a total return of about 22%. If we increased our bet size to 30% of our portfolio, the total return would fall to 16%.

While the Kelly Criterion is a good starting point, it has a lot of problems. First, it assumes that bets are uncorrelated. If I have 20 equities in my portfolio, their returns are certainly very correlated; a global depression will send all equities tanking. Even if we use Kelly for sequential bets, the correlation problem remains. In the real world, corporate earnings, GDP growth, and even stock market returns are not independent events each quarter; the current period impacts the next. Finally, the Kelly Criterion requires that we know the “edge” of any bet. We can never be sure of “edge”, and we are very likely to estimate it poorly. As with any formula, garbage in = garbage out.

The are numerous way to improve on Kelly for investors. First, we can adjust the Kelly weighting by the beta of the security to the rest of our portfolio; this will better take advantage of the benefits of diversification. For example, if Kelly recommends a weighting of 10% of our bankroll but the security has a negative beta to our portfolio, we will probably be happy with a higher weighting, since the security reduces our portfolio volatility. Second, we can recognize that the Kelly allocations will be too high because they fail to account for correlation and we can systematically reduce the allocations. Several prominent hedge fund managers routinely use the Kelly Criterion but divide the result by 2. Finally, we can use Kelly as a rough starting point for deciding how much capital to risk for a given amount of expected reward.

The greatest value of the Kelly Criterion is that it demonstrates that even when we’re sure we have found a great investment, we only want to commit a small portion of our portfolio.

2) Portfolio Variance

A complimentary approach to portfolio construction looks at the relative attractiveness of securities. Many fund managers feel more comfortable investing from the bottom up than trying to time the market. Mutual fund managers and pension managers are in the same boat because they generally prefer to be 100% long the market. To what extent should these managers concentrate their capital in their best idea? Even if you are a market timer, you must consider how to divide your capital between your best and second best investment ideas.

Imagine we’re considering a simple portfolio with two assets, A and B.  We believe that asset A will return 20% a year and asset B will return 15% a year, and they are uncorrelated.  How should we distribute our funds?  To maximize our expected value we would put all our money in Asset A, but we can earn almost as much with much lower risk through diversification.  If we split our money evenly between the two assets we can expect a 17.5% return but we cut our portfolio’s variance in half!  In the real world, very few assets are uncorrelated and managers face a more subtle decision. Calculating portfolio variance for a portfolio of 50 assets is hard by hand but easy with the proper software. The problem is that, as with any formula, garbage in = garbage out. If we make a poor estimation of the covariance of assets, we may end up with much more risk than we expected. 

3) Rules of Thumb

We can use a computer program to calculate the risk/return profiles of possible portfolios, but this is so imprecise as to be little better than simple rules of thumb in most cases.

Here's a very simple approach: Let’s start with the world of equities.  Compared to holding just 1 stock, a portfolio of 4 stocks will have roughly 65% of the volatility, 12 will have 50%, and a portfolio of 60 stocks will have 40% of the volatility.  As you can see, diversifying beyond 12 equities provides little benefit.  We need to tweak this assumption when considering stocks that have very low correlation to our portfolio.  For example, if you hold a dozen pro-cyclical stocks (like airplane and car makers), adding a couple counter-cyclical stocks (like an outplacement agency or fast food company) to your portfolio would provide significant diversification benefits.  

In allocating capital between two stocks with average correlation (roughly 0.6), a useful rule of thumb is to adjust the capital allocation by the square root of the edge differential.  This is a lot simpler than it sounds.  For example, let’s say I have a portfolio consisting of only Apple and Caterpillar and I believe that Apple will appreciate by 20% next year and Caterpillar by only 10%.  Since Apple has twice the edge of Caterpillar, I will devote sqrt(2) as much capital to Apple.  If I had $100, I would put $58 into Apple and $42 into Caterpillar.  This simplistic approach will generally deliver a happy medium between maximizing your returns and minimizing your portfolio’s risk.  If the two stocks are very highly correlated, there is less benefit from diversification, so we might put $80 into stock A and only $20 into B.  Alternatively, if the two assets are completely uncorrelated, the diversification benefits are greater so we should consider a 50/50 split.
     
  If we’re building a long equity portfolio, we should aim for 6-20 stocks (depending on the prevalence of opportunities and our time available to analyze them), and overweight the most attractive investments by the square root of the extra edge they provide
     .
   When we include non-equity assets, the issue of correlation becomes much more difficult.  Correlation deserves (and will get) it's own Risk over Reward essay, but I'll offer some simple ideas today. A very conservative approach is to assume that correlations will rise to their historic highs. For example, commodities and equities have at various times had very negative correlations, very positive correlations, and even been uncorrelated. If I have a portfolio that is long commodities and long equities, a very conservative measure of its risk assumes that the assets are very positively correlated. The absolute most conservative assumption is a correlation of 1. If I assumed a very negative correlation, the portfolio would look like it had very little risk; a poor assumption because even if correlations are negative today, they may become positive in the future. 

4. Don't Diversify with Dutch Tulip Bulbs
     Most investment managers are chronic over-diversifiers. A portfolio of 20 stocks has almost the same risk as a portfolio of 100 stocks, so why dilute your best investment ideas? Warren Buffett wrote: "Many pundits would therefore say [that concentrating your capital] must be riskier than [diversifying like] more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." Another great quote from the oracle, "Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing."
     
The very best investment managers like Warren Buffett and Seth Klarman usually have 70%+ of their capital in just 5 stocks! Diversification is a crutch used by managers who lack the confidence or will to perform deep due diligence on the companies in which they invest.
     
The modern twist on this fallacy is diversifying with asset classes. Funds are putting capital in commodities and real estate because those asset classes historically have a low correlation to equities...but that's not a good reason to put your money in an asset. No matter how uncorrelated a bad investment is to your portfolio, it's still a bad investment. 

2010 in review - Ari Paul

2011-01-07T08:41:00.000-08:00

2010 climbed a "wall of worry." We began the year with a growing Eurozone debt crisis and a sharp fall in the value of the Euro; the European Central Bank and IMF came to the rescue with a series of massive bailouts. The big US banks faced new regulations and lawsuits over mortgage fraud, but little came of either. A "flash crash" in May sent the market 9% lower in under an hour, and evidence of a double dip recession showed up in July.

