how one China-related ETF has fared

Yesterday I mentioned a Factset article about the trading behavior of China-related ETFs during the current market gyrations in Shanghai and Shenzhen.  It focuses on the Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (ASHS).  Quite a mouthful.

ASHS opened for business last year and has about $41 million in assets.  Its goal is to track the performance of 500 Chinese small caps.  It holds all of the names in the appropriate proportions, to the extent that it can.  Where it can’t, it finds the best proxies available.

Year to date through yesterday, ASHS has risen by 37%+.

The fund melted up in mid-June, however.  Its price rose by 40% from June 8th through June 10th alone, at which time it had y-t-d performance of +113%.

The bottom fell out in the following month, when ASHS lost slightly more than half its value–before bouncing back up by +30% over the past few weeks.

Two points about ASHS:

1.  The fund uses fair value pricing, which is the industry norm in the US.  Fair value pricing, usually performed by a third party the fund hires, does two things:

—-it adjusts the prices of foreign securities in markets that are closed during New York trading for information that has come to light after their last trade, and

—-it gives an estimate for the value of securities that are not trading for one reason or another on a given day.

(Note: in my experience, both types of adjustment are surprisingly reliable.)

This second feature has doubtless come in handy over the past couple of months, since there have been days when as many as half of the Chinese small caps haven’t traded.

 

2.  A mutual fund transacts once a day, through the management company, after the market close and at Net Asset Value.

In contrast, an ETF like ASHS trades continuously during the day, through a number of broker dealers (Authorized Participants), and not necessarily at NAV.

The idea is that these middlemen will use the very cheap brokerage record systems for fund transactions, thus keeping administrative costs down–and that the brokers will use their market making and inventory capability as a way of minimizing the daily flows in and out of the ETF portfolio.

In June, this worked out in an interesting, and ultimately stabilizing way for ASHS.

As I mentioned above, the market price of ASHS rose by 40% over two days in mid-June.  We know that, according to Chinese trading rules, the stocks in the portfolio itself could rise in value by at most 10% daily, or 21% over two days.  I can’t imagine the ASHS fair value pricing service decided that the portfolio was actually worth 40% more than two days earlier when the market signal was twenty-ish.  If I’m correct, the broker dealers decided to meet (presumably large) demand for ASHS shares by letting the premium to NAV expand substantially  …by 20%?…thereby choking some of the demand off, rather than issue a ton of new ASHS shares at a lower price.

According to Factset, the brokers did create new shares.  But they apparently lent at least some of them to short sellers, who sold them in the market, further tamping down demand.

So the Authorized Participants performed their market-making function admirably–presumably making a boatload of money in the process.   But this situation illustrates that the worst fears of possible ETF illiquidity in crisis times may be overblown.

 

 

 

 

 

Chinese stocks—and related ETFs

I got home late last night and flipped on the TV to watch baseball.  What came on first was Bloomberg TV, where reporters in London (?) and Hong Kong were exchanging near-hysterical comments about the declining Shanghai and Shenzhen stock markets.

The facts couldn’t have been much more at odds with their dire pronouncements.  Yes, the markets were down by 2% – 3%.  Yes, a small number of stocks were limit down.  But the markets were relatively stable and trading was orderly.  Given, however, that the main concern for global investors, as well as Chinese participants in the domestic stock markets, is to have China shrink the still-large amount of margin debt outstanding without a market collapse, overnight market action in Shanghai and Shenzhen  was a very positive development.  As it turns out, although the markets closed down slightly for the day, they were even up at one point.  Volumes were reasonable, too.  Let’s hope this continues.

(An aside:  the Bloomberg TV spectacle I witnessed is one more illustration, if anyone needed it, that the recent shakeup of the Bloomberg news organization is taking it further down the road toward infotainment and away from analysis.)

