Saturday, August 30, 2008

U.S. versus China

Everywhere I turn I seem to bump into another article warning investors away from China and cautioning investors from putting money into the Chinese stock market. It never fails to amuse me that this advice always seems to be given AFTER a market has fallen over 50%. Let's take a look at the Chinese stock market and compare it to the S&P500.

The S&P 500 is down about 18.5% from its peak last fall. On a trailing basis, its P/E is 18.4x on an operating basis and 24.7x on a reported basis. Neither are attractive entry levels historically. U.S. GDP growth, corporate earnings growth, and corporate profit margins had all been above trend for many years. It's likely that all three will spend some time below trend over the next few years. Despite a recent rebound in exports, the U.S. still has a large trade deficit, and our national debt, deficit, and unfunded liability position portend further long-term deterioration in the value of the dollar.

China's Shanghai Index is down 60% from its bubbly peak of last fall. On a trailing basis, its P/E is about 16x, which is the lowest it has been in over 10 years. As for growth, the Chinese outlook over the long-term is far more robust than that of the U.S. There will be hiccups and problems along the way, but demographics, rising incomes, and China's cost advantage (even with higher oil/transport prices) are likely to fuel strong growth in China for some time (think decades). Yes, there are plenty of problems in China (as there are everywhere), but what the Chinese have accomplished in just the last 10 years is nothing short of astounding. Furthermore, they have a large trade surplus and a steadily (managed) appreciating currency. In many ways, the Chinese are much better capitalists than we are.

If you have a longer-term investment horizon and were going to buy one of these markets and then ignore it for the next 10 years, which would you buy? Hopefully, that was read as a rhetorical question. Chinese stocks went parabolic and were in a bubble, but they've come down hard to a pretty attractive level.

When will the Chinese market bottom and at what level? No one knows. It will be determined by psychology and valuation. It isn't at all unusual for attractive valuations to become absurdly cheap at the bottom. I wouldn't be at all shocked if the Chinese market traded with a 10 P/E at its bottom. Even with strong earnings growth, that could mean a further 30% drop in the market. For this reason, I've been gradually building a Chinese position since the spring rather than trying to pick a spot. The ultimate size of this position will depend on just how silly things get on the downside relative to other opportunities.

As a reminder, this optimism about Chinese stocks is long-term optimism. Substantial downside over the next quarter or year would hardly be surprising. Turning to that long-term view, the realistic return possibilities built into today's market level are fairly attractive. The table below is very simplistic, but it illustrates the point. It provides the compounded future 10-year returns on the Shanghai index for each set of earnings growth rates (x-axis) and ending P/E values.

Trailing P/E in 10 years

10.00 12.50 15.00 17.50 20.00
2.50% -2.22% -0.02% 1.82% 3.41% 4.80%
5.00% 0.16% 2.42% 4.31% 5.93% 7.35%
7.50% 2.55% 4.86% 6.79% 8.45% 9.91%
10.00% 4.93% 7.30% 9.27% 10.97% 12.46%
12.50% 7.32% 9.74% 11.76% 13.49% 15.02%
15.00% 9.70% 12.18% 14.24% 16.02% 17.58%
17.50% 12.09% 14.62% 16.73% 18.54% 20.13%
20.00% 14.47% 17.06% 19.21% 21.06% 22.69%

It would hardly be a stretch to imagine trailing P/Es at or above 20 in a more normal environment for a high-growth country. It also doesn't seem unreasonable to imagine earnings growth north of 7.5% per year given consensus expectations for GDP growth and what are likely to be rising margins as China expands more into services and higher value-added manufacturing over time. With these assumptions, the Chinese market would provide an average return in the low double-digit to mid-teen range.

