Russia as the new Malaysia?

To me, what made Malaysia noteworthy during the Asian financial crisis of the late 1990s was how vigorously the country defended the interests of a small cadre of insiders who had amassed mega-fortunes over the prior decade or more.  Political connections + aggressive use of financial leverage–after all, what local bank would deny them a loan?–were the keys to  their success. In the end, Kuala Lumpur imposed capital controls lasting about a year to prevent foreigners from selling assets and withdrawing the funds from the country.  That action gave Malaysian financial markets a long-lasting black eye, something that could have been avoided if Malaysia had chosen to raise interest rates to achieve the same end instead.  But doing so would have bought down more than one of the local moguls.

In current crisis among oil-producing countries, Russia is already taking the first step down the Malaysian path.  Last week Moscow orchestrated a $11+ billion sale of bonds by oil giant Rosneft.  The issue had a coupon below that of government debt.  It was reportedly taken up mostly  (entirely?) by state-owned banks.  The central bank promptly declared itself willing to accept the bonds as collateral for loans to be made at rates below the bond coupons.  Indirectly, then, the funds Rosneft raised come from the Russian equivalent of the Fed.

That President Putin should protect his cronies shouldn’t come as any surprise.  But if this is a chief aim of his government, which it appears to be,  investors have to at least consider the possibility that Moscow may be forced to impose capital controls at some point.  For you and me, this implies checking to make sure we know what exposure we may have through emerging markets or yield-hungry fixed income funds/ETFs.

doing securities analysis vs. getting inside information

the “mosaic” theory

When I became a securities analyst in 1978, the mosaic theory was what was commonly understood as being an adequate defense for an analyst accused of trading on inside (that is, material, non-public) information.

An example:  I’m interviewing the CFO of a large company I know is in negotiations over a very lucrative project in China.  This firm has a smaller, publicly traded partner, for whom this project could, say, triple its earning power.  After a series of questions, I tell the CFO that I’m estimating the company’s interest expense for next year will be $200 million.  I ask if this sounds right.  He responds that it will more likely be $250 million.

I know the company’s cost of debt is about 5%, so the added interest expense means new borrowing of $1 billion.  The only reason to do so would be to fund the China project, which seems innocuous enough but which has enormous implications for the smaller partner.   So I buy the stock of the partner for my clients’ portfolios.

Let’s add one more thing.  I’ve spent a half hour on the phone with the CFO, asking a lot of questions.  My main purpose has been to create an atmosphere in which he’d answer the interest expense question.

Am I trading on inside information?  At the start of my career, the answer would have been no.  Ten years ago, I might have gone to a compliance officer before acting–and most likely would have been told not to trade.

Another example:  Same companies, but this time I’m in Narita Airport in Tokyo and see the CFO boarding a plane for Beijing.  He doesn’t appear to be on vacation.  He hates business travel.  The only work reason he would have for a trip to Beijing would be to sign the joint venture project agreement with the Chinese government.  Do I have inside information or have I just made an astute conclusion based on my professional background and experience?

Same answer.  I’d worry and would again seek assurance that my firm would defend me in a lawsuit.  I’d probably be told not to trade.

To be clear, I’m not at all a fan of so-called “expert networks,” which are many times thinly veiled centers for bribery of corporate officials and theft of proprietary information.  At the same time, it seems to me that over my career the focus of SEC prosecution of traders on inside information has gradually shifted from a focus on the illegal character of the information collection to whether the information itself is widely known, with no regard to if its possession is the result of professional skill and knowledge or simply theft.


A recent appeals court decision (I read about it in the New York Times) overturning the insider trading conviction of two hedge fund managers may signal that the scales are starting to move in the other direction.

The court ruled that the SEC must prove that the receiver of an “inside” tip who acts on it must know both:

–that the information is not for public release, and

–that the provider has received an “exchange that is objective, consequential and represents at least a potential gain of a pecuniary or similarly valuable nature” in return.

The ruling seems to me to have wider implications than just protecting securities analysts from arbitrary prosecution.  It also appears to open the door widely to old-boy network activity, which I don’t regard as a good thing.  Still, if I were still a working analyst it would give me heart to do my job more aggressively.