More important than all of this however, was the quantitative easing. The federal reserve launched a new round of quantitative easing in which they bought almost all new treasury issuance and kept long-term interest rates around 3%. This supported an equity market rally of 11%. It also supported a huge run up in commodity prices, including 30% in gold and copper and 36% in agricultural commodities.

The quantitative easing also supported a moderate recovery in economic activity with roughly 3% GDP growth and 3.5% growth in retail sales, although unemployment remains near the highs at 9.6%.

As we reached the end of the year, investor sentiment reached very bullish levels. Mom & pop are still pulling their money from the market, but hedge funds, analysts, and pundits have jumped on the bullish trend with both feet. The equity rally is supported by strong fundamentals from companies. Corporate earnings and growth have been strong and companies are sitting on a growing cash pile. Current valuations look reasonable if US GDP grows about 3% a year going forward, and we avoid a new major crisis. My view on that likelihood has not changed; policymakers spent the last 3 years kicking the economic crisis can a few years further down the road. I'll write at greater length about the risks facing us in 2011 in a couple weeks.

An honest periodic self-appraisal is a healthy habit for any investor. I started off 2010 by anticipating the Eurozone crisis and capturing most of the Euro's collapse with a sizable short position. In mid-2010 I suggested adding to our long commodity position with a special focus on agricultural commodities, and that too worked out very well. However, like in 2009, my single biggest position was short US equities, and that was very wrong. Fortunately, the huge gains in commodities compensated for the smaller equity rally in my portfolio. I have moderately reduced all position sizes but remain short US equities, long agricultural commodities, and slightly short the Euro. I also have tiny equity positions of long GST and short MCO. I still believe the only hope for decent equity performance is continued money printing, which will cause severe inflation. If instead we get a deflationary shock, that will send equities down sharply. Generally though, this is a boring time to be a value investor. From a bottom up perspective, US equities and corporate bonds look roughly fair while emerging market equities are moderately overpriced. The most important driver of all markets remain the US and European central banks.

A Primer on QE2 - Alpha

2010-12-05T22:25:00.000-08:00

What is QE2?
QE2 is a second round of quantitative easing (“printing money to buy high-quality bonds”) by the Federal Reserve System (“Fed”), America’s central bank. It’s the world’s biggest spending spree. The Fed announced after the mid-term elections, on Nov. 3rd, that it would buy $600 billion in long-term Treasuries over the next eight months. The Fed also announced it would reinvest an additional $250 billion to $300 billion in Treasuries with the proceeds of its earlier investments (QE1). If the Fed were to print money to buy lower-quality securities like stocks or REITS, that would be both quantitative and “qualitative” easing. Economics like to use big words to hide outrageous actions.

What is the Fed?
The Fed is America’s central bank; it is the bank where every other bank stores their “reserve” deposits. The Fed’s main goals are to keep inflation low and unemployment low. These goals often conflict. For example, one easy way to create jobs in the past has been to print a lot of money and boost the economy in the short run; in the long run, this extra money chases a fixed supply of goods and services, creating inflation. Most central banks are just supposed to keep inflation low (prices rise within a 1% to 3% annual level); they have no jobs goal. The Fed also has other goals like: ensuring the financial system is stable and doesn’t collapse; regulating banks and mortgages; controlling the money supply and how much banks in the US lend. Only the Fed has the power to print money in the US; even President Obama could not do it to buy dresses and helicopters for Michelle and the kids (though he appoints the Fed Chairman and board).

Wikipedia entry on the Federal Reserve System:
http://en.wikipedia.org/wiki/Federal_Reserve_System

Meltzer’s Multi-Volume History of the Fed:
http://www.amazon.com/History-Federal-Reserve-1913-1951/dp/0226520005

Why is the Fed doing QE2?
It means the Fed is printing money because it has two worries. First, the Fed says it is worried about deflation, that is, falling prices. This is nonsense because prices have been rising between 1-3% in the last year (as the chart below shows, prices only briefly fell in mid-2009). Second and more importantly, the Fed says it’s worried about high unemployment, about 10% in the US (16-17% by some broader measures, like the U-6). Yet the Fed is disingenuous since few economists think that QE2 will create jobs (though many think it can act as insurance to keep more jobs from being lost). See the discussions by Fed Chairman Bernanke and NY Fed President Dudley here where they justify QE2.

Bernanke’s Speech on QE2:
http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm

Dudley’s Speech on QE2:
http://www.ny.frb.org/newsevents/speeches/2010/dud101001.html

Does the Fed actually print money? Where can I get some of this cash?
No, the Fed creates money electronically, at the touch of a button; it doesn’t need to print cash. After the 2008 crash, the Fed created a lot of money (over a $1,200 billion, over a trillion dollars!) to buy “agency securities”, which are basically bonds backed by mortgages and a US government guarantee on top. This was QE1 and it was done to support the economy and the housing markets. In quantitative easing, the Fed creates money electronically and then buys high-quality bonds such as US Treasuries or agencies. This reduces the supply of high-quality bonds and forces investors to buy other assets, which tend to be lower-quality and riskier. The Fed’s actions are one big reason that stock markets in the US took off after May 2009. Anytime the Fed prints money to buy bonds, its balance sheet (a financial statement showing what it owns) gets bigger.

The Fed’s balance sheet (H41):
http://www.federalreserve.gov/releases/h41/current/

Fed Official Sack Explains the Fed’s Balance Sheet: http://www.ny.frb.org/newsevents/speeches/2010/sac101004.html

If I can’t get the cash and QE2 probably won’t create jobs, why is the Fed really doing this?
Informed observers are speculating on the Fed’s real reasons. First, QE2 acts as insurance and makes the odds of a “double-dip” second recession less likely. This would prevent more jobs from being lost. Second, QE2 puts more dollars into the global financial system and basically lowers or “depreciates” the value of the dollar compared to other currencies like the Euro. A “cheaper” or “weaker” dollar helps boost the US economy and US exports, but hurts foreign countries who then have a “dearer” or “stronger” currency. Third, the US federal government is running large fiscal deficits. This means the government is spending much more than it raises in taxes. When it does that, the government has to go to the markets to sell US Treasuries to raise money, just like any other large borrower. The easiest person to sell Treasures is to the Fed because the Fed can print money and pay for it that way. The US government needs to raise hundreds of billions of dollars every month, and the Fed has now committed to buying about $60 billion every month.