If we happen to see another bubble within the next 10 years and the Chinese market were to trade at the trailing multiple it reached this past fall, the average annual compounded return would move closer to the 20% range.
Of course, there are risks. There's always the prospect for political turmoil. Higher wages and transportation costs could severely crimp export growth. No one really has a great handle on the quality of bank assets. A severe global slowdown would also impact growth. If growth disappoints, then earnings multiples are likely to be lower.

There will be hiccups along the way. Despite the inevitable growing pains, the future of China appears to be very bright.
Their stock market is a "Rip Van Winkle Buy."

Disclosure: The Rubbernecker is long table tennis, Mah Jong, the number 9, and General Tso tofu.

Thursday, August 28, 2008

Pakistan-Style Free Market Capitalism

You thought we had it bad here in the U.S. with the decline in our stock market? Take a look at Pakistan. First of all, yes. Pakistan does have a stock market. How else would you expect all of the sand, camel, Kalashnikov, and plutonium merchants to raise capital? And where else would you expect Al-Qaeda to launder their money?

Relax. I'm just kidding. It actually inspires hope that a coup-ridden developing country with little in the way of stability, democracy, or natural resources even has a stock market.
This is, however, a very small stock exchange. We have about 100 companies listed in the U.S. that are bigger than the entire stock exchange of Pakistan.

Regardless, it exists, and it had been doing extremely well in recent years. Per the Karachi Stock Exchange's website:

Karachi Stock Exchange is the biggest and most liquid exchange and has been declared as the “Best Performing Stock Market of the World for the year 2002”. As on July 31, 2008, 653 companies were listed with the market capitalization of Rs. 3,301.908 billion (US $ 46.258 billion) having listed capital of Rs. 713.077 billion (US $ 9.990 billion). The KSE 100 Index closed at 10583.58 on July 31, 2008.

KSE has been well into the 4th year of being one of the Best Performing Markets of the world as declared by the international magazine “Business Week”. Similarly the US newspaper, USA Today, termed Karachi Stock Exchange as one of the best performing bourses in the world.
Unfortunately for Pakistan, the stock market peaked back in April and has since fallen 41%. Now that's a bear market. The decline seems to have irritated local investors who had become accustomed to only rising prices. As reported by the TimesOnline on July 17th:

Pakistani investors and traders ransacked stock exchanges in Karachi, Lahore and Islamabad today, reacting furiously to a share-price rout that has decimated the life savings of many.

Police and paramilitary officers were drafted in to protect the Karachi Stock Exchange after a thousand-strong mob stoned the building, smashed windows and chanted anti-government slogans. In the eastern city of Lahore, investors burnt tyres and blockaded the local bourse.

Fortunately for the new breed of Pakistani capitalists, the powers-that-be have now come to the rescue. Securities will now be allowed to trade within a range of 5%. BUT they won't be allowed to trade below a floor price -- which just happens to be the previous day's closing price. Therefore, prices aren't allowed to fall! Why didn't we think of this!? It's so simple. Just don't allow prices to fall.

Sure, we could get mired down with silly little facts, like the fact that this type of price fixing has never worked before and is doomed to failure. Or the fact that actual price discovery will be impossible. Or the fact that trading volume is sure to dry up. Or the fact that firms won't be able to raise capital in such an environment.

The important thing is that this floor will probably result in a 0% return on the Karachi 100 Index so long as it's in place. A 0% return just might be enough to enable Pakistan to regain the title of "Best Performing Stock Market of the World."

Thursday, August 21, 2008

McCain: Numbers, Numbers, Numbers

"A plague o' both your houses!" Or on at least four of them! Maybe seven.

This past week, McCain's campaign did a bang-up job of appealing to the out-of-touch, mathematically-challenged, ridiculously wealthy demographic. First off, he suggested that you're not really rich unless you make at least $5 million a year. I took a quick look at the Census Bureau data on income and found that, as of 2006, only 1.9% of U.S. households earned over $250,000. According to the IRS, the top 1% of earners made $1.1 million in 2007, and the top 1/10th of 1% earned an average of $5.6 million. Thus, according to McCain, slightly more than 1/10th of 1% of Americans are rich. It really makes you feel for those poor middle-class folks making $1-4 million a year and struggling to afford their Bentley Continental GTs, ocean-front vacation villas in Monterey, and month-long vacations in Monaco.

