Monday, October 31, 2011

Bullish For Next Ten Years?

I just found this chart in a promotional video from Davis Funds and I thought it was interesting in that it illustrates what I tell people about dumping stocks because they say stocks are no good.

The chart below shows every ten-year period since 1928 that the market rose less than 5%.  The gold bars show what the market did in that ten-year period, and the green bars next to it shows what the market did in the following ten years.


A flattish ten-year period is not so uncommon.

I show this not to say that we are about to enter a big bull market, but more to caution people against reacting to historical performance.  Just like the financial press rushed to promote stocks in 2000 saying that you can't afford to retire unless you own a lot of stocks and showed historical performance to prove it, they are now pretty busy telling us that stocks just don't cut it and show the returns of the past decade+ as proof.

This chart shows you that if you react to historical returns like that, you may come to regret it.

This is not just retail investors, of course.  Institutional investors too are rushing into all sorts of non-stock investments.  I like stocks when others are running from them.

Of course, this is not to say that we can't have another decade of a flat market.  Bears will point to Japan and say, gee, you could've said the same thing in Japan back in 1999 (ten years after their stock market peak in 1989), but I would argue that stocks were far from reasonably priced back in 1999 in Japan, even ten years after the start of their bear market.

In any case, I understand what people would say when seeing this chart:  government debt levels are far higher now than during any of those other periods in the chart, Europe is a disaster,  margins are at abnormally high levels so even with low p/e ratios the market is unsustainably high etc...  Or one can argue that the entire 20th century was a bull market and that has ended so these historical figures don't matter now in a bear market century etc...

This all may be true.  This time may be different.  Who knows.   At the very minimum, I would say that the take-away from this chart is to be very skeptical of people who tell you to stay away from stocks because they haven't performed well recently.

By the way, the videos posted there are not bad at all.  Chris Davis is a solid value investors with the right approach and principles and runs a low turnover, high quality fund.  I don't own any of the funds, though. 



Friday, October 28, 2011

VIX: Fear Index Update

VIX Index, Last Five Years



Wow, so that was quite a rally since my recent post(s).  I am tempted to list up the things that I've mentioned in the past month and how well it's done, but I won't.  I didn't make those comments as a short term call on the market.

But the fact that the market was reasonably if not cheaply priced, that the VIX was pretty high up, sentiment was bearish and there was a lot of fear, that even Buffett thought BRK was cheap that he announced a share repurchase, great financial companies like Goldman Sachs and JP Morgan were trading under *tangible* book value per share etc... were all indications that things might go up.

Of course, this may just be another reflex rally in an ongoing bear market.  I wouldn't know.   I just look for values and act accordingly.

BX: Blackstone Group

I was going to pick this apart to see what it is worth and all that, but a few things about this is bugging me so I will hold off on looking at this in too much detail for now.

Anyway, just some quick thoughts.  I do like the idea of private equity.  I am not one of those that think of private equity guys as asset strippers or anything like that.  I think they serve an important function in the economy/capital markets.  I know some of the older school financial people don't like what private equity does but I am not one of those.

One of the main issues I have with BX as an investment is simply it's huge success over the past few years.



This is the table of their assets under management (AUM) since 1995 from their 2010 annual report.  So AUM went from $3 billion in 1995 to $131 billion at the end of 2010.  That's an astonishing growth rate.

I think the Blackstone reputation was already solid back in the 1980s and 1990s.  They built a very good track record in private equity with AUM under $5 billion or so.

Again, when AUM goes up so much in private equity, they have to increasingly chase the mega-deals, and do that with other giant private equity firms which tends to make prices much higher.

So Blackstone has done the right thing; they have diversified away from private equity.  They still do a lot of it, but much of their AUM increase since 2005, as you can see, comes from areas other than private equity. 




At this point, the private equity portfolio is a small portion of total AUM.  On a fee basis, as the above chart shows (also from the 2010 annual report), only 15% of the fees come from the private equty business. 

Hedge funds and Real estate now account for more than half of the fee related income at Blackstone.

That may be good, actually.  But for me, I was attracted to Blackstone for their reputation in private equity, and I do have a lot of respect for Stephen Schwarzman.  I think he is very smart and competent.

But to own BX now is not the same as owning a private equity firm that generates 30-40%/year returns for their clients.  Most of the portfolio as it exists today will not generate those kinds of returns.

So first of all, this is not a pure private equity play investment that some may believe it to be.  It is a very different bet than that.

I don't have anything against real estate and hedge funds.

There is good disclosure on the real estate fund returns in the financials of BX, but there really isn't much for the hedge fund business.  An aggregate, composite return is mentioned here and there, but there is no breakdown in terms of strategy like Och-Ziff (OZM) and Fortress Investment Group (FIG) discloses.  Nor do I have much knowledge or comfort with the people who are running BX's hedge fund business (not to mention that I am not a big fan of funds of funds).

My concerns with size apply to these two segments too.  Many high return hedge funds turn flat once their asset base gets too big.  There is just no getting around that.   But without a look 'inside' it's even more worrisome.

This is not to say that BX can't do well going forward.  Schwarzman is no fool and he will probably continue to do well.  It's just more a comfort issue for me.

AUM level too high, private equity now a minority business there, not much disclosure about the big hedge fund business segment are issues that I can't get comfort with. 

Also, I tend to like asset managers as they have operating leverage: they have a high fixed cost base but when asset levels rise due to investment performance and net inflows of investment funds, the asset managers earnings go up a lot.

But I notice that a lot of asset increase at BX recently has come from adding different strategies.  This is good from a diversification standpoint, I suppose, but it does increase the cost base.  If they increase AUM by increasing the number of different stategies, fund types and fund managers, then the operating leverage won't work to the same effect.  This, of course, is not necessarily a bad thing.  Schwarzman is actually trying to build a sustainable business that will outgrow his own presence. 

What I worry about is in fact Schwarzman's goal.  He wants BX to be a company that can survive without him into perpetuity.  So again, this is not automatically a bad thing.  It's just a personal preference issue for me as an investor on why I would or wouldn't be interested in investing in BX.

The other issue is that the S&P 500 index has been flat since 2000 and interest rates are very low.  This means that pension funds and other financial institutions have very little chance of making their projected investment returns. 

This is kind of a dangerous thing.  The right thing to do when pension asset return assumptions are too high is to reduce them and take an earnings hit.  But CEO's don't generally want to do that.  They would rather take the 'easy' way out and simply not own bonds and stocks (or they will reduce allocation to those assets dramatically).  They will shift their asset mix to 'alternative' investments that promise them higher returns.

As far as I'm concerned, and maybe I am overly conservative, that might be a recipe for disaster.

A lot of the assets rushing into BX and other alternative asset managers are flowing in for this reason, and that is kind of scary.

Looking into these things, it's no wonder that a lot of large, blue chip stocks are trading so cheaply; nobody wants to own stocks since they've been flat forever.  They want to own 'alternative' assets that will make them enough so that they don't have to take down their pension asset return assumption (and worsen the underfunded status of the funds, or take an earnings hit).

Monday, October 24, 2011

OZM: Och-Ziff Capital Management Group

Listed Hedge Fund Company
Here's a listed hedge fund that looks interesting although I don't own it at the moment.  A few hedge funds and private equity houses went public in the past few years and it is pretty interesting because you get to invest with some pretty amazing people.  Of course, the performance in many of these vehicles in the past few years have been horrible because many of them went public at the height of the hedge fund / private equity bubble. 