 

I came across a Factset article this morning discussing the performance of ETFs that specialize in small-cap Chinese stocks.  These have been the center of speculative activity in China over the past year.  But they have also been an area subject at times to protracted trading suspensions for some stocks and to days where some have been limit-up or limit-down with no trade.  The short story is that thanks to fair value pricing the ETFs themselves have experienced no problems.  More on this tomorrow.

Chinese stock markets

After recently stabilizing and then rising by about 15%, Chinese stock markets gave up half their gains overnight, causing worry in global financial markets.

For what it’s worth, given that I don’t follow the mainland Chinese stock markets carefully, this is what I think is going on.

Three important factors:

–a government crackdown on real estate speculation has shunted tons of “hot” money into stocks

–Beijing didn’t pay much attention to direct and indirect margin trading ( indirect meaning commercial loans collateralized by stocks bought with loan proceeds, which avoid the letter of the law), thereby allowing speculators to leverage themselves very highly

–stock market rules set limits on the daily movement in individual stocks to + / – 10%.  The way this works is that the exchange attempts to set an opening price at the start of the day.   Let’s say yesterday’s close was 100.  The exchange sees there are sellers at 100 but no buyers.  So it waits a little while and then moves the proposed opening to 99.50. Again sellers but no buyers.  So it moves the proposed opening to 99.  Same thing.  So the proposed opening price continues to ratchet down either until buyers emerge or the proposed price reaches 90.  In the latter case, the price remains at 90 until either buyers appear or the trading day closes.  The same process happens the following day.  (Of course, there might be overwhelming upward pressure as well, in which case the price ratchets up without trade, or stocks might trade–as appears was the case overnight–for part of the day before reaching the daily limit price.)

snowballing downward pressure

A big problem with the daily limit system is that in times of stress often no selling gets done.  For speculators who get margin calls, this means that each day the amount they owe their broker rises (as the market falls) and they can’t take any action to stop the bleeding.  So a horrible sense of panic comes into the market.

The resulting downward spiral is what Beijing was trying to fix when it initiated extraordinary market stabilization measures a short while ago.

The first step in recovery is to stop the market decline.

The second–which is where we are now, I think–is to begin to unwind the enormous margin position that Beijing inadvertently allowed to develop.  The only way to do this is to gradually withdraw the official props under the market, not enough to have the market freeze up again but enough to allow selling to happen.  My guess is that this is what is starting to go on now.  The keys to watch are volume figures and the total value of transactions–the higher, the better.  Unfortunately, I can’t volume figures for today’s trade anywhere.

effects?

In my experience, most emerging stock markets have problems like this in their early days.  Once the crisis is over, authorities usually pay better attention to margin debt.  Invariably, they effectively dismantle the daily limit rule.

Typically, stock market problems have no overall negative effects on the economy.

In the short term, however, margin or redemption selling can create perverse market signals.  Forced sellers liquidate what they can, not necessarily what they want to.  This means, for example, that Hong Kong stocks can come under pressure.  It also suggests that smaller, low-quality stocks may outperform blue chips–the former will be suspended while the latter go down.

This can be a real disaster for margin speculators, who may be left with an account that technically has equity in it but is filled with unsalable junk.  On the other hand, the forced nature of a margin-related selloff can give new entrants a chance to buy high-quality stocks at distressed prices.

One seemingly odd sign that the worst is over will be a collapse in smaller stocks as larger ones are beginning to rise again.  This means that buyer interest is returning to the smaller ones and they’ve resumed trading, which is a much better state than they’re in today.

Another, perhaps lagging, indicator that the worst is over would be Beijing ending the daily trading limit rule.

How long will the cleansing process take?

I don’t know enough detail to have an educated guess.  A couple of months would be my initial estimate.

 

 

 

big day for Amazon (AMZN)–why?

AMZN reported 2Q15 results after the close last night.  They were very good.

Sales were up 20% year-on-year; expenses rose by 17%, three percentage points less.  As a result, the company reported an operating profit of $464 million vs. a loss in the second period of 2014.