He followed that stunner up a few days later by admitting that he didn't know how many houses he and his wife owned. He said he had to check with his staff, and then he responded that he owned "at least four." Newsweek had recently estimated that the McCains own at least 7 properties. Now, all of the numbers between 4 and 7 are fairly small numbers -- for a preschooler.

It's a little disconcerting that a Presidential nominee has to have his staff check on how many homes he owns. It's easy to Monday morning quarterback, but there were so many better responses:
  • "I only have one home, and that's wherever my wife is."
  • "As I was saying about my time as a prisoner of war..."
  • "A nun, a democrat, and a Sunni walk into a bar..."
  • "I really need to hit the head. Let's pick it up here later."
  • "Speaking of houses, did you know that Obama's middle name is Hussein?"
At the same time, there is a touch of brilliance in the "at least" approach. This is something all politicians could use.

Q: How many kids do you have?
A: At least one.

Q: How many years have you been married?
A: At least a couple.

Q: Have you ever cheated on your spouse?
A: At

These comments from McCain are hardly surprising given his admitted lack of knowledge about economics. McCain has previously said:
"The issue of economics is something that I've really never understood as well as I should. I understand the basics, the fundamentals, the vision, all that kind of stuff,'' he said. "But I would like to have someone I'm close to that really is a good strong economist. As long as Alan Greenspan is around I would certainly use him for advice and counsel."
Now, some may feel that a solid grasp of economics would be helpful given our budget deficit, national debt, unfunded liabilities, rising unemployment, trade deficit, deteriorating currency, rising commodity prices, and stagnating incomes. They can be forgiven for their naivete. All that really matters is that our President surrounds himself with experts in the field like Alan Greenspan, who presided over and encouraged unprecedented credit growth, a ridiculous increase in the money supply, and cascading bubbles in the stock and housing markets.

I want to be clear that this is not an endorsement of Obama in any way. McCain and Obama both quibble over marginal differences in their economic plans while demonstrating no understanding or appreciation of the precarious and deteriorating financial condition of our country. President McCain would probably trip all over himself in his eagerness to start a war with Iran and Russia simultaneously. President Obama, with the support of a democratically controlled Congress, could certainly do some damage in the tax and spend arena.

Given these two potentially awful outcomes, I recommend the following:
  • Buy gold.
  • Buy a gold mine.
  • Remove, melt, and save any gold fillings you have.
  • "Accidentally" swap luggage with Michael Phelps at the Beijing airport.
  • Gradually strip mine your neighbor's property when he's at work.
  • And buy some silver, too.
Disclosure: The Rubbernecker is long gold and silver and short the Republicans and Democrats.

Tuesday, August 19, 2008

Awwww Rats

Finally, one country is starting to get creative about rising food costs. The following article entitled "Food crisis? Try rats, says Indian state government" is from Reuters:

PATNA, India (Reuters) - A state government in eastern Indian is encouraging people to eat rats in an effort to battle soaring food prices and save grain stocks.

Authorities in Bihar, one of India's poorest states, are asking rich and poor alike to switch to eating rats in a bid to reduce the dependence on rice. They even plan to offer rats on restaurant menus.

"Eating of rats will serve twin purposes -- it will save grains from being eaten away by rats and will simultaneously increase our grain stock," Vijay Prakash, an official from the state's welfare department, told Reuters.

Officials say almost 50 percent of India's food grain stocks are eaten away by rodents in fields or warehouses.

Jitan Ram Manjhi, Bihar's caste and tribe welfare minister, said rat meat was a healthy alternative to expensive rice or grains, and should be eaten by one and all.