Listed Private Equity Funds
Some of the private equity shops do look interesting, but I worry that they have gotten so big in the past few years that I wonder how well they will do.  Shops like Blackstone and KKR have done extremely well over time with 30%-40% annualized returns on their funds.  But this is when they had assets under management of under $10 billion.  It's one thing to really get huge returns when you only have $2 or $3 billion under management. 

If you look at the assets under management of these private equity guys, going over $20 billion (or whatever they are at this point), it gets a lot harder to move the needle in terms of investment performance.  I think that was part of the reason why so many of them did poorly in 2007/2008.  The funds were so huge that only mega-deals made sense for them.  And when you have too many of those guys chasing the few available mega-deals, prices go up and returns go bad.  It also encourages them to move into areas where the capital can be deployed in size, like commercial real estate.  Oops.

I'm sure Blackstone, KKR, Fotress Investment Group will do well over time, but with so much assets to move, I doubt they will be making 30-40% returns going forward.

Back to Och-Ziff
Anyway, here is one interesting hedge fund (not private equity), Och-Ziff Capital Management (OZM).  Och-Ziff is a solid hedge fund shop with a pretty good reputation.  It is run by Daniel Och, a former Goldman Sachs trader (Goldman haters and Off Wall Street protestors can stop reading here).  They are very specific in the sort of trades they do and pretty much do strategies similar to what is done on Wall Street investment bank proprietary desks; special situations, arbitrage and things like that.  None of these strategies are going to return 30-40%/year over time, like George Soros.  But they won't really blow up too much either.

Here is the breakdown of strategies in their flagship fund:


These strategies, for the most part, are long/short type strategies and are typically not highly leveraged like fixed income arbitrage funds (like Long Term Capital Managment).  They do sometimes have big drawdowns in stressed periods, but they usually don't blow up like credit arbitrage guys since they don't get 10-1 or 20-1 leverage.  They deal in vehicles that are known to be very volatile.
(All tables and graphs pasted here are from OZM 10-K, 10-Q's, presentations and other company filings)

The return table below shows how OZM strategies are pretty non-correlated to the S&P 500 index.  The top chart shows the return of the OZM fund during only the down months of each of those years.  Between 1994 and 2010, they only lost money three times during the down months of any given year and the rest of the time they made money.  That's pretty good.

On the other hand, they did give up some upside during up months, but they didn't lose money cumulatively either during up months in those years.  This shows the stability of the strategies they use.


They have returns +14.2%/year from 1994 through 2010 versus +8.4%/year for the S&P 500 index.  (As an aside, it's kind of incredible that the S&P 500 index has returned +8.4%/year since 1994 despite having gone through the great recession, 2000 internet bubble pop etc...)

Below is a look at the returns over various time periods for the OZ Master fund.  It has nicely outperformed in most periods (except the past year through 2010) with much lower volatility than the S&P 500 index.


How are they doing this year?  Here is the returns for the second quarter and year-to-date as of June 30, 2011.



Assets under management has grown substantially too at OZM, from under $6 billion in the early 2000s to $28 billion at the end of 2010.  Of course, like the private equity funds I mentioned above, I do think size will be a factor going forward.  I wonder if they can continue to achieve 15%/year type returns at the size they are.  They will have to look for more trades to put on to absorb the capital.
So OZM was founded in 1994 by Daniel Och and is still run by him.  He is still 50 years old so we can expect him to continue to run this thing for a while longer; no succession issue here.

OZM IPO'ed back in November 2007, right around at the height of the bubble, or right before things really started to fall apart.  The IPO price was $32/share to the public.

This is, like other recent hedge fund/private equity IPO's really complex, but to keep it simple, the class A shareholders owns (as of June 2011) 25.6% of the operating business of Och-Ziff.  The other 74.4% is owned by the class B share holders.  Class B shares are not listed and they are basically Och and his partners.

The income statement shows a $1.6 billion expense item under reorganization cost or something like that, but that is not an ongoing, cash expense.  It was part of the pre-IPO reorganization that causes OZM to expense $1.6 billion per year for the OZM class B shares it issued to the original, pre-IPO partners.

Anyway, not to get too bogged down in that, let's just say that this $1.6 billion expense is something you can ignore.  It relates to a stock issuance back in 2007 and the expenses will run for five years after the IPO (so will end in 2012).  No cash changes hands; it is amortization of something that already happened.

Before we look at what the business itself is actually worth, there is a couple of other balance sheet items to look at. 

Balance Sheet Stuff
There was cash and cash equivalents of $168 million as of June 30, 2011.  But there is also $635 million of term debt on the balance sheet, so this isn't net cash.   I don't think it would make sense to look at the $168 million cash position alone and add it to the per share value of the investment management business.

There is also some consolidated fund positions on the balance sheet that is a little hard to figure out.   In the consolidated balance sheet, there is a net $536 million for "Assets of consolidated Och-Ziff Funds" (I netted out the liabilities with the same label).   I don't know how much of these assets actually belong to OZM and how much to investors.  The netting of other interests is clumped into one category on the balance sheet.

However, in the VIE (Various Interest Entities) section of the notes to the balance sheet, there is a section "Assets (and liabilities) of consolidated Och-Ziff Funds" listed, and the note says that these assets/liabilities belong to the investors.  If I assume that this is included in the consolidated balance sheet section of the same name, then I can subtract this amount from the above $536 million to get OZM's ownership in their own funds.

The VIE Och-Ziff fund assets listed was a net $258 million.  If I'm right, then OZM's ownership in their own funds is $536 - $258 = $268 million.

Again, this plus cash together is still less than the funded debt on the balance sheet so it may not be fair to include this in a sum of the parts analysis of OZM;  $436 million of cash and investments is still below the $635 million funded debt.

If you say that the funded debt is completely carriable by the investment management business and in a split up will have no problem supporting it, then you can add this value of cash and investments as a spin-offable value (but I wonder about that; the lenders are aware of this big chunk of liquid asset for sure; otherwise there would be left only desks, PC's and some file cabinets as collateral).

But let's just put a per share value on it anyway.  Since OZM class A shares own 25.6% of the whole business, the class A share of this cash and fund assets is $111.6 million, and with 97 million class A shares outstanding, that comes to $1.15/share.

With a $10 current share price, maybe this was much ado about nothing.  Even being generous, it would add only 10% or so to the current value of the stock.

There is also $800 million or so of "payable to related parties" or something like that, but that's ignorable too.  This offsets the tax assets on the asset side of the balance sheet.  Basically, whatever tax savings OZM gets from amortizing the high cost basis over time (because they 'bought' the business from the former partners) has to be paid back in cash (or 85% of it, I forget the exact number) to the old partners; basically there was a tax agreement that pays the tax savings of the new entity to the original partners.  This is a common structure in the recent hedge fund/private equity IPO boom).

What is the actual business worth?
OK, so let's look at the actual business.

The hedge fund business makes money by earning 1. management fees and 2. incentive fees.

Management fees are earned on the assets under management on a fixed basis.  OZM fees average 1.7%.  Incentive fees are earned on the profits they generate.  This is 20% (for most funds.  Some funds, like the real estate funds have a different fee structure, but let's keep it simple).