Shaping a portfolio for 2015: elaboratng on yesterday’s post

A reader had two questions about yesterday’s post, which I figured it would be easier to answer here than simply in a comment.

emerging markets

The big attractions of emerging economies to an equity investor are the possibility of very rapid economic growth for the country and of finding future titans of world industry as infants.  The two standard paths of gaining exposure to these markets are: to invest directly or to buy a developed-world multinational with significant presence in the economy in question.

Some emerging markets aren’t open to foreigners.  For those that are, the most important thing to realize, I think, is that there is typically little local support for stocks.  There are usually no pension funds or other local institutional investors (because there are no pensions and residents aren’t wealthy enough to afford financial products like insurance).  Local citizens don’t have enough money to be able to own stocks.  As a result, emerging market performance ends up being heavily dependent on foreign inflows and outflows.

Foreign flows can be very cyclical.  When developed market investors are feeling confident, inflows to emerging markets are typically very large.  When they’re scared, outflows are the order of the day.  Because there’s little local buying power, these outflows invariably cause sharp price declines.

Right now, oil-exporting emerging markets are being hurt very badly by the declining price of crude.  investors are also worried that emerging markets-based companies may have borrowed excessively, in US$, during the past few years of easy credit.  Such debts were a big factor in the crisis in emerging Asian markets that started in 1997.  In fact, today’s developments in Russia sound a lot like what happened in Malaysia in the late 1990s.

Yes, emerging market will eventually settle out.  I don’t think we’re anywhere close to that point, though.

rent vs. buy

Take Adobe.   Say you’re a web designer who wants to start a business on your own and that you want to use Adobe tools.

Buying a Creative Suite package to get started used to cost $2,500 – $3,000.  That’s a lot.

Many people would do one of two things:

–bite the bullet and buy, but never, ever upgrade; or

–find a bootleg copy on Craigslist for $200 or so.  Yes, it would probably stop working after six months, but it was cheaper than getting an “official” copy.

How many people took the second route?   I don’t know  …but probably a lot. I once heard Bill Gates estimate that 40% of the small business users of Office in the US were using counterfeit copies

Adobe has now gone over to a rental model.  $50 a month gets you access to the Creative Cloud version of all the Adobe tools.  The same sort of thing for photographers–$10 a month for Photoshop + Lightroom, vs. $600 to buy  (Amazon is selling the last disk version of Photoshop for $1500).

The plusses:

–the move from buy to rent changes a big one-time capital expenditure by a small business customer into an affordable monthly operating expense.  If users stay subscribers for at least five years, Adobe gets more money from rental than from a sale.

–Just as important, matching the tool expense more closely with customer cash flows is bringing a whole bunch of former illegals into the fold

–the company may also be attracting casual photography users who would never before have contemplated using Photoshop, but for whom $10 a month isn’t a big deal

–subscriber growth has continually exceeded consensus expectations.

The rental model isn’t exactly new.  It has been used for all sorts of equipment for years, from copiers to burglar alarms to colonoscopes.

What surprises me is that Wall Street has been so slow to figure out that the rental model works for software, too.  Yes, in the early days, the accounting looks ugly.  In fact, the faster the transition to rental goes, the uglier the income statement looks.  Development expenses remain the same, but instead of chunky sales revenue, the company only shows subscription payments for that month.  But professional analysts should be able to see past that.  My guess is that they miss completely the bootleg copy phenomenon.






Shaping a portfolio for 2015 (vii): putting the pieces together

I expect 2015 to be a “normal” year, in contrast to the past six.  This is important.

Over the past six recovery-from-recession years, global stock markets have had a strong upward bias.  Yes, outperformance required the usual good sector and individual security selection.  But if “bad” meant up 12% instead of up 15%, most of us would be happy enough with the former.

This year, though, is more uncertain, I thin.  Whether the S&P 500 ends the year in the plus column or the minus depends on importantly on four factors:

–PE expansion.  Unlikely, in my view.  

–interest rates.   Arguably, rising rates may cause PE contraction, ash or bonds become more attractive investment alternatives to stocks

currency changes.  A rising currency acts much like an increase in interest rates.

profit growth.  In a normal year, earnings per share growth is the primary driver of index gains/losses.  It will be so for 2015, in my view.