"We are very serious to implement this project since the food crisis is turning serious day by day," Manjhi, who has eaten rats, told Reuters.

In Bihar, rat meat is already eaten by Mushars, a group of lower caste Hindus, as well as poorer sections of society.

This is simply brilliant. Increase the amount of available meat, preserve grain stocks, and reduce the rat population all at the same time. If we Americans could apply the same degree of creativity to our problems, imagine what we could accomplish during these difficult times. Here are a few of my very preliminary ideas:
  • Eat politicians (some protein but mainly gas-inducing bacteria)
  • Eat vacant and foreclosed houses (fiber)
  • Eat Wall Street executives (carbon capture)
  • Eat the budget deficit (saturated fat)
  • Eat securitized mortgages (recycling toxic waste)
  • Wash it all down with a Paulson/Bernanke chaser (a laxative)
I would have added rats to the list, but that would have been redundant.

Wednesday, August 13, 2008

Trading Around Earnings

With earnings season in full swing and beautiful bike riding weather tempting me, I haven't been writing too much lately. Furthermore, my wife and I are expecting our first baby (a daughter) in about 7 weeks, so I've been hunkered down conducting intensive research on girls-only day care, nunnery applications, and state gun permitting laws.

But earnings season is finally winding down, and I'm sufficiently recharged to once again form complete sentences. With earnings still fresh on the mind, I thought I'd share a few thoughts about earnings season. First of all, I think the idea of quarterly earnings reports is ridiculous. Company management is supposed to be focused on building long-term value, and quarterly reporting only encourages an emphasis on short-term results. It's a tremendous distraction. Twice-a-year reporting would make much more sense -- and not just because it would interfere only half as much with my bike riding.

I've been asked a number of times about my opinion on trading in anticipation of an earnings miss or beat. This isn't surprising since there are plenty of bloggers/gurus/charlatans/hucksters/frauds/ personalities and Wall Street analysts offering their opinions about which stocks you should trade heading into earnings season. I'm not a big fan of placing these trades. The difficulty lies in the fact that the stock may not rise or fall just because it met or missed earnings expectations. Here are a few of the possibilities:

  • The company could report a great quarter, and the stock goes up.
  • The company could report a great quarter, but it might not be as strong as the market was expecting so the stock gets hit.
  • The company could report a great quarter but guide the next quarter down, so the stock gets hit.
  • The company could report a great quarter and an SEC investigation, so the stock gets hit.
  • The company could report a great number, but the quality of those earnings could be poor, and the stock gets hit.
  • The company could report a great number and a stock offering, so the stock gets hit.
  • The company could report a great number, but the stock had run up in anticipation of the great number, so investors take profits on the news (buy on the rumor and sell on the news).
  • The company could report a bad quarter, and the stock gets hammered.
  • The company could report a bad quarter, but it might not be as bad as feared, so the stock goes up.
  • The company could report a bad quarter but announce that it's pursuing "strategic alternatives" so the stock goes up.
  • The company could report a bad quarter but offer strong guidance, and the stock goes up.
  • The company could report a bad quarter and a stock buyback, and the stock goes up.
  • The company could report a bad quarter, but the Street might believe that the worst is over, and the stock goes up.
I'm sure I missed a few, but the point is hopefully clear. Placing a short-term trade based only on whether you think a company will beat or miss earnings expectations can be treacherous since that's only part of the picture. Still, from time to time I will buy or short a stock shortly before it announces its earnings (such as shorting GOOG before last quarter's earnings release), but there are a few requirements.

First of all, if I'm buying, then I must feel very confident that the company will beat expectations AND/OR raise its guidance. If I'm shorting, then I must believe that the company will miss expectations AND/OR guide lower. The trade also has to be consistent with my view of the company's valuation and fundamentals. I'm not likely to short the stock of an inexpensive company with great fundamentals, and I'm not likely to buy the stock of an expensive company with poor fundamentals, regardless of the time frame.