As of June 30, 2011, OZM had assets under management of $30 billion or so.   That means that their rate of management fees is $510 million.  Let's assume that over time they can generate 10% returns.  They have done 14%/year over time, but with $30 billion in assets, maybe we should lower that.   Also, this is the new, new normal, so it would be conservative to lower the return expectation.

If they earn 20% incentive fee on 10% returns, that's $600 million/year in incentive fees.

Combine those and you get a run rate revenues of $1.1 billion per year.

What about costs?  The great thing, usually, about asset management firms is that they have a lot of operating leverage; their cost base (other than bonuses) is largely fixed, so any increase in assets either from more fund inflows or good returns (usually both) goes right to the bottom line (after big bonuses, of course).  Some funds have recently learned that this operating leverage works both ways, though.  But OK, that's a different story.

So we have a revenue run rate of $1.1 billion/year.  What is the expense structure of OZM? 

For that, I just looked at the the economic revenue and economic income over the past few years to try to see what the operating income margin has been.   I don't know what the normalized economic income margin should be, or the fixed cost base.  We can look at both to see what the expected economic income would be.  (Economic income is a measure that OZM uses to evaluate results that exclude things like the $1.6 billion reorganization expense).

Here are the two things side by side: 

                  Economic income           Economic revenues minus
                  margin                             economic income
2006          75.9%                              $231 mn
2007          72.0%                              $315 mn
2008          53.8%                              $271 mn
2009          59.9%                              $284 mn
2010          60.8%                              $289 mn

If we assume a 65% income margin, that would be $715 million in economic income.  If we use $300 million as the cost base (looks stable at that level in the past few years), we get an economic income of $800 million on a normalized basis.

I agree with using economic income as some one-time things like the reorganization expense really obscure the economics of this business.

However, one thing I don't agree with adding back, or excluding from the cost base is their equity compensation:  they give RSU (restricted stock units) as compensation to employees and the RSUs do earn dividends on them at the same rate as the class A shareholders (that would be 10% at a $1.00 dividend), and the dividends are paid in-kind (they issue more RSUs to pay the dividend on those RSU's).

This ranged between $100 million to $122 million in the past three years, so I would deduct another $120 (to be conservative) from the above income.

That would give us a range of pretax, economic income of $595 million - $680 million.

This is pretax (this is a partnership so the class A owners pay taxes on partnership distribution and income), so to keep it simple and keep it comparable to other corporations, I will slap a 35% tax on that.  That gives us net profit of $387 million - $442 million.

The Class A owners own 25.6% of the whole business, so the class A's share of this is $99 mn - $113 mn.

With 97 million class A shares outstanding at June 30, 2011, that comes to an EPS of $1.02 - $1.16/share.

At the current stock price of $10.74, it is trading at a comparable (to other corporations) p/e ratio of 9.2 - 10.5x.

In more normal times (when strong financials aren't trading at under tangible book value), asset management firms tend to trade at 15-20x p/e.  I wouldn't be surprised to see this get to that valuation either over time.  Maybe once the $1.6 billion/year reorganization cost runs off and the income statement starts to look better (superficially), people will pay more attention to it and maybe it goes up.

Dividends
Oh yeah, and OZM pays dividends.  Their goal is to pay out all their distributable earnings.  From 2007 to 2010, the dividends were:

               Dividends paid per share
2007        $1.20
2008        $0.27
2009        $0.72
2010        $1.01

Assuming 2010 was not an extraordinary year (they returned 8.5% or so, so nothing special), they will probably be able to pay out $1.00 or more over the next few years.  That's close to a 9.3% dividend yield; not bad at all in this environment.

The problem some people may have is that this will come with a K1 attached since it's a partnership.

If you assume 9.3% dividends is sustainable, and OZM continues to make money for investors and their AUM continues to go up, it's not hard to see a decent return going forward.


Anyway, this is just a quick first pass look at this thing and I have ignored a lot of things.  This is a partnership, which means the class A shareholders pay taxes and people may have different rates.

Asset management companies generally are good in bull markets due to the operational leverage and things like that, and I do have confidence that OZM will do well over time. I think this is a good, solid firm and Och's reputation over the years I think has been pretty good.

However, they are getting pretty big in assets under management and people need to be aware that running a company with $5 billion of AUM is very different than running one with $30 billion.  They may need to find larger and larger deals, ideas and things like that which will lead to lower hurdle rates on investments etc...  If you are too picky with $30 billion, you won't deploy much capital and if you don't, your returns will suffer (they may suffer anyway if you overpay for assets).

Also, this is a complicated structure with class A shareholders having very little control.  I think Och can do pretty much what he wants to do.

Even if OZM does well, it is possible that class A shareholders don't do well.  Increasing issuance of RSU's to employees will certainly dilute shareholders over time, and of course, class A shareholders have very little say on executive compensation/bonuses which can be very big at these hedge funds.

This is certainly one to keep an eye on and it is certainly an interesting idea, but with so many other financial companies selling for so cheap (like Goldman Sachs), I tend to like other opportunities better (not to mention the simpler structures of financial corporations versus these complicated partnerships!).

Again, this is not a stock recommendation.  Do your own work!  If you buy stocks mentioned on anonymously posted blogs, you deserve what you get!

Tuesday, October 18, 2011

BPS Growth at Banks versus the S&P 500 Index

OK, I keep saying I won't do something and then go ahead and do it a post or two later.

One thing interesting to notice about these bank earnings announcements is how solid they are despite the horrible environment (or so it seems when you read the newspaper).

For example, the S&P 500 index has declined 14% in the third quarter of this year.  The third quarter was truly a horrible quarter with one of the worst declines in market history and a near melting down over in Europe.

If you owned an equity mutual fund, you have most likely lost money; 14% or more.

Of course if you owned bank shares you would have done much worse.

But let's take a step back and see what the banks actually did on a fundamental basis.

JPM's book value per share (BPS) during the third quarter 2011 went like this:

                                                                2Q2011                3Q2011             
Book value per share:                             $44.77      -->       $45.93
Tangible book value per share:              $32.00      -->        $33.04

So the BPS for JPM went up during the third quarter while the stock market went down in one of the biggest drops in history.  (OK, critics will say that is largely due to the debt valuation adjustment; an extraordinary gain due to the *worsening* of JPM's own credit spread.  Yes, that's a one time thing and not a real profit, but so are some other items that offset that in the quarter.  Putting them together, the DVA is not that big a distortion as it seems at first glance).

Why is this relevant?   This would not be an issue if JPM was trading at 2-4x book value, but now JPM is trading under BPS and even under tangible BPS (current price $32/share).

And as I said in a previous JPM post, Dimon thinks the bank should earn at least 15% on tangible book value.  You get to own a business that can earn at least 15% return at under tangible book value. 

If you own the S&P 500 index, you can expect to make 10%/year over time.  Maybe 6-7%/year to be conservative.  Take out the 1-2% management fee that you will end up paying in a mutual fund and that gets you 4-6% return possible in the S&P 500 index over time.

And here, you have an investment that can probably earn 15%/year over time.  Think about that. To see a real life 'stress-test' of J.P. Morgan, go to the above mentioned post and look at JPM's tangible BPS for the last five or six years.