US Government Borrowing Announcement: http://www.treasury.gov/offices/domestic-finance/debt-management/quarterly-refunding/11-1-2010/Sources%20and%20Uses%20-%20November%202010%20Borrowing%20Announcement%20%282%29.pdf

Why are foreign governments so angry about the Fed doing QE2?
Foreign governments are angry for two reasons. First, they (correctly) think the Fed is starting a “currency war” by making the dollar cheaper. A cheaper/weaker dollar makes the US economy grow more strongly, but saps the strength of foreign countries like China, Japan, Germany, and Korea, since their currencies become more expensive and so their exports fall. Second, the Fed is devaluing or cheapening some country’s holdings of US Treasuries. For example, more than half of all privately-held US debt is held by foreign countries (it was as high as 61% in June 2008)! Analysts estimate China itself owns over a trillion dollars in Treasuries, with Japan holding nearly half a trillion. When the Fed weakens the dollar with QE2, it is basically making these countries poorer. It also adds rocket-fuel to the fiery price of gold.

Largest Foreign Holders of US Debt (2005): http://www.frbsf.org/education/activities/drecon/answerxml.cfm?selectedurl=/2005/0507.html

Largest Foreign Holders of US Debt and all US Securities (2009 TIC Report):
http://www.treas.gov/tic/shl2009r.pdf

What are the long-term consequences of what the Fed is doing?
As I’ve written about before, the big macro problem the US (and much of the rich, Western world) faces is too much debt at all levels of society, especially government debt. Congress in the US is deadlocked and can’t implement the optimal solution (stimulus through tax-cuts and/or spending in the short run coupled with a deficit reduction plan in the long run). Hence the Fed is doing the best it can to prevent a double-dip recession, weaken the dollar, and meet the excessive borrowing needs of the US government. It is effectively the only responsible, functioning part of the US government. Given the lack of decisions from Congress, the Fed is taking the “least painful” or “least worst” path, given a very bad set of options.

Eventually, the Fed will want to start selling the bonds it has bought to shrink its balance sheet again. However, there’s a high chance that will cause financial instability or “an extreme market reaction associated with the Fed's exit from potential purchases”, as the TBAC (an expert panel advising the US government) notes. If the reaction is too intense, the Fed won’t be able to “exit quantitative easing”, “reduce its balance sheet,” or “sell the bonds it bought” (all the same thing). That means that the money it printed is here to stay and whenever the US economy starts to grow strongly again, there’s a high probability that inflation will return and be high (above 5%). The Fed itself explains in a “goals” page why high inflation is bad (high inflation hurts economic growth, makes decision-making hard by people and businesses, hurts the tax system, and redistributes wealth).

US Government Debt Position and Activity Report:
http://www.treasurydirect.gov/govt/reports/pd/pd_debtposactrpt_0910.pdf

Minutes of the latest TBAC Meeting (Q4 2010, on Nov. 2nd, 2010)
http://www.ustreas.gov/press/releases/tg942.htm

The Fed on its Goals and Why Inflation is Bad:
http://www.frbsf.org/publications/federalreserve/monetary/goals.html

QE2, QE3? - Ari Paul

2010-11-17T14:07:00.001-08:00

On November 4th, the Federal Reserve announced a second round of quantitative easing (QE2). Bernanke will buy an additional $800 billion in treasury bonds; this represents roughly 100% of all new treasury issuance. Over the following week, equities rallied about 3%, while gold and most commodities surged higher out of inflation fears. China and Germany loudly criticized the US for deliberately debasing the dollar in a currency war. The newly elected Republican majority in the House began applying political pressure to prevent the Fed from printing more money. Will the combination of external and internal political pressure be enough to reduce the Fed's credit easing? Over the last few days, equities have sold off moderately and commodities have collapsed as interest rates have risen. Some market participants are speculating that either the Fed's easing will be insufficient, or they will not be able to continue easing for political reasons.

The other big story has been the continuing collapse of the EU. It never ceases to amaze me how for most people, "out of sight" equals "out of mind." Early in the year there was widespread talk of how an EU breakup may be inevitable because of the huge differential in labor productivity across EU countries. The IMF announced a nearly unlimited bailout of the PIIGS and the talk vanished, but the fundamental problem remained. Now, Greece has already violated the terms of their bailout by running too high a fiscal deficit, and Ireland is teetering on the brink of bankruptcy. I continue to believe that there are only two feasible outcomes: a very sharp devaluation of the Euro, or a break up of the Euro. The third path that we are currently on would require a new massive bailout every few years. Eventually, German voters will get sick of continually providing "emergency" support to their neighbors.

Back in the last quarter of 2008, many pundits predicted imminent inflation, because the Federal Reserve had just doubled the monetary base. I quoted Milton Friedman who wrote that there's generally a 2 year lag between money printing and its effects. Well, here we are two years later, and we're starting to see significant inflation in just about everything. Food prices, gold, healthcare costs, rental prices etc, are all rising faster than the fed's inflation mandate. The official inflation gauge, the CPI, is a poor model at best and chronically understates inflation. Moderate inflation is here. Some brilliant hedge fund managers like John Paulson believe it will escalate quickly and become double digit inflation in the next couple of years. Others like John Hussman believe that moderate inflation is sustainable, while others like Chanos believe the world will soon experience further deflationary shocks.

My focus remains on the credit cycle. This time last year I thought the credit cycle was near its peak. I failed to anticipate that Bernanke would launch a second round of quantitative easing equal in size to the entire monetary base that existed in early 2008. At the time, the idea that the Federal Reserve would buy 100% of new treasury issuance seemed extremely unlikely to me for political reasons. Bernanke has proven his willingness to print an unlimited amount of money, so we return to the question, will the external pressure from China and Germany, and the internal pressure from the House Republicans, be enough to halt the credit expansion? Without QE3, and QE4, I believe the equity market and risk assets in general will perform poorly.