Rather than take a new position just before an earnings announcement, I usually prefer to see the market reaction following the earnings release and possibly the conference call. Especially in volatile times like these, investors tend (in my opinion) to be prone to overreacting to news. Of course, the stock reaction has to be out of proportion to the news. These overreactions are more likely to occur during after hours trading when liquidity is relatively thin. I only placed one of these trades this earnings season, and it was a purchase of MEMC Electronic Materials (WFR) after hours on July 23rd following a poor earnings release. The stock was purchased at the mid-$38 level when it was briefly down about 30%. The position was sold the following morning just shy of $45.

So what should you do? Place a trade in anticipation of some earnings outcome, or look for over-reactions following earnings releases? You probably shouldn't be doing either. It's very difficult to make money consistently with any short-term trading strategy, and you're up against pros with far more experience and far better contacts. Stick with the long-term, focus on valuation and the fundamentals, and go for a bike ride.

Disclosure: The Rubbernecker is long post-earnings season lobotomies but short earnings season.

Monday, August 4, 2008

The Merrill Defense

The New York Times is out with an article entitled "Merrill's Chief Defends Recent Sale" which discusses Merrill CEO John Thain's reasons behind Merrill's recent CDO sale to Lone Star. According to the article:

A week after he stunned Wall Street by selling billions of dollars of toxic mortgage investments for pennies on the dollar, Mr. Thain defended his decision on Monday, saying he needed to take decisive action to shore up the Wall Street giant and morale among its employees.

“We have over 60,000 people working every day,” Mr. Thain said in an interview after eight tumultuous months as chief executive of Merrill. “All the efforts of these people were overwhelmed by the write-downs in the mortgage-related assets.”

Employee morale? That's touching, but it's a bit anticlimactic. This is an investment bank. I was expecting to hear something about maximizing shareholder value or improving risk-adjusted returns. If he wanted to boost employee morale he could have offered chair massages, personalized "We're #1" paperweights, or more stock options. Well, he could have offered the paperweights or massages.

The article adds:

At the end of Merrill’s whirlwind month, investors are still questioning its C.D.O. sale. Not only did Merrill sell $31 billion at a fire-sale price of $6.7 billion, but it also lent $5 billion to the buyer, Lone Star, a private equity firm in Dallas.

“We went to a lot of trouble to get this deal done, and we structured it in a way where there is very little chance that we ever get these C.D.O.’s back or take the same risk back,” Mr. Thain said.

Let's take a closer looks at the deal. Merrill lent $5 billion of the $6.7 billion price tag, and that $5 billion loan is only secured by the CDOs that were "sold." Merrill is protected from the first $1.7 billion of losses on the securities, but they are still on the hook for that $5 billion loan. If Thain really thinks there's "very little chance that we ever get these CDOs back" then he must believe that no more than $1.7 billion of the securities will default. For the deal to also make sense for Merrill, Thain must believe that the CDOs will not be worth more than the $6.7 billion (I'm simplifying) sale price, otherwise he's leaving money on the table.

Lone Star basically wins if the net effect of any future defaults, any future appreciation, the interest expense on the $5 billion loan, and the income from the securities provides an adequate return on the $1.7 billion of equity at risk. But,
even if Lone Star doesn't default on this loan, Merrill will have taken a loss of 78% on these CDOs. That oughta boost morale.

Here's my favorite part of the article:
A broker in California said it just seemed to be more of the same. Customers, he said, still complain to him that “Merrill Lynch can’t control its money — why should I give you mine?”

Great question! I just can't believe that there are still any customers there to ask it. These Wall Street financial titans want to manage money, raise capital for firms, advise businesses on mergers and acquisitions, and use shareholder money for proprietary trading, but they thought it was a good idea to lend billions of dollars to people with bad credit, no money, and no verified income to buy assets at inflated prices with no equity. You can't make this stuff up.