And then in a horrible market where stocks go down 14%, this 'business' manages to increase BPS and tangible BPS.

The same can be said about Goldman Sachs (GS), Wells Fargo (WFC) and other 'good' banks. 

Let's see GS for a second (I haven't listened to the conference call yet).   People will focus on the fact that GS lost money and say, "Aha!  Told 'ya the investment banking model is dead!".

Despite this horrible market environment and a plunge in investment banking fees (my fingers keep Freudian slipping and I keep typing investment baking), GS has managed to keep BPS and tangible BPS flat.

GS BPS at quarter-end was $131.09/share, and tangible BPS was $120.41 versus a current stock price of $99 (this morning, I saw it trade down to $90).  That's pretty cheap.

When people start declaring the end of the investment banking model, stop and think for a moment.  As long as businesses need to raise funds and access the capital markets and as long as people need to invest and trade, the investment banking will exist, thank you very much.

Again, GS has kept BPS flat in a market that went down 14%.  Why is this?  Of course this is due to fees and commissions and other sources of income (which applies to JPM and other banks too).   This is the banking and investment banking model at work.  They have streams of income other than trading gains, net interest income that will absorb losses in bad markets.

And this is why, over time, I expect good financial companies to grow book value (or book value plus dividends) at a pace far exceeding the S&P 500 index and it is the reason why I get excited when very good, solid financials trade at or below BPS.

Having said all that, this is not one-sided, of course.  It would be foolish to pile into financials with all of your net worth.

I expect good financials to do better when bought at or below BPS, but there are risks.  Financial companies do blow up.  At one time, Citigroup and AIG were seen as solid, blue chip financial companies and they blew up.  There were others.   (I was not a fan of Citigroup under Chuck "Still Dancing" Prince, nor was I comfortable with the big black box of AIG's financial products business that was sort of a long time Wall Street mystery (how do they make money?!).  The warning flags were there for both companies long before the blowups).

An S&P 500 index may not be that exciting (even though it's still one of the best ways to invest) and it may go down 14% in a single quarter, but the S&P 500 index itself will never blow up and go to zero (even though it may go down 90% in a depression). 

So as much as I like the financials (and Occupy Wall Street makes it even *more* attractive to me as a cultural contrary indicator of sorts; kind of like the opposite of the Beardstown Ladies), there is only so much I would put into financials.

And as we have seen, financials are very, very volatile.  Most people wouldn't have the stomach for holding these stocks.

Oh, and in case people may wonder if I have been a fan of financials forever and through the crisis, this is not true.  I can't prove it on a new blog like this, but I have hated the financials all throughout the 1990s and 2000s.  I couldn't understand why these banks were trading at 2-4x BPS and in some cases 5x BPS. 

The revenues/earnings of investment banks tended to look like, to me, the Brooklyn Bridge (very cyclical with big booms and busts) so I could never understand why people could put p/e multiples on these very volatile earnings.  Back in 2006 and 2007 they were capitalizing (putting p/e multiples) on huge trading and investment gains.  This didn't make any sense to me either; people were assuming the boom times would continue for a long time.  I thought it would only continue for a year or two and then a drought would follow.  I found it difficult to figure out what the normalized earnings rate would be.

Also, the financial markets is very, very cyclical.  When the stock market goes up, historical returns look good and mutual funds gather a bunch of money.  They invest more, stock prices go up more which brings in more money and the stock market gets more expensive.  Then financial companies' earnings look really good as the industry is booming so valuations go up.  

This cycle is the same in the credit markets, but is arguable more dangerous.  As the economy booms, default rates go down, credit quality improves and credit spreads shrink.  What used to trade at 800 basis point spread to treasuries can shrink to 150 basis points.  This is very dangerous because this encourages leverage (this doesn't exist so much in the equity markets as equities are invested using cash for the most part).

When a credit desk makes $xx dollars on 800 basis point spread, but has to increase earnings 20% next year, but the credit spread shrinks to 600 basis points, they have to increase leverage and get a bigger balance sheet just to earn the same amount.  So to produce earnings gains, they really have to put on leverage.  Imagine spreads shrinking to 200 basis points.  They would have to increase their balance sheet by four-fold to earn the same amount of money as they did when spreads were 800 basis points.  This goes on and on.   Historical default figures look better and better too as capital is more readily available to roll debt no matter how the underlying credit is actually doing.  So in this business, you have the maximum leverage and balance sheet size at the point of maximum risk.  Financial companies are obviously reporting record profits and incredible ROEs, so the stock prices also tend to be at high valuations.  At this point, a small speed bump can cause a complete collapse.  This is sort of what happened in the 2000s leading up to the collapse (and has happened many times in the past).

Smart CEO's stayed out of the game.  People like Chuck Prince begged regulators to clamp down on this reckless lending but inexplicably kept making the same of their own in order to maintain market share.  Folks like Dimon opted out.  They refused to play the game.   (It's an interesting and reassuring footnote to WFC that when John Paulson was structuring CDO derivatives against subprime loans, he demanded that the structures *exclude* WFC loans; he knew they were of better quality than the rest)
Anyway, that cycical and pro-cyclical factor is another reason why I hated financials for a long time.  Today, I don't think we are at that point at all of major risk, and we are certainly not at a cyclically risky point, not by a long shot.

I also didn't like that bank executives exercised their call options (bonuses).  They take huge risk and if they succeed, they walk away with huge bonuses.  If they fail, shareholders lose money. 

This seemed like a raw deal to me.

So I have never really been a fan of financials at all.

I only get excited about them at attractive prices and that's what's driving me to write this stuff now ( I was also very bullish in early 2009 and made some big bets then).  Do I still feel the way I did about financials back then?  Yes and no.    Now that some of the excellent businesses that I assumed would survive the worst crisis in history and seems to continue to grow their business, I feel good about them at these very reasonable prices.

Do shareholders still get a raw deal?   I still sort of feel that way, but at the end of the day, what's important is return on equity.  If I am paying BPS, I care about ROE (return on equity).  If I get a reasonable return there, I don't care too much what the bonuses are, and as long as I feel that the executives are taking prudent risk.

I think firms like Goldman, J.P. Morgan, and Wells Fargo have proven that they take only prudent risk.  I love how Dimon has managed the business throughout this crisis.  The same goes with GS and WFC.

Anyway, wow, that's a bit longer than I expected.   

This is just my opinion and not necessarily a recommendation.  These stocks are very, very volatile and if we do have a double dip, triple dip or depression, some may go to zero so be careful...   Also, one should never buy a stock just cuz some anonymous guy on the internet thinks it's a good idea; that's a quick way to the poorhouse (but then you can go to Zuccotti Park and get free food so you'll be OK) so do your own work!  (if not, stick to an index fund!)


Real Economy OK?

Earnings conference calls are great because you really get a feel for what is going on in the economy more so than macro announcements and economist opinions, market expectations and things like that.

Of course, there are companies that are always upbeat so are totally useless in gauging the economy; Starbucks, Yum Brands, Cisco and some others who always seem to be pounding the table calling for incredible growth (overuse of superlatives in their calls sounding more like cheerleaders than CEOs).