With 10 year bond yields still below 3%, we are likely much closer to the end of the credit easing cycle than its beginning. The trend of cheap money (and the desire to bid up risky assets that comes with it) is likely close to an end. Unfortunately, I have no particular insight into whether the tightening cycle began this week or will begin in two years. Even if credit expansion has peaked, there remains the risk that inflation could surge out of control and become self-sustaining.

Commodity Markets - Ari Paul

2010-11-09T12:07:00.000-08:00

Commodity Markets

In this issue:

1) The Basics
2) The Players
3) Speculation and Manipulation
4) How to be Eddie Murphy from "Trading Places"

For a PDF version of this newsletter, please look here: http://www.scribd.com/doc/41670648/RoRCommodityMarkets

Dear Friends, Colleagues, and Investors,

      In this edition of "Risk over Reward" I'll provide a primer on how commodity markets function and delve into the effects of speculation and manipulation.  

1) The Basics

Commodities are fungible, physical products like gold, crude oil, sugar, and soybeans. Commodities can be traded in a few different forms. One common contract is the deliverable future. A deliverable future trades on an exchange with a specific expiration date. Let's say I buy 1 crude oil future for $80 with an expiration date of January 23rd 2011. On that date I will be obligated to take physical delivery of crude oil at a specific location at a price of $80. The contract specifies the quality of the product I will receive and the logistics of accepting the product. A deliverable future may change hands thousands of times on an exchange before expiration; most of the traders having no intention of dealing with the physical commodity.

Non-deliverable futures (also known as "cash settled futures") are similar, except that no product is ever delivered. Instead, the contract expires at a specific date and the holder receives the difference between the contract price and the price of the product. For example, if I paid $80 for the crude oil contract, and oil is now trading at $85, I will receive $5 from the seller of the contract. Another common type of commodity contract is the "forward." Forwards differ from futures in that they do not trade on an exchange. Instead, they are between two parties. This allows the contract to be more customizable but exposes both buyer and seller to counterparty risk.

For any given commodity, there are a series of futures with various expiration dates. For example, crude oil futures exist for every month from now through at least 2018. The contracts with nearer expiration tend to trade much more frequently. All of these futures taken together are called "the curve", because they tend to form a relatively smooth shape. Some commodities typically form an upward sloping curve known as contango. For example, a gold future with a later expiration date will almost always cost more than a nearer date. This is because the future with later expiration includes the price of storing and insuring the gold, as well as the cost of capital. If it costs me $1 a year to store an ounce of gold and another $1 to insure it, I would rather own the right to buy gold in a year for $1000 than buy it today for $999.50. Below is a graph of the gold curve.

Some commodities frequently form a downward sloping curve known as backwardation. This generally occurs in commodities that are costly or difficult to store for lengthy periods. It can be caused by a short-term lack of supply, but may persist if producers hedge more than consumers. I'll discuss this at greater length in the next section. Below is a graph of the crude oil curve in 2007.

2) The Players

Natural Sellers - The natural seller of a commodity is the producer. For example, a coffee grower must sell his coffee. He could eschew the commodity market and wait to sell his coffee until it is harvested, but that would be risky. In this scenario, he will invest in equipment and fertilize without knowing what price he will eventually receive for his product. Instead, he can enter into a contract to deliver his coffee in 3 years at a specified price. He will know today exactly what price he will receive in 3 years, so he can make smarter business decisions about how much to invest in production. He can also reduce his earnings volatility from seasonal weather fluctuations. The downside is that the farmer will not benefit from an unexpected increase in the price of coffee.

Natural Buyers - The natural buyer of a commodity is the consumer. For example, Starbucks is a massive consumer of raw coffee. Over time they can pass some price increases on to their customers, but their profit margins are still hurt by sudden increases in the price of coffee beans. To reduce their risk, they buy coffee in the forward market.

In some commodities, the natural sellers are more active than the natural buyers. This causes the commodity curve to slope downward in a condition known as normal backwardation. The future price of the commodity keeps falling until market makers or speculators believe they have a high enough expectation of profit to buy the futures.

Market Makers - The market maker effectively serves as a middleman between the natural buyers and sellers. The coffee farmer may wish to enter a contract to sell his harvest in May, while Starbucks may wish to enter a contract to buy coffee in July. The market maker will take the other side of each trade and bear the risk that the price of coffee moves significantly between May and July. Another service the market maker provides is in preventing temporary supply and demand imbalances. For example, let's say the farmer wishes to sell his coffee today and Starbucks will be buying tomorrow. The market maker will buy from the farmer today and sell to Starbucks tomorrow. In exchange for the risk and the time it takes to facilitate these exchanges, the market maker can expect to earn a profit by slightly underpaying the farmer and overcharging Starbucks.

Speculators - Traders at hedge funds, large banks, and commodity companies speculate on future price moves. These speculators generally have no interest in the physical commodity itself, they are simply betting on what the natural buyers and sellers will do. For example, a speculator may sell coffee futures as a bet that the weather will be conducive to a healthy coffee crop. If the weather is good, farmers will produce more coffee and have more to sell, so the price will drop. The speculator will be able to buy back his futures later at a lower price and earn a profit.

3) Speculation and Manipulation

Speculation in commodities takes many forms. The price of commodities is ultimately driven by supply and demand, so any factor that influences supply or demand is a potential source for speculation. In the previous section, I mentioned that speculators bet on how weather will impact the supply of an agricultural crop. Another common weather bet is to speculate on the extent to which hurricane activity in the gulf of mexico will decrease crude oil production.
Speculators also make longer term bets on both demand and supply. For example, a speculator may believe that global GDP growth will surpass expectations leading to higher than expected demand for commodities. Another speculator may wager that aggressive investment in production will increase supply and depress prices.