Another point.  Four moving parts is an unusually large number.  There are other strong forces acting on sectors like Energy and Consumer discretionary, as well.  Because of this, unlike the past few years, where one could make a plan in January and take the rest of the year off, it will be important in 2015 to monitor plans frequently and be prepared to make mid-course corrections.

profit growth

Here’s my starting point (read:  the numbers I’ve made up):

US = 50% of S&P 500 profits.  Growth at +10% will mean a contribution of +5% to overall index growth

EU = 25% of S&P 500 profits.  Growth of 0 (due to euro weakness vs. the dollar) will mean no contribution to index profit growth

emerging markets = 25% of S&P 500 profits.  Growth of +10% (really, who knows what the number will be) will mean a contribution of +2.5% to             index growth.

Therefore, I expect S&P 500 profits for 2015 to be up by about 7% – 8%.

interest rates

The Fed says it will raise short-term rates, relatively aggressively, in my view, from 0 to +1.5% by yearend 2015, on the way to +3.5% by yearend 2017.  This plan has been public for a long time, so presumably at least part of the news has already been factored into today’s stock and bond prices.  What we don’t know now is:

–how much has already been discounted

–what the Fed will do if stocks and junk bonds begin to wobble, or emerging market securities fall through the floor, because rates are rising.  My belief:  the Fed slows down.

–is the final target too aggressive for a low-inflation world?  My take:  yes it is, meaning the Fed’s ultimate goal of removing the US from monetary intensive care may be achieved at a Fed Funds rate of, say, 2.75%.

My bottom line (remember, I’m an optimist):  while rising rates can’t be considered a good thing, they’ll have little PE contractionary effect.  Just as important, they won’t affect sector/stock selection.  The major way I can see that I might be wrong on this latter score would be that Financials–particularly regional banks–are better performers than I now anticipate.

If rising rates do have a contractionary effect on PEs, the loss of one PE point will offset the positive impact on the index of +6% -7% in earnings growth.  So the idea that the Fed will slow down if stocks begin to suffer is a crucial assumption.


currency effects

The dollar strength we’ve already seen in 2014 will make 2015 earnings comparisons for US companies with foreign currency asset/earnings exposure difficult.  Rising rates in the US may well cause further dollar appreciation next year.  Even if the dollar’s ascent is over, it’s hard for me to see the greenback giving back any of its gains.

Generally speaking, a rising currency acts like a hike in interest rates;  it slows economic activity.  It also redistributes growth away from exporters and import-competing firms toward importers and purely domestic companies (the latter indirectly).

The reverse is true for weak currency countries.  At some point, therefore, companies in weak currency countries begin to exhibit surprisingly strong earnings growth–something to watch for.

growth, not value

Typically, value stocks make their best showing as the business cycle turns from recession into recovery.  During more mature phases (read: now) growth stocks typically shine.


–Millennials, not Baby Boomers

–disruptive effects of the internet on traditional businesses.  For example: Uber, malls, peer-to-peer lending.  Consider an ETF for this kind of exposure.

–implications of lower oil prices.  Consider direct and indirect effects.  A plus for users of oil, a minus for owners of oil.  Sounds stupidly simple, but investing isn’t rocket science.  Sometimes it’s more like getting out of the way of the oncoming bus.

At some point, it will be important to play the contrary position.  Not yet, though, in my view.

–rent vs. buy.  Examples:  MSFT and ADBE (I’ve just sold my ADBE, though, and am looking for lower prices to buy back).  Two weird aspects to this: (1) when a company shifts from buy to rent, customers are willing to pay a lot more for services (some of this has to do with eliminating counterfeiting/stealing); (2) although accounting for rental operations is straightforward, Wall Street seems to have no clue, so it’s constantly being positively surprised.



is the current equity selloff about oil?

I’m postponing my 2015 Strategy summary/conclusion on Monday.


The price of oil has been steadily declining since June  It’s now below $60 a barrel, after having moved sideways at around $100 from January through early July.

I think the drop is being caused by the fact that supply and demand for petroleum are relatively inflexible in the short term, so small changes in either can cause surprisingly large changes in price.  In 2008, for example, the oil price quickly spiked up from $100 to almost $150 a barrel.   It moved above $125 for a short period in 2011 and again in 2012.

Unlike the prior three surges–caused by fears of supply disruption–the current decline is being created by the steady increase in shale oil output from the US.  In a sense, no one needs all the oil now being brought to the surface.  No one has a place to store the excess.  No producer is willing to cut back his lifting to make room for the extra.  The only mechanism available to clear the market is that the price drops until it reaches a level where buyers are willing to take the risk of increasing their inventories.   Doubtless, commodities speculators of all stripes have been accentuating the downward trend with their shorting activity.