Buffett said recently that all of his businesses (with the exception of housing related) are doing well and will post new highs in profits/revenues, so he sees no signs of a double dip.  Buffett is certainly not a macro forecaster, but he has so many businesses reporting to him that he has a good feel of what is going on.  He said the economy was in a recession long before economists acknowledged it; he knew because he can take the pulse of the economy in a very specific way (on a daily or weekly basis), not by waiting for GDP figures to be announced, revised and then re-revised (and unemployment reports etc...).

Banks are also announcing loan growth, and things are sounding a lot different than 2008.

Also, I recently ran into a salaryman that works for a major Japanese chemical manufacturer and he said that volume is not down at all in Europe.  He is on a business trip around the world and he was in Europe last week.  He was surprised to hear that order trends are firm, volumes are holding up and there is no sign of any slowdown despite the headlines.

I talked to the same guy back in 2008 and there was a drastic drop in order volumes and business almost stopped to a frightening degree.

This time, he said despite all the negative headlines and market reactions, the underlying economies seem to be going well.

This is very interesting.  If Europe can get it's act together and prevent a complete meltdown (which is possible with forceful, TARP-like action), things may turn out OK even in Europe.

Anyway,  I don't want to empasize these anecdotal things too much nor do I care to try to predict what will happen in the economy, but sometimes when the press and markets are leaning so hard one way, it's nice to hear what the guys on the ground are actually experiencing.

Earnings Season

Just a quick note that this blog is still alive and well.  It's earnings/conference call season so I will be spending most of my day for the next week or two reading earnings announcements and listening to conference calls.

I won't be making comments on quarterly earnings as I only look at stocks from a 'normalized' perspective; what a business should earn over time etc. so quarter by quarter is not really relevant, but I will post comments on things I find interesting.

Stay tuned!

Thursday, October 13, 2011

CRESY: Emerging Market, Farmland, Real Estate

This is a stock that Leucadia owned for a brief time.  I think they paid around $15/share for it and even participated in a global offering of the stock at $17 (per U.S. ADR) back in 2008.  Asked at the annual meeting whether they were worried about the populist policies of the Argentina government, Leucadia said that bad government policy shouldn't hurt the value of CRESY's holdings (mostly real estate and farmland; hard assets that would hold it's value).

Recently, this stock has been trading at $11.70 or so.  Since 2008, we had the global financial meltdown and the European crisis this year and worries about China which has taken down all of the emerging markets.

OK, so let's take a step back.  What is Cresud Inc (CRESY)?  CRESY itself is an old company, a spinoff of collateral assets from a bank many years ago, but is now an investment conglomerate.  CRESY owns a large stake in IRSA Invesiones Y Representaci (IRSA) which is a real estate company that owns commercial real estate (offices, retail, residential).  CRESY owns other real estate companies, but the attention here goes to the 686,000 hectares of land that they own.  This is about 1.7 million acres. 

One thing that I should mention is that I've seen a lot of research/commentary on this company with the idea that U.S. farmland is valued at $2,000 - $5,000 per acre while CRESY owns 1.7 million acres and is capitalized at a much lower rate than that excluding it's holdings in IRSA and other equity investments.

However, I am surprised that all of the analysis that I've seen fail to mention that out of this 686,000 hectares, 340,000 hectares of that is natural woodland preserves, so is not nearly as valuable as crop producing farmland.  They also use a lot of the land for grazing and milk production; both of which would be much less valuable on a per acre basis than say, soybean or corn producing land.

Of the 686,000 hectares CRESY owns, only 126,000 hectares is utilized for crop production.  Also, of the crop production, not all of it is in high value soybeans or corn.

In any case, I will look at this stock from this angle in a separate post later on, but for now what attracted me to this again is that according to Yahoo Finance, it is trading at 1.1x book value.

For something like this, I would certainly be interested in it at book value as they probably do own a lot of assets that are understated on the balance sheet. Also, CRESY/IRSA is regarded as shrewd capital allocators (otherwise Leucadia wouldn't have bought into it in the first place).  

CRESY's mission is to buy land and other assets at attractive prices, improve them by investing in them to increase yields, for example, and then to sell at a profit.  So this is not a static investment where the entity owns property statically for a long time.

So book value would be an attractive way to 'participate' in their activities. 

They are in Argentina, and they focus on agriculture (excluding their stake in IRSA, which is now a consolidated subsidiary).  With increasing food demand due to increase in global wealth, farmland certainly does look like an interesting area to get involved, and South America tends to be a great place to do that. 

Of course, Argentina has political/economic problems, but that is a reason why CRESY is cheap.

In any case, let's see how CRESY has done in growing book value per share over time. 

First of all, this was a bit complicated as Yahoo Finance figures were wrong, or not complete.  They used undiluted number of shares outstanding to calculate book value per share, and the shareholders' equity used was not U.S. GAAP based. 

CRESY does file a 20-F with the SEC every year, but despite the fiscal year ending in June, they don't file their 20-F until late December.

This made things a bit complicated, but bear with me.

If you use diluted outstanding shares, then the price-to-book value would go up to 1.26x rather than 1.1.  Also, U.S. GAAP basis shareholders equity was around 5-6% lower than Argentina GAAP shareholders equity, so on a U.S. GAAP basis and on diluted shares, the p/b ratio is more like 1.3x.

I will take a look at this later as a sum of the parts story, but let's also just look at this on a BPS basis.  If this entity's goal is to buy, improve and sell assets, then over time, one would expect the BPS to increase at a nice pace.

Using the above basis (fully diluted shares outstanding and U.S. GAAP based balance sheet), the historical book value per share (or per U.S. ADR) and the ADR stock price at period-end were as follows. 



The then current foreign currency exchange rates were used to translate book value per share (BPS) into U.S. dollars.

The stock price for 2011 is the current stock price.  The 2011 BPS is not based on U.S. GAAP (all other years are U.S. GAAP).

We can see that CRESY has in fact grown BPS nicely over the years despite all the problems in the recent past.  During this period, CRESY paid a total of $1.38 in dividends.  So starting at $3.93 BPS in 2002 and an ending stock price of $9.29 plus total dividends paid of $1.38 ($10.67 in total value; dividends assumed to earn zero after being paid), that is a +11.7% return per year on book.

The above figures take into account the weakening in the Argentinian Peso, so the growth in BPS has outpaced any currency weakening.  This confirms to some extent that real estate, farmland and other hard asset prices hold their value despite a weakening currency.

The price-to-book value ratio has historically looked like this:



The P/B ratio for CRESY has averaged around 2.1x since 2002, and it is currenty at 1.26x so it is selling at an attractive valuation level compared to it's past.

When you look at a stock like this today, it has all the wrong associations.  Emerging markets?   Increasing food demand globally?  Real estate, land?  Argentina?  Don't they blow up every few years?

This is all quite true, and this is why it is interesting.  Things are much more interesting when they are unpopular and cheap than vice versa.

Food demand will probably continue to increase over time and the need for more arable land is probably very real.  South America will be an important factor in this for sure.

Of course, a major risk is that the Argentine government seems to be doing everything it can to destroy the economy.   Leucadia at some point, even though they said the government can't destroy the value here, did give up and dump their stock.  Maybe they are right.

CRESY also has listed warrants, ticker symbol CRESW but I will take a look at those in another post.




Tuesday, October 11, 2011

Stocks No Good? (Superinvestors)

Continuing on the "stocks are no good" theme, it is interesting to look at what the Superinvestors did during the long flat market period between 1965 and 1982.  I think the Dow hit 1,000 back then and didn't go above it for good until late 1982.