These speculators serve a valuable function of researching commodity fundamentals and sending price signals to the market. For example, crude oil supply and demand may be balanced at a price of $80 today. However, speculators may believe that in 5 years, demand will far surpass supply causing a severe shortage. The shortage may send prices flying up to $300 and reduce global GDP. The speculators bid up crude prices to $120. The price increases is noticed by oil executives, who respond by investing in new production. In 5 years, this increase in production could result in a crude price of $150 and mitigate the damage to global growth.
Commodities are generally believed to be an inflation hedge. Theoretically, they should rise at the same rate as inflation and produce a 0% real return. However, since many investors become attracted to commodities when they fear inflation, commodities tend to surge as inflation rises. A speculator may buy commodities on the expectation that inflation fears will soon cause other market participants to buy commodities. In the last year, gold surged 30% as investors desired a hedge against the effects of the US Federal Reserve tripling the money supply.

Other speculators try to profit directly from the trades of others. For example, a speculator may notice a pattern that at the end of every month, a corn farmer sells futures, resulting in a temporary decrease in the price of corn. The speculator will sell futures an hour before he expects the corn farmer to sell. An hour later, the corn farmer will still sell futures, be he will receive a lower price. The speculator will buy back his futures for a profit. The speculator's profit comes directly at the cost of the farmer.

In general, studies suggest that speculation reduce the volatility of commodities by reducing temporary supply and demand imbalances. However, a growing number of speculators are "momentum traders" who increase volatility.

Commodity speculation is generally short-term and performed by specialists. However, in 2007 and 2008, a large amount of new money began chasing commodities. Fund Managers and Mom and Pop retail traders looked at charts of commodities over the previous 5 years and decided they wanted to participate in the commodity rally. They bought commodity ETFs, which in turn bought commodity futures. This price insensitive buying pushed all commodity prices higher and caused a bubble. Crude oil was pushed up from a fair value of around $75 to $145. Like all bubbles, the commodity bubble soon burst and sent crude oil below $40.

Commodity markets are much less regulated than stock markets. There is no clear definition of "insider trading" and very few traders have ever been prosecuted for manipulation. "Manipulation" of some kind is a daily occurrence in the commodity markets. A minor example is of a trader pushing the market price of a commodity a few pennies to trigger stop market orders. A much more serious form of manipulation is cornering a market. In 1979, the Hunt brothers bought up 1/3 of all the world's silver, mostly on credit. By controlling such a large percentage of supply, they were able to control the market price of silver and drive it artificially higher. In 1980, the COMEX created a new rule that limited the purchase of commodities on credit, and effectively forced the Hunt brothers to sell a portion of their silver. This triggered a 50% price collapse over four days.

A common form of manipulation is forcing out the "weak hand." A trader puts on a position against a known counterparty. The trader estimates that if he pushes the position far enough against his counterparty, the counterparty will give up and close the position, pushing the bet further in favor of the trader. For example, let's say you bet that corn prices in 2013 will rise and I bet they will fall. If you control several billion dollars and I only control a hundred million, you can keep bidding up corn prices far longer than I can sell them. Eventually my loss will be so great that I will be forced to buy back my futures and drive prices up even higher. Whether you are right or wrong about corn prices in 2013 is irrelevant - you will earn a profit by forcing me out of my position.

4) How to be Eddie Murphy from Trading Places
In the movie "Trading Places", Randolph and Mortimer Duke try to corner the market for orange juice concentrate. They bribe a government official to get an early look at a critical crop report. Billie Valentine (played by Eddie Murphy) and Louis Winthorpe (Dan Akroyd) foil their plans by stealing the crop report and passing on a fake report to the Duke brothers. Even in the lightly regulated commodity markets, stealing a government crop report and using it to manipulate prices is illegal. So, unfortunately we won't be getting rich following Eddie's lead any time soon.

The closest we can come is trying to identify situations where a speculator is overexposed. The Duke brothers committed their fortunes to a leveraged position; when the futures began moving against them, they were forced to sell and this dramatically increased the volatility, and potential profit for a savvy trader. When Brian Hunter of Amaranth made an oversized bet on Natural Gas futures, another trader was ready to sweep in for the kill. John Arnold of Centaurus let Hunter push the market far from equilibrium and then swept in to take the opposite position. Arnold profited from Hunter's bust.

Your speculating trader,

Vega

Startup Reading List - The Best of It - Alpha

2010-11-08T19:47:00.000-08:00

After reading dozens of books on startups, here is what I recommend. The books below are a great introduction into business thinking, experimentation, and how to invest (not just money, but time and other resources too).

START HERE – these books all have good information and complement each other – I recommend buying all four. You will read them many times.

ART OF THE START (Kawasaki): http://www.amazon.com/Art-Start-Time-Tested-Battle-Hardened-Starting/dp/1591840562 (basics for a tech startup – Kawasaki focuses too much on pitching to angels/VCs/funders as opposed to bootstrapping)

START SMALL FINISH BIG (DeLuca): http://www.amazon.com/Start-Small-Finish-Big-Successful/dp/product-description/0446524026 (basics for all new business creation, from the Subway founder DeLuca – lots of great bootstrapping tips – how to get from small to very large)

DO MORE FASTER (TechStars): http://www.amazon.com/Do-More-Faster-TechStars-Accelerate/dp/0470929839 (more detailed basics for tech startups, from the venture incubator TechStars in CO/NY – most important tips are on how to create a good initial team and how to iterate quickly from bad ideas to products that sell soon – I think a committed team of people who trust and complement each other matters more than an initial idea for most startups)

REWORK (Fried): http://www.amazon.com/Rework-Jason-Fried/dp/0307463745 (conceptual basics from the 37 Signals founders on how to build a solid business and conceptualize a product – many new ventures face these issues)

“HOW TO MAKE WEALTH” (Graham): http://www.paulgraham.com/wealth.html (the single best essay on startups and one of the best things ever written about business and wealth). Graham has written a few other excellent essays on startups:

“STARTUPS IN 13 SENTENCES”: http://www.paulgraham.com/13sentences.html
“WHAT STARTUPS ARE REALLY LIKE”: http://www.paulgraham.com/really.html
“WHY TO NOT NOT START A STARTUP”: http://www.paulgraham.com/notnot.html
“HOW TO FUND A STARTUP”: http://www.paulgraham.com/startupfunding.html
“THE 18 MISTAKES THAT KILL STARTUPS”: http://www.paulgraham.com/startupmistakes.html

ADVANCED READING – explore here as you need more specific information or some great inspiration – you can borrow these or consult them at libraries (I own them).