Disclosure: The Rubbernecker is long chair massages and short investment bank CEOs.

Why Did Oil Fall $3.69 Today?

U.S. crude oil for September delivery fell $3.69 to settle at $121.41 per barrel today on the New York Mercantile Exchange. Why?

According to an Associated Press article:

Oil initially turned lower after the Commerce Department reported that consumer spending fell in June as shoppers dealt with higher prices for gasoline, food and other items. That bolstered analysts' arguments that a U.S. economic slowdown is forcing Americans to scale back on energy use.
A number of other news sources essentially attributed the oil price decline to the same report. The problem with this is that the Commerce Department report was released at 8:30 a.m. As shown in the intraday chart above, oil didn't start falling until after 10:00 a.m. In fact, it first rose following the release of the report.

Bloomberg takes a stab at it:
Crude oil fell for a second day amid speculation Tropical Storm Edouard will skirt most offshore oil facilities as it approaches the coast of Texas.
I checked the status of Edouard before 8:30 a.m this morning on the Weather Channel, and it was very clear at that point that Edouard wasn't going to cause much of a disruption for the Gulf of Mexico energy complex. Edouard developed fairly quickly. We didn't have a $4 rise in oil attributed to Edouard, so it's hard to believe that the fall in oil today can be attributed just to Edouard.

Next, Business Week gives it a shot:

A report that Iran's chief nuclear negotiator Saeed Jalili and the European Union's foreign policy chief, Javier Solana, had called on Monday for a "positive air" over Iran's nuclear issue and would continue to keep communication open was also weighing on oil prices.

This is just laughable. Iran has been in the news practically every day with alternating stories of their openness to talks and their insistence that they won't be giving up their nuclear program. This doesn't even qualify as news anymore. Jalili and Solana are going to have to do better than "positive air" to have a real impact on oil prices.

The fact is that something happened at 11:30 a.m. that sent traders running for the exits. I couldn't pinpoint any specific item that came out at that time. It could have just been a large seller with other traders jumping on board. The issues mentioned above may have fed the sell-off, but they didn't cause it. The other key point is that there was a sell-off across the board in commodities yesterday, not just in oil. Natural gas, corn, base metals, wheat, and soybeans were all hit. Even commodity-related companies that benefit from lower energy prices (like fertilizer firms) were hit hard.

The lesson here, as I've cautioned before, is to be careful about what you read from "reliable" sources. Many writers and investors explain away the actions in the financial markets with a ridiculous degree of certainty when they should be using words such as "perhaps", "maybe", and "possibly". Maybe we'll perhaps possibly even find them some day admitting that they just don't know.

Friday, August 1, 2008

General Motors - "It's Your Money, Demand Better"

The quote in the title ("It's Your Money, Demand Better") was actually the Oldsmobile ad slogan from 1993-1997. Oh, the irony.

General Motors reported a $15.5 billion loss this morning. That's a loss of over $27 per share on an $11 stock. That's big. Of course, there are plenty of reasons for this huge loss. I have no intention of getting into them since I have no intention of ever owning this stock. I was interested, however, in looking at a longer history of GM's financial performance.

I compiled the history of GM's net income back to 1993. I would've gone further back, but this was all that was easily available in Edgar.

Net Income (millions)

20082Q -$15,471

20081Q -$3,251

2007 -$38,732

2006 -$1,978

2005 -$10,417

2004 $2,805

2003 $3,822

2002 $1,736

2001 $601

2000 $4,452

1999 $6,002

1998 $2,956

1997 $6,698

1996 $4,963

1995 $939

1994 $822

1993 $724

Since 2005, GM has LOST about $70 billion. That works out to $123 per share. If we look at GM's cumulative net income since 1993, we come up with a LOSS of over $33 billion. I knew it was bad, but these numbers are astounding. I thought only the U.S. government could lose this kind of money so quickly.

Disclosure: The Rubbernecker is short cutesy ad slogans.