Bad as the price drop has been for oil-producing countries–Russia, the Middle East and Africa–it’s a big plus for the rest of the world.    …yet stock markets are falling on the news.  Why?

–Some market strategists are saying that falling oil prices are being caused by a mysterious–and as yet unseen in other data–falloff in economic activity.  In other words, lower oil is supposedly a harbinger of recession.  Other than for the oil producers, this makes no conceptual sense.  And it flies in the face, at least in the case of the US, of all the economic data we’re seeing–which indicate that the economy is accelerating.

–Others argue that falling oil presages deflation, presumably of the type that has plagued Japan for decades.  Again, other than for oil producers and their banks, I don’t see the problem.  Ex oil companies, no one is going to have less money to spend or to use to repay debt.

–There is a stock market-specific issue, though.  Take the US as an example.  In rough terms, the country produces 13 million barrels of oil a day and uses 20 million.  So it imports 7 million.  The price fall means the country as a whole is keeping about $100 billion a year that was previously going to foreign pil producers.  The loss to domestic producers/gain to domestic consumers is about $200 billion a year.  That money isn’t leaving the country.  It’s just going into different pockets.

In an $18 trillion economy, the whole thing is peanuts, even with secondary effects.

But oil stocks represent 8%+ of the S&P 500 (for the MSCI Global index the proportion is about the same).  So the effect on stocks is much more dramatic.

Energy stocks went down by 10% last month   …and they’ve declined another 5% so far in December.  This has two influences on the market.  The drop in oil stocks themselves depresses the index.  In addition, short-term traders, thinking oil shares look cheap (rightly or wrongly), will short other sectors to buy the oils in the expectation of a bounce.  This arbitrage activity drags the rest of the index down as well.  This is just the way stocks work.

–The fact that we’re close to the end of the year, when many professionals have begun closing down for the year, doesn’t help.  They’ll prefer to sit on the sidelines for now and hunt for bargains in January.

my take

I think the “expert” opinions about possible deflation and recession are silly.  The outsized representation of oils in stock market indices is an issue, but a temporary and minor one, in my opinion.  If anything, I think the oil price fall is a trigger for investors to begin discounting potentially higher interest rates next year.  Some investors may simply be taking profits after a 2014 that has been much stronger than anyone expected.  But declines in December seem to me to imply a better chance of gains in 2015.


Shaping a portfolio for 2015 (vi): the rest of the world

world GDP

A recent World Bank study ranks the largest countries in the world by 2013 GDP.  The biggest are:

1.   USA         $16.8 trillion

2.  China         $9.2 trillion

3.  Japan          $4.9 trillion

4.  Germany          $3.6 trillion.

The EU countries taken together are about equal in size to the US.

stock markets

From a stock market investor’s point of view, we can divide the world outside the US into four parts:  Europe, greater China, Japan and emerging markets.


In the 1990s, Japan choked off incipient economic recovery twice by tightening economic policy too soon–once by raising interest rates, once by increasing its tax on consumer goods.  It appears to have done the same thing again this year when it upped consumption tax in April.

More important, Tokyo appears to me to have made no substantive progress on eliminating structural industrial and bureaucratic impediments to growth.  As a result, and unfortunately for citizens of Japan, the current decade can easily turn out to be the third consecutive ten-year period of economic stagnation.

In US$ terms, Japan’s 2014 GDP will have shrunk considerably, due to yen depreciation.

If Abenomics is somehow ultimately successful, a surge in Japanese growth might be a pleasant surprise next year.  Realistically, though, Japan is now so small a factor in world terms that, absent a catastrophe, it no longer affects world economic prospects very much.


In the post-WWII era, successful emerging economies have by and large followed the Japanese model of keeping labor cheap and encouraging export-oriented manufacturing.  Eventually, however, everyone reaches a point where this formula no longer works.  How so?    …some combination of running out of workers, unacceptable levels of environmental damage or pressure from trading partners.  The growth path then becomes shifting to higher value-added manufacturing and a reorientation toward the domestic economy.  This is where China is now.

Historically, this transition is extremely difficult.  Resistance from those who have made fortunes the old way is invariably extremely high.  I read the current “anti-corruption” campaign as Beijing acting to remove this opposition.