ENTREPRENEUR’S GUIDE TO BUSINESS LAW (Bagley): http://www.amazon.com/Entrepreneurs-Guide-Business-Law/dp/0324042914 (basic info/guide to all the legal issues – you’ll never need anything else)

FOUR STEPS TO THE EPIPHANY – CUSTOMER DEVELOPMENT (Blank): http://www.amazon.com/Four-Steps-Epiphany-Steven-Blank/dp/0976470705 (a great process/way to talk to customers and develop a product that they want iteratively – geared toward tech)

MADE IN AMERICA (Walton): http://www.amazon.com/Sam-Walton-Made-America/dp/0553562835 (how Sam Walton built Walmart from one store to the largest US company by sales)

BEHIND THE CLOUD (Benioff): http://www.amazon.com/Behind-Cloud-Salesforce-com-Billion-Dollar-Company/dp/0470521163 (how Marc Benioff, a serial entrepreneur, built Salesforce, with great tips on doing a tech startup)

DELIVERING HAPPINESS (Hsieh): http://www.amazon.com/Delivering-Happiness-Profits-Passion-Purpose/dp/0446563048 (how Tony Hsieh, a serial entrepreneur, built his tech companies, and his vision of a company not just selling things but actually improving people’s lives, making them happier)

COPY THIS (Orfalea): http://www.amazon.com/gp/product/B001PO64KA/ref=pd_lpo_k2_dp_sr_1?pf_rd_p=486539851&pf_rd_s=lpo-top-stripe-1&pf_rd_t=201&pf_rd_i=0761137777&pf_rd_m=ATVPDKIKX0DER&pf_rd_r=1NEATZ91HJQV4KFMP7VR (how Paul Orfalea built Kinkos from one store after graduating from college – lots of great stories and personal growth advice)

“THE GOLDEN GUT” (Kirkland on Adelson): http://money.cnn.com/magazines/fortune/fortune_archive/2005/10/17/8358041/index.htm (how Sheldon Adelson, a serial entrepreneur, built multiple businesses and sold them, getting bigger every time and taking smart risks and experimenting)

The Recent US Mid-term Elections Analyzed - Alpha

2010-11-08T19:39:00.000-08:00

The mid-term elections were a big deal for two reasons. First, it’s the first time since the 1940s that the voters removed the party in control of the House for three consecutive elections (the GOP lost both houses in 2006 and the Presidency in 2008, only to win the House back in 2010). Second, it was the largest change in House seats since 1948. The GOP’s strategy of gridlock and non-cooperation worked.

The election results fell in line with consensus expectations. Basically, with unemployment stuck at 9.6%, voters kicked the Dems out of the House early due to the lack of JOBS.

The irony was that while the House was passing many bills, the Senate is where the bills went to die, thanks to the self-imposed filibuster, 60-vote Senate rule used by the GOP mostly (and some wavering Dems). However, voters left control of the Senate to the Dems, with 53 Senators and so a 3 vote margin.

While NBER dated the recession’s end to mid-2009, the flatlining jobs situation (and so stagnating income and skills) has made voters furious.

Jobs are a big deal. A landmark study in the Economic Journal followed 130,000 people for a few decades, allowing researchers to look at major life events, like marriages, divorces, births, deaths, and so on. It found that unemployment for over one year might be the only major life event from which people (esp. men) do not recover within five years. People were more likely to recover from the death of a spouse than from prolonged unemployment. See Clark, A.E. et al. Lags and leads in life satisfaction: A test of the baseline hypothesis. Economic Journal, 118(529), 2008, F222-F243.

By that measure, the US has a crisis on its hands. Politicians may say “Jobs!” while not actually doing anything, such as providing leadership, enacting pro-stimulus or pro-business policies, or reducing political risk and uncertainty for businesses to expand and hire.

How to Invest Your Savings - Alpha

2010-10-10T22:46:00.000-07:00

These are some thoughts for an ordinary person who doesn’t follow markets or business much, but needs to invest his or her savings.

First of all, congrats. The most important financial decision is to pay down expensive debts (credit card debt, especially) and to live within your means. To save. If you’ve done that you should pat yourself on the back. I would suggest you try to save 50% of your after-tax income.

Now to markets and investing.

Generally, for periods longer than 15 years, stocks have higher returns than bonds. However stocks can go down a lot in a single year (a 40% drop or more), whereas bonds usually go up every year (3-5% gains). So you need nerves of steel to buy stocks and hold them (they can also go up over 30% in any given year). Also, stocks follow the business cycle. Every 5, 7, or 10 years (the number isn’t exact), business goes through a cycle when times are good and fat, and then a peak is reached and times become bad and lean. Ideally you would own more stocks at the beginning of the cycle and more bonds at the end. Buy low, sell high. Easier said than done.

So, how to invest?

1) Hold diversified index funds, not individual stocks. Index funds are meant to match broad markets like the S&P 500 Index (largest US stocks), Barclays US Aggregate Bond Index (broad US bonds), or MSCI AC World Index (largest global stocks) at low cost. Index funds generally beat most mutual funds. Vanguard and Fidelity provide good, low-cost index funds. Generally the biggest index funds are the best (size gives liquidity and pricing discounts – it’s like buying bulk at Costco).

2) Divide your holdings between bonds and stocks. The percentage of your holdings to bonds should equal your age. So if you are 30 years old, invest 30% in bonds and the rest (70%) in stocks. I would hold about half in a domestic fund and half in an international fund. This is called “asset allocation.” Here are diversified Vanguard funds (International stock fund and a diversified bond fund):
https://personal.vanguard.com/us/funds/snapshot?FundId=0129&FundIntExt=INT
https://personal.vanguard.com/us/funds/snapshot?FundId=0522&FundIntExt=INT

3) Re-balance your holdings every 2 years or so to match your age. Check your statements every 6 months.

You’re done. That was simple.

So what could make this more complicated? Two things.