The talk now is that the U.S. may go down the path of Japan since 1989, or that the U.S. stock market is in a period of going nowhere for another decade like back in the late 1960s, 1970s in the U.S.

Also, there is so much risk out there that it is suggested that one shouldn't be invested in the stock market.

Should we just give up on stocks for now?

Well, you could have made a pretty persuasive case to stay out of stocks in the late 1960s too.  There was plenty to worry about.  Vietnam seemed to go on and on and it was much bigger than the recent Iraq wars.  Johnson was going to destroy the economy with government spending.  The U.S. and Russia were a single button away from total destruction.

In fact, a lot of the gloom and doom predictions of the late 60s / early 70s came true.  The U.S. had to get off the gold standard.  Bretton Woods was dead and the dollar crashed. Gold prices spiked. Oil prices went through the roof.  Inflation went into double digits as did interest rates.

Anyone who would have predicted that accurately would surely not have been invested in stocks since 1966, or certainly not since 1972.  If you went back to any investor and told them exactly what was going to happen over the next decade, most would have opted out of the stock market.  Can you imagine telling someone back in the late 1960s that the U.S. would delink the dollar from gold and all the major currencies would float freely, and that the then $2.00-3.00/barrel crude oil price will work it's way up to the $20-$40 range, and that inflation and interest rates would go up for many years?

It is a nightmare scenario that would surely put most investors in cash, gold or something other than stocks.

But back then, there was a small group of investors that ignored that stuff and kept their nose to the grindstone and did what they did best.  Did they blow up? 

The following investors are some of the Superinvestors from Buffett's 1984 essay "The Superinvestors of Graham and Doddsville".  It's one of the best things written about investing (so make sure read it here for free if you haven't already). 

These superinvestors are traditional value investors.  Nothing fancy.  No leverage, derivatives or long/short or anything like that at all.

If you told them of all the trouble in the years to come, they wouldn't have cared.  Luckily for them, they just kept doing what they are good at.  Here are their returns:



The Dow hit 1,000 back in 1965, and didn't break above it permanently until late 1982.  Until then, it got up to or slightly above 1,000 and then fell back again, for 17 years.

And in this market, notice how Schloss did.  Between 1966 and 1982, in a pretty flat market (excluding dividends), Schloss returned 21%/year. 

Tweedy Browne was also a hard core value shop and they earned +19%/year in the fifteen years between 1968 and 1982.

The Sequoia Fund gained +16%/year from 1969 through 1982. 

These are some pretty bull marketish figures.  Again, this was done in a pretty flat market with horrible fundamentals as stated above.  Just look at the years between 1966 and 1982 and think about what the newspaper headlines were like.  They were pretty dreadful.

The peak sometimes is marked as late 1972.  This was right before the market collapse, when the nifty-fifty party seemed to end.   The market went straight down into late 1974 after that.

Let's see how the above investors did after 1972.  Below are their returns for the ten-year period between 1972 and 1982:

                                   1972-1982 return
Schloss                       +27%/year
Tweedy Browne         +21%/year
Sequoia Fund             +16%/year

Again, these are some pretty incredible figures.  Very bull market-like in a completely flat market.  What's astonishing is that late 1972 was the end of a bull market of sorts, and 1982 marks the end of a bear market, so the end points are as unfavorable as can be (unlike mutual fund promotional literature that likes to start at 1982 for long term returns).

Did these guys buy into levered bear funds, oil ETF's and gold futures to generate these returns?  Nope.  They did it with plain old stock-picking and pretty much from the long side.

Perfect Hindsight?
Is this a case of perfect hindsight?  In a bad period, there will always be a few funds and people who did really well.  And these people tend to become stars.  Is that the case here?    I think not.

First of all, these investors are investors Buffett has known for a long time.  When Buffett closed his partnership in 1969 or so, he told his clients to put their money with Sequoia.  So Buffett knew early on that Sequoia was going to do well.

In fact, after the 1984 essay "Superinvestors of Graham and Doddsville" came out, the superinvestors continued to outperform the S&P 500 index. 

This is not a case of just cherry picking with perfect hindsight the lucky few who did well during bad times.

This is a testament to the approach more than anything else.

But we are not superinvestors!
When you show the above table to someone, they will go, oh yeah.  If you're a superinvestor, you'll be fine.  Sure.  But how many superinvestors are there? So I think I'll stick with my gold.

Well, in order for them to be successful with gold in the longer term, they will have to acquire George Soros-like sense of timing to get out of gold and into stocks at the right time.  How many people can do that?

Let's put it this way; the gloom and doomers in the 1970s were right, but how many of them have made money over the long term?

There are guys that were dead right on making macro calls but couldn't make any money at all (see this post: Perils of Trying to Time the Market).  I think that was probably true in the 1970s too.  There were probably some people who made tons of money for a while and then either gave it all back or suffered decades of subpar returns since then. 

The superinvestors, however, were probably wrong on their macro calls (or were agnostic) and have pretty much made good money every single year through the 1970s and since then.

So which is more important?  Getting the macro right and timing the market?  Or just picking the right stocks?   (Maybe the subject of another post is the complexity of macro-guessing and market timing; you have to get at least two things right:  The macro call AND the timing of the market.  If one or the other is wrong, your performance can suffer).

The market doesn't always go up
This is also not to be confused with the argument that the stock market always goes up, or that as long as you invest for the long haul, everything will be OK. 

The stock market does not always go up, as can be seen in the 1966-1982 flat period and the flatness we've had in the U.S. in the past decade.  Japan has been flat for a long time too. 

To say that investing in stocks is a good idea is not the same as to say that the stock market always goes up. 

Also, investing for the long term only works if you are invested in the right things.  People always point to Japan and the recent U.S. market as proof that buy-and-hold is dead.

Buy and hold is only good if you buy the right thing at a reasonable price.  If not, it doesn't matter how long you own something (Japanese stocks are a great example; subpar businesses for high prices is what kept the market flat for so long).

So don't get confused about that.  Some people equate "stock market is a good place to invest" with "the stock market always goes up".  So when they see evidence that the stock market always doesn't go up, they conclude that the stock market is NOT a good place to invest. 

This is the same with buy and hold.  There have been so many articles in the past few years about the fact that buying and holding is dead, but they all seem to miss the point.  Buy and hold is no good if you buy and hold something that is not a good investment.  If you own a great business and paid a good price for it, it's fine to hold it for the long term.

So again, people seem to equate "Buy and hold is a good strategy" with "The stock market is a good place to invest".  When they see evidence that buy and hold doesn't work too well, they conclude the stock market is not a good place to invest.

Even worse, they conclude that the only way to make money in the stock market is to trade, or day-trade it.  I don't even want to get into how much money is lost by people trying to trade in the stock market.

Let's not confuse these issues. 

Sometimes, the alternative is even worse than the disease (that people fear).  Don't forget, the housing bubble was partly fueled by the need to replace stocks as an investment vehicle.  They figured the stock market is no good (due to the 2000-2003 bear market) and figured housing prices will never go down (because it has never gone down), and that the Fed's pump priming will eventually fuel inflation which will push up housing prices even more.  It's a 'hard' asset, right?  I remember people screaming and yelling on TV that you can't sleep in an IBM stock certificate. 