I find the Chinese political situation very opaque.  Nevertheless, a few things stand out.  To my mind, China is not likely to go back to being the mammoth consumer of natural resources it was through most of the last decade.  My guess is that GDP growth in 2015 will come in at about the same +7%or so China will achieve this year.  In other words, China won’t provide either positive or negative surprises.

For most foreigners, the main way of getting exposure to the Chinese economy is through Hong Kong.  Personally, I own China Merchants and several of the Macau casinos.  The latter group looks very cheap to me but will likely only begin to perform when the Hong Kong market is convinced the anti-corruption campaign is nearing an end.


In many ways, the EU resembles the Japan of, say, 20 years ago.  It, too, has an aging population, low growth and significant structural rigidity.  The major Continental countries also have, like Japan, strong cultural resistance to change.  These are long-term issues well-known to most investors.

For 2015, the EU stands to benefit economically from a 10% depreciation of the euro vs. the US$.  As well, it is a major beneficiary of the decline in crude oil prices.  My guess is that growth will be surprisingly good for the EU next year.  I think the main focus for equity investors should be EU multinationals with large exposure to the US.

emerging markets

I’m content to invest in China through Hong Kong.  I worry about other emerging Asian markets, as well as Latin America (ex Mexico) and Africa.  Foreigners from the developed world provide most of the liquidity in this “other” class.  If an improving economy in the US and higher yields on US fixed income cause a shift in investor preferences, foreigners will likely try to extract funds from many emerging market in order to reposition them.  That will probably prove surprisingly difficult.  Prices will have a very hard time not falling in such a situation.


Shaping a portfolio for 2015 (v): the US

a healthier economy

2015 will likely be the first normal year for the US economically for a long time.  The unemployment rate is close to full employment levels; job creation is high–and accelerating; recent signs suggest that wages are beginning to rise.

Wage gains are important for two reasons:

–higher wages imply more consumer spending, which means accelerating economic expansion, and

–the resulting increase in the price level diminishes the possibility of deflation.

alone in growth mode

The EU is, generally speaking, a less dynamic area than the US.  But it is also years behind the US in putting recession in the rear view mirror.  It is still struggling with structural problems–Greece, for example, is flaring up again.

I continue to believe that Abenomics is not going to solve Japan’s economic woes.  So pencil in no growth there.

China is attempting to transition from being an export-driven economy to a doemstic demand-oriented one.  As one would expect, it is encountering tremendous resistance from the export establishment.  This struggle will keep the Chinese economy range bound around 6%-7% GDP growth for a while.  Big numbers, yes, but no acceleration like the US is experiencing.

a lower oil price

I’ve written about this in more detail earlier in this Strategy series.  For the country as a whole, a lower oil price is a plus.

Assuming, as I do, that prices will stay around this level, effects will likely be:

–the biggest percentage change in disposable income for the less affluent,

–diminishing interest in alternate energy sources

–economic, and possible political, troubles for oil-producing countries–Russia, the Middle East and Africa.

We’re already seeing renewed interest in gas-guzzling cars and trucks in the US.  But also–a good thing, in my view–politicians are beginning to talk about raising taxes on gasoline.  This would provide funds–at least in theory–to repair decrepit roads and bridges.  By encouraging conservation, it would also lessen the long-term economic power of the oil producers.  And it would bring US policies more in line with the rest of the developed world.

rising interest rates

The good economic news opens the door for the Fed to begin to raise interest rates from the current emergency-low levels.  I’ve written about this too in more detail earlier in this Strategy series.

Normalization of rates is a long-term plus.  But rising interest rates will also tend to slow growth a bit, both by raising the cost of borrowing and by rising interest rate differentials between the US and other countries giving strength to the US$.

structural factors

The Internet continues to be an amazingly powerful force of creative destruction in the economy.  No end in sight.

Millennials have surpassed Baby Boomers as the largest segment of the population.  In addition, Millennials will be the chief beneficiaries or rising wages, while Boomers will see their incomes drop as they enter retirement.

my bottom line:  the fact that the US is coming further out of recession is a huge long-term plus, both for the economy and for US financial markets.  Purely from a stock market point of view, however, there are a lot of conflicting variable in the equation for 2015.  And that’s apart from trying to handicap what the markets have already begun to discount.  More about this when I put all the pieces together in a couple of days.


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