First, there’s the business cycle. If you have a perceptive eye for the world and go to many cocktail parties, you’ll notice that at the top of a business cycle many people will tell you about the killing they’re making in stocks. They’ll brag and then show you something fancy they bought (car, house, boat, trophy wife, other toy, etc.). When you see this happening a lot, sell all your stocks and hold just bonds for a while. When people reach the other extreme (a disgust of stocks due to large market drops and their new toy being taken away due to a foreclosure), go back to your regular allocation, or put more in stocks. The whole process is called “market timing” and experts often discourage it. I call it “going against the herd” and encourage it. At the very least, don’t run with the herd.

Second, there’s inflation. In today’s world, the bank and money system is controlled by central banks, namely the Fed in the US. Every few decades the central bank comes under enormous pressure to create inflation. In the US, the 1970s was one time. I suspect 2011-2019 will be another because of all the deficits and debts that people don’t want to deal with. Inflation is generally bad for all bonds and most stocks. Older people who hold more in bonds are hurt the most. The best things to hold when you expect inflation are energy/metal/commodity stocks and real estate. Vanguard and Fidelity have index funds for these. Generally I think it’s better to hold and manage local real estate, bought at foreclosure sales or from banks. But that takes some gumption, skill, and effort. So most people should stick to index funds. Here are three funds to consider (precious metals, energy, and REITs):
https://personal.vanguard.com/us/funds/snapshot?FundId=0053&FundIntExt=INT
https://personal.vanguard.com/us/funds/snapshot?FundId=0051&FundIntExt=INT
https://personal.vanguard.com/us/funds/snapshot?FundId=0123&FundIntExt=INT

(NOTE: I have no tie or connection to Vanguard or Fidelity, and I get no compensation from them. I've found that these two are generally well-run financial firms that mostly try to do the right thing - this is something quite rare in the world of finance and unlike the rest of Wall Street, which is simply greedy and amoral.)

Causes of the US Economic & Financial Crisis in 2008 - Alpha

2010-09-19T12:56:00.000-07:00

by Alpha and Vega, an Investor and a Trader
September 19th, 2010

In this issue:
1) A difficult question
2) Long-term structural economic problems
3) Short term catalysts for the financial crash
4) Bluto’s revenge in the movie “Animal House”

In this letter we answer the question: “What caused the US economic and financial crisis in 2008?” We look at long-term structural causes and short-term catalysts. This is a longer piece than most, and we try to present many arguments, data points, and references for further reading.

1) A difficult question

What caused the US economic and financial crisis in 2008?

Whatever it was, it was enough to cause former Fed Chairman Alan Greenspan, a free-market disciple of Ayn Rand, to sit in front of a Congressional panel and admit, while squirming in front of lights and TV cameras: “This crisis has turned out to be much broader than anything I could have imagined. It has morphed from one gripped by liquidity restraints to one in which fears of insolvency are now paramount. . . I don’t know how significant or permanent [the flaw in my ideology] is. But I’ve been very distressed by that fact.” Greenspan was one of the few intellectually honest people in admitting his own ignorance and error.

Greenspan Admits Mistakes in 2008 (Testifying to Congress in 2008)

No one has given a cogent, comprehensive answer that is brief and non-technical. Economists have responded like ducks by sticking their head in the water and blaming one another, with debates between “saltwater” and “freshwater” economists. Historians point to disparate episodes and facts like the Great Depression and Asian Crisis of 1998 (while ignoring the US depression of 1870-1890 and the Japanese balance sheet recession of 1990-2008). Financial experts point to short-term catalysts and trends, like MBS or CDO issuance and the failure of ABCP or money markets (acronyms are one tool Wall Street uses to screw people); but these experts ignore the big picture.

This letter will attempt an explanation for what caused the 2008 crisis in the US while acknowledging its global context. I shall also link the insight that numerous thinkers and writers have brought to the issue and try to frame a robust answer. For further reading beyond the books and articles in this letter’s references, the St. Louis Fed has a nice repository of academic articles about the US financial crisis (and a first-rate glossary).

Two types of problems created the crisis. First were deeper, long-term structural problems, such as:

a) Too much total debt accumulation per person and per unit of GDP from1980-2007
b) Looming structural deficits from Medicare and Social Security (off-balance sheet debt) make the US even more insolvent
c) Consistent trade deficits powered by the US’s reserve currency status, an undervalued Chinese yuan, and the resulting decline of the US export and manufacturing bases:
d) A financial industry acting as a giant tax on the US: Too much deregulation of financial markets, leading to spurious innovation that enriches the financial sector at the expense of consumers (corporate and retail)
e) A massively inefficient tax code, with too many complex rules and hidden “tax expenditure” subsidies to wasteful interest groups
f) Resources wasted on two wars (2002-2008) and US military protection for the rest of the world

Most politicians, economists, and the news media personalities have tried to conceal the structural economic problems of the US rather than honestly deal with them. Within the structural environment of economic degradation, there came second a group of short-term catalysts. When these combined, they were toxic and led to a period of financial fragility from 2007 on and a tipping point in September 2008:

a) Low interest rates and weak mortgage regulation: this enables speculation leading to the mortgage boom and real estate bubble
b) Bad bank balance sheets due to excessive risk-taking and agency costs: Weakening regulation of large banks causes re-consolidation and dangerous investment bank debt levels
c) Black-box derivatives: The development of a complicated and unstable, even destabilizing, derivatives market
d) The trader mentality in the US: The short-term price appreciation and momentum mentality of professional investors versus long-term yield oriented mentality (average holding period for stocks has fallen from 8-10 years (pre-1960 average) to 4 years (pre-1980 average) to about six months in 2007. Very few investors left (some VCs and corporate investors).
e) Extreme financial fragility through 2007 into 2008:
-Early signs: Bear Stearns hedge funds blowing up and the implosion of the shadow banking system (an old fashioned bank run)
-Inflection Point: From Bear Stearns going bankrupt in March 2008 to the failure of insolvent Fannie/Freddie in early September 2008 – largest financial institutions in the US (maybe the world) based not on their actual balance sheet, but their guarantee liability for mortgages (above $5 trillion combined)
-Phase Shift: Failure of insolvent Lehman Brothers and illiquid AIG causes phase shift in markets in late September 2008