(Now you have these silly Lind-Waldock (futures broker) commercials telling people to invest in commodity futures, because with commodities, you don't have to worry about corporate scandals and p/e ratios.   I kid you not.)


One other thing
Oh, and there's one other thing I noticed when I look at the table above.  A lot of people these days seem to think that the key to investment success is to buy stocks during panics and then get out when the market bounces back.

I remember reading about how people bought stocks in 2008 and early 2009 and then just sold out in mid-2009 saying that the market is no longer cheap.

If you look at the table above, you will notice that the superinvestors probably didn't do that. They probably owned stocks in 1970, 1971, 1972 etc... and they may have bought a bunch if they had cash in 1974 as the market bottomed out. But when the market came back in 1975/1976, you will see that their returns continue unabated, indicating that they didn't just buy in 1974 and then sell in 1975 or 1976. 

This is true for all of these investors.  Look carefully at the table and look at the Dow chart during this period below.

Dow Jones Industrial Average 1966 - 1982


So I don't think timing the market was the major contributor to the high returns.  To learn (or relearn) how these returns were achieved, read the "Superinvestors" essay.

Being distracted by overall market valuation and macro concerns, I think, are usually way more detrimental to investment performance than not.  (But you do have to pay close attention to valuations of stocks you own!)

Ungold!




Gold has done really well the last decade or so and more and more people are talking about the inevitability of gold as a wealth saving asset (protection against inflation, monetary pump-priming etc...).

However, a lot of what we hear today sounds a lot like Howard Marks' first-level thinking (see here what that means).  Central banks can't be trusted, money-printing and inflation is inevitable etc...

If the economy tanks, they will have to print more money so gold will go up, or if the economy recovers, then inflation will go up and so will gold.  Either way, gold is going to go up.

The sentiment these days seems to be the exact opposite of the late 1990s.  Back then with gold under $300/ounce, everyone loved stocks.  In fact, if you didn't own stocks, valuation be damned, then you won't be able to afford retirement.  Don't believe me?  Look at stock returns in the past five, ten and twenty years (in 1999/2000, all those periods showed 20%+ returns, I think).  Gold?  Garbage.  Greenspan has everything under control.  With the advanced economics models in use at the Fed, the economy will never tank and inflation will never go out of control.   Even central banks were dumping the gold they owned.  Who needs it?

Result?  High stock prices, low gold prices. 

Where are we today?
We seem to be at the exact opposite point today.  Gold can do no wrong.  If your portfolio has no gold in it, you will never be able to retire, or even make any money.  Stocks?  They don't work.  Stocks are not good long term investments.  Proof?  Look at what stocks have done in the past decade!  Nothing!  Flat!  Look at what gold has done in the past ten years.  Answer?  Own gold, of course.

This seems really silly but this is what almost everything I read seems to say, and many of the very same publications that told us to buy stocks in 2000 if we wanted to retire on schedule are telling us to buy gold, gold stocks and other commodity related things because, sorry, stocks just doesn't cut it anymore.

Oh, and what are central banks doing?  Buying gold!  Uh oh. 

OK, OK.  I am not really trying to call the top in gold here or anything like that, but if I had to bet, I would bet that a good active stock manager will easily outperform gold over the next five to ten years. 

Are value investors wrong?
Here's the other thing that I seem to read alot.  People are saying that old folks like Warren Buffett just doesn't get it anymore.  They say he is totally wrong about gold.   That he is a fool for buying bank and other stocks.  That he should own gold if he had any brains left.  He just doesn't get it (remember the last time they said that?  Yup.  It was in 1999/2000; he is an old, has-been that just doesn't get it (because he doesn't own tech stocks)).

But first of all, is he wrong?  I have never, ever heard Buffett make a call on gold prices, ever.  So how can he be wrong?  He can be wrong if he said gold will go down and it goes up.  But he never said that.  What he has said over and over is that gold is just not his thing.  He likes to invest in things that produce cash flows and where intrinsic value can be calculated so he can pay a discount to that intrinsic value.  

There is no cash flow or intrinsic value for gold that I have heard of.  And that's Buffett's only point, really.  He has said he would rather own all the farm land in this country, ten Exxon Mobils and a trillion dollars of cash for what gold is valued at; gold doesn't produce cash flow, but the other assets do. 

It's not a prediction on where gold prices will go, which he would admit he has no idea about.

A similar scenario was happened in the 1970s; it's a good thing he didn't latch onto the gold thing and dump his stocks.    I think the key, as usual, is sticking to what you know.  If you know how to value businesses and know a little about the stock market, you will do much better than owning gold.

It just seems that there are so many experts on gold these days, even some former value investors.  And the funny thing is that they are all saying the same thing and nobody seems to have any more information that anyone else; it all sounds very first-level thinking.   It even feels like some are editorializing with their portfolios.

Gold Standard?!
People seem to love gold so much that many people are even calling for a gold standard now to take away the power of printing money irresponsibly.

On the surface, this sounds like a good idea.  If we link the U.S. dollar to gold, then the Fed can't just print more money and keep on devaluing the dollar, and we will never have a Zimbabwe moment.

However, this misses a crucial point.  I don't think a gold standard would work at all.  Why?  Because a gold standard is basically a price control and I don't believe price controls work.  History shows that price controls don't work, period. 

We can control either price or quantity, but never both.  If you control price, then the economic adjustments will occur through quantity.  This means that in the economy if we can't ease money, the economy will suffer; that means unemployment will go up. 

The U.S. is proof that a gold standard is unsustainable.  The U.S. and much of the world was on a gold standard and they went off of it for a reason:  It was unsustainable.  If Nixon didn't delink the U.S. dollar from gold in 1971, the alternative was for the U.S. to default (run out of gold).  

This was partly due to big spending by the U.S. government, of course. But did gold prevent this irresponsible overspending?  Nope. The fact is that it didn't, and the U.S. had to go off the gold standard.  Politicians will spend.  The public will demand it.  If the gold standard ties the hands of the government, people will demand a delinking from gold.  Otherwise the economy may plunge into a deep recession or depression which would then cause a delinking or devalation of some sort as FDR did back during the Great Depression.  Do we really think politicians will allow constituents to be crucified on a cross of gold? I think not.

Fixed exhange rates are simliar to the gold standard.  It is basically a price control, and therefore it is ultimately unsustainable over time.

This is why the 1997 Asian crisis occurred.  Asian countries linked their currencies to the U.S. dollar, but this was unsustainable.  Many thought that the currency link will provide stability as excessive foreign exchange volatility was disruptive. 

Well, when you fix the price, then adjustments occur in quantity.  And that often means economic pressures. When the pressures on the economy build up, the price control becomes unsustainable, and when that cracks, all hell breaks loose.


This happened in the U.K. too in the early 90s.  The British tried to keep the Pound within a certain range of other European currencies.  The British had to raise interest rates to keep the Pound within the valuation range and also had to intervene (in the foreign exchange market) .  This put serious pressures on the economy (higher interest rates are not good for the economy) and this was ultimately unsustainable.


The exact same thing is happening now in Europe.  To promote stability, Europe adopted a single currency. But that's sort of like a price control.  They locked in the foreign exchange rate and fixed it for every country in the Euro.  This too was unsustainable from day one.

In the old days, a country like Greece would have adjusted to problems by a cheapening currency.  The Greek central bank would print more money to pay down debt, and the market would lower the value of the Greek Drachma.  This is now impossible.  The banks would have been able to hedge away their Greek sovereign risk by using foreign exchange forward contracts and swaps.   In the pre-Euro world, I would guarantee you that the European banks would have hedged their Greek sovereign exposure by using foreign exchange forwards and swaps and European banks would be in much better shape.

In a single currency Euro world, that is impossible.  The Greek economy can't adjust itself through foreign exchange rates or anything like that.  

It has gotten to the point where Greece will either have to leave the Euro, or they have to default.  Either one will be very disruptive to the European banking industry.  The European banks are in crisis largely because of this artificial 'link'; they were allowed to lever up on this illusory stability and now that the fan gets hit, the problem is much worse than otherwise (if they didn't force these price controls).

The other point people don't realize is that if you go back to a gold standard, you basically fix the price of gold.   A crucial point in that case is that you lose a very important price signal. 

When gold prices are free to be set by the market, it sends off a very important price signal to everyone that can serve as a warning.


Some also say that a gold standard would be similar to legislating public government spending. Some argue that that would be enough; to mandate limits on government spending and debt.  This would have the same effect as a gold standard.

Again, we can point to Europe. This is basically how the EU decided to solve this problem.  In order to become a member of the European Union, you had to have a government debt to GDP of below a certain amount and a government deficit of less than a certain amount.

And yet we have the problems of Greece, Spain, Portugal, Italy etc... 

Oops, that didn't quite work either.  If things get worse in Greece, the public will demand getting out of the EU, or the Germans will demand they get out of the EU, or they will demand they kick Greece out.

You can't really force things by fixing prices or legislating limits.  The only possible solution is for reponsible behavior by the governments.  If they can act responsibly then a fiat currency system can work fine.  If not, no amount of legal limits, gold standard or any other thing like that will help matters.

I think the people calling for a gold standard have things backwards.  We are off the gold standard now because we couldn't sustain it; things didn't get bad because we got off of it.  Their arguments make it sound like things got bad because we went off the gold standard, but I argue that it got bad enough so that we couldn't sustain it.  If we go back to the gold standard, that will happen again for sure.   Free markets that can give price signals are far better than fixed prices where imbalances can really build up invisibly until they blow up.

Anyway, that's just my opinion.

Friday, October 7, 2011

Renault-Nissan: The Stub Trade from Hell?

Here is a stub trade that doesn't seem to get talked about much.  I remembered that Renault owns a big chunk of Nissan and that it is very valuable.  The talk a while back was that if you backed out Renault's ownership of Nissan and Volvo, you can get the Renault auto business for free.

Well, since we are in such a bad news environment for autos (post 'great-recession' blues), Japan (post-earthquake/tsunami blues) and Europe (Greek/Euro crisis), I thought maybe this stub trade would look interesting.

Sure enough, a quick look at this shows an incredible negative valuation of Renault's auto business.  For simplicity and because Renault sold much of their Volvo holdings, I will just look at the market capitalization of Renault versus the market capitalization of the Nissan stock they own.  If you subtract their Nissan holdings (number of shares they own x current price) from the market cap of Renault, you get a big negative number now.

Renault owns around 2 billion shares of Nissan Motors, or a 43.4% stake.  This is accounted for by the equity method, so the market value is not reflected on the balance sheet.

Reanult has around 293 million shares outstanding and is trading at around 26 Euros/share (Renault uses a lower figure (270 million) for EPS because they back out the shares in Renault that Nissan owns).   The Euro, despite it's problems is trading at $1.3/Euro.  So the market cap of Renault is currently around $9.9 billion.

Renault owns 2 billion shares of Nissan Motors stock.    Nissan is at around 700 yen/share, and at 76 yen/$, that's $18.4 billion. 

So if my math is correct, here are the two key figures:

Renault's current market cap:                                             $9.9 billion
Value of Nissan Motors Stock that Renault owns:           $18.4 billion

So Mr. Market is valuing Renault's auto business excluding it's holdings in Nissan stock at a whopping negative $8.5 billion!  I can see how things can be worthless and even have negative value, but negative $8.5 billion?! 

Assuming that the number of shares owned of Nissan Motors has been unchanged over the years, and the number of shares outstanding of Renault has been stable over the years (a quick look at the annual reports seem to confirm this), then this figure (Renault's market capitalization minus market value of Renault's ownership in Nissan stock) historically has looked like this:

Implied Value of Renault Excluding Nissan



You can see that this number was positive between 2004 and 2008, and you can see how people may have seen this as a good stub trade from 2008-2010.  It did look like Renault was available for "free".  But as the chart shows, a huge decline in that has caused big losses for anyone who had put on this stub trade in the past.

However, just because it was a bad trade in the past doesn't mean it's not a good one now.  This negative spread is as large as it has ever been;  in other words, Renault has never been cheaper on this basis.
Here's another look at this.  Below is the stock price chart of Renault stock (in Euros) and NSANY which is a dollar denominated ADR trading in NY.

Stock Price Comparison:  Blue = Renault, Red = Nissan



As you can see, Renault stock did go up a lot while Nissan declined back in 2007 and now the reverse is happening, Renault stock is tanking while Nissan seems to be stable.   I would guess this has to do with the European crisis; French and other European stocks are getting hit very hard on the financial crisis there.

This may be an interesting way to play it, as if the relationship between the two stocks 'normalize', that can lead to some substantial gains on Renault stock.

What is Renault's business worth excluding Nissan?

Here are some quick fundamental figures:

The figures above are in billions of Euros and they exclude figures for Nissan and other affiliates (that are accounted for under the equity method).  Net interest expense has been around 350 million Euros in the last couple of years, so assuming Renault has similar results to last year in terms of sales and operating income, net income assuming a 40% tax rate would be: 1,100 million - 350 million interest expense = 750 million pretax income.  @40%, that's 450 million in net income for Renault's business ex-Nissan. 
At a conservative 5x p/e for that, Renault's business would be worth 2.2 billion Euros.   If Renault can earn a 5% operating margin (Ghosn was targetting a 6% operating margin before the world blew up) and get revenues up to 40 billion Euros, that would be worth 1 billion Euros in net earnings, which may be worth anywhere from 5 billion to 10 billion Euros (5-10x p/e ratio).
In any case, even if Renault's stock price DOUBLED from here, that would still value Renault's business at zero.
An important point here is that out of simplicity (and laziness), I have left out Renault's holdings in Volvo and AvtoVAZ.  Renault used to own 20% of Volvo but now owns only 6.8% which was valued at around 1.7 billion Euros at December 2010.
This is just a quick preliminary look at this idea so I am not confident at all about the future of Renault or even Nissan.
But there does seem to be enough here to merit some further investigation and even maybe a speculative position.  A long/short stub trade may be risky due to the possible volatility of the position (look what happened if you put this trade on earlier).
But as a naked long trade, it would be a play on a recovery in the auto industry, a recovery or some stability in Europe, a normalization in the relationship between the stock prices of Renault and Nissan etc...
I think this is certainly something to look at for people who are already interested in ideas in France/Europe, the auto industry, Nissan etc...  This is a play on all of them at once.