To read the full letter, please see the pdf on Scribd here:
Causes of the 2008 US Economic and Financial Crisis (Sept. 2010)

Common Stock Analysis of Collective Brands (PSS) (Formerly Payless Shoe Stores) - Alpha

2010-09-16T20:40:00.000-07:00

Collective Brands (PSS - $12.50 on Sept. 2, 2010) was a Topeka Kansas company founded in 1956 with a strategy of selling low-cost, high-quality family footwear on a self-service basis. It was bought by May Department Stores in 1979, went public again in 1996, and in 2007 bought Stride Rite (a Mass. Shoe company started as Green Shoe in 1919). PSS is one of the largest shoe retailers in North and South America, with 4,500 stores selling 140 million pairs of shoes and 40 million accessories in 2009. Its wholesale division is PLG, selling shoes to a range of stores in North America. Here’s how the company defines its strategy in its 10-K:

“We seek to compete effectively by getting to market with differentiated, trend-right merchandise before mass-market discounters and at the same time as department and specialty retailers but at a more compelling value. North American stores are company-owned, stores in the Central and South American regions are operated as joint-ventures, and Middle East stores are franchised. Stores operate in a variety of real estate formats. Approximately a quarter of the company-owned stores are mall-based while the rest are located in strip centers, central business districts, and other real estate formats. We also operate payless.com® where customers buy our products on-line and store associates order products for customers that are not sold in all of our stores. At year-end, each Payless ShoeSource store stocked on average approximately 6,700 pairs of footwear. We focus our marketing efforts primarily on expressive moms and expressive self-purchasing women ages 16-49. These consumers use fashion as a means of expressing their personalities, but also place importance on low prices. They tend to have household incomes of less than $75,000 and make a disproportionately large share of household footwear purchasing decisions. We believe that over one-third of these target consumers purchased at least one pair of footwear from our stores last year.”

Here are the financials:

10-K: http://www.sec.gov/Archives/edgar/data/1060232/000095012310028931/c57088e10vk.htm#305

10-Q: http://www.sec.gov/Archives/edgar/data/1060232/000095012310055069/c58454e10vq.htm

Key Stats: http://finance.yahoo.com/q/ks?s=PSS+Key+Statistics

Thesis:
-Cash-flow generating healthy retail company, selling the staple of shoes - trades at cheap levels and is paying off debt. Fair Value range of shares between $32 to $40.

-Health of the core business: Seems positive but needs further investigation by talking to store managers (esp. in intl. locations). Most of the PPE seem to be in store fixtures, not the actual real estate which they tend to lease (financials are not fully clear about this). So the real value of the PPE is prob. less than the book value. All their inventory is made abroad (China, Vietnam, etc.). SG&A has held consistently around 29%-30% since 2006 – not worried about that (recent gross margins at 35% are at the high end though – not sure if this is cyclical or a positive trend). Turnover slowed because their assets went up (growth of book value) but sales basically stayed flat or slightly decreased (peak was $3440mn in 2009 and the TTM is $3320mn).

-Negative same store sales growth has slowed: This has flattened as of Q1 2010, going from -5% in Q1 2009 (the worst) to -1% (total net sales were up 2%, as US sales fell by 4% but international sales were up by 18%). COGS were down and margins up. The biggest question is PSS’s relative competitive position compared to discounters like Walmart, Target, etc. (do people go to a special shoe store for cheap shoes, or are they happy buying them on a discount store trip?). This isn’t a shoe business (like Nike or Asics), but a shoe retail store business.

-Earnings don’t matter much, cash does: The numbers are volatile. The margins and earnings are about par with the comps, but this business is selling much more cheaply. After hitting a low in May 2009, cash balances are coming back up. More importantly, OCF and FCF are holding up quite well. Total current assets at $1050 is about equal to total liabilities and LT debt at $1150. The company has been paying off debt steadily.

-The business is cheap: Then you have the net book value of PPE at $450mn, along with an OCF of $310mn and FCF of $210m. This is for a current equity market cap of $914mn (as of Sept. 10, 2010).

So basically, for $914-450= $464mn in equity invested, you’re getting $210mn of FCF a year. A pretty decent return of 45%. Even at the full $914mn, you’re getting 23%.

-Current CEO is a Cole Hahn and JCrew vet – he knows branding.

- Recent big strategic investor is Blum Capital in SF, whose MO is to take a large stake for 3-5 years and then work on building value over that period.

Risks:
- Sales uncertainty: The biggest question is whether intl. sales growth can keep strong and domestic sales decline can be stemmed. The retail shoe business isn’t going anywhere, though, and Payless/StrideRite own the bottom end of the market (strategy is to focus on “expressive women”, i.e. moms and young women who want cheap but fashionable shoes for themselves and their kids). People still have to buy cheap shoes in a recession (millions of working class people go to PSS’s stores). Still some uncertainty about this large topline risk.

-Some valuation risk, maybe not enough of an asymmetric bet: Tangible book value is close to 0 (does BV matter anymore?), they've been experiencing negative same store sales growth over the last 3 years, margins stink (and have stunk for the last 4 years). So, all you're getting is current earnings. This quarter earnings are $0.83 per share, and last year they were $0.59 so let's go with the more conservative number. Simply annualizing that and applying a PE of 6 (treating this as a utility with no growth prospects), we get a fair stock price in the area of $14.16. If they get a couple of good quarters and people get optimistic, I could easily see investors applying a PE of 12 with earnings of $.90 which would produce a stock price of $43.20. So, potentially plenty of upside, but the true economics are not attractive. I wouldn't consider this a value investment unless I could it buy it for <$9. On the positive side, customers are very spread out, and average price increases in a year were 4-6% (pretty strong), as same store sales fell 2-3%.

- Company's cost structure is bad: It has high fixed costs and low margins. It may take little to send them on to a road of bankruptcy, despite a strong cash position (a risk for all companies with such debt levels, though PSS is paying off its debt fairly quickly and the maturity wall doesn’t seem to be a problem).

Trigger:
-We anticipate a high change (60-70%) of a general US stock market sell-off, making the business even cheaper (a 40% FCF return on market value would be perfect).