More than that, AMZN’s cloud services division, AWS, had revenue growth of 81% yoy and a quintupling of segment profits (basically operating profits less stock option expense) to $391 million.  AWS, broken out as a separate segment for the first time after 1Q15, remained a bit more than a third of the AMZN total.

 

AMZN posted an overall profit of $.19 a share for the quarter, vs. analysts’ expectations of a loss of $.13 a share and a deficit of $.27 per share in the year-ago quarter.

On the announcement, the stock immediately rose by 15% in aftermarket trading.

AMZN opened up by 20% this morning, before drifting down steadily during the day to close +9.8% in a market that was down just more than 1%.

 

Why the strong advance?

I have no good explanation, although I do have some ideas.

1. The obvious factor that changed overnight was the earnings announcement.

It contained a significant positive earnings surprise, one that makes it more likely that the company will earn, say, $1- a share in the current year. It makes the analyst consensus of $2.78 a share for 2016 more believable.   On the other hand, the stock was trading at $482 before the earnings report, or 173x the 2016 consensus.  Looking at the stock price another way, let’s say that at maturity for its businesses (whenever that may be), AMZN shares will be trading at 20x earnings.  To sustain the pre-earnings report price, that would imply a burst of rapid growth that shoots earnings up to around $24 a share.  That would be something like a doubling of earnings each year for the next five or six.

That’s already baked in the cake.  A buyer of the stock at this level must believe that $24 a share in eventual earnings is way too low.

I find it hard to believe that a $.32  per share earnings surprise during one quarter–when expectations were already sky-high=-would be enough to add 20%, or even 10%, to AMZN’s perceived market value.

2.  A second hypothesis…

What if investors are beginning to separate AMZN into two parts, AWS and everything else, and are doing a sum-of-the-parts evaluation.  To me, this sounds a little more plausible.  What would the numbers look like?

Let’s say that in 2016 AWS will comprise half of AMZN’s earnings and AMZN Retail the remainder.  To make the figures easier, let’s say each half earns $1.50 a share next year.

Let’s assume AMZN retail can grow in earnings at 20% a year for a long time, and that we’d be willing to pay 50x current results–a big number for a retail stock–for that future profit stream.  If so, AMZN Retail is worth $75.  To reach a sum-of-the-parts value of $482, AWS must therefore be worth about $400, or close to 270x its 2016 eps.  Ok, while I personally wouldn’t be willing to pay that much for AWS, I can see how someone else might.  However, I still don’t understand why confirmation that a holder at 270x earnings isn’t insane would cause the multiple to expand.  (Also, before I’d be comfortable valuing AWS as a separate company, I’d want to know more about how AMZN apportions revenues and costs among segments to ensure the published numbers don’t flatter AWS.  I’d also think long and hard about the possible effect of stock options.)

3.  The explanation for AMZN’s rocket ship ride that I’m leaning toward, however, is more technical.  Two factors may be involved.  At what Google Finance reports as 21+ million shares, today’s trading volume in AMZN was 7x normal.  The sharp opening spike suggests to me that algorithmic trading computers were at work reacting to the earnings report, not humans.  Humans, I think (?!?), would have a better sense of valuation.  I also suspect that the report and immediate upward move triggered a lot of short covering.

I’m partial to #3 because I think the whole reaction is a little  crazy.

Why is any of this important?  AMZN is a high-profile, large-cap stock with almost two decades of operating history.  There’s got to be a way to make money from the possibility that something like AMZN’s big move will occur with other similar names.

 

 

The Signal and the Noise

I’ve been reading statistician Nate Silver’s 2012 book The Signal and the Noise.  He makes three points that I think are useful for us as investors:

1.  Some ostensible information sources aren’t really that.

TV and radio weathermen, for example, deliberately forecast more rainy days, and amp up the amount of rain that will fall, than they actually think will occur.  Why?  People apparently like to hear about bad weather.  Also, we only get mad if the weather is worse than predicted.  If it’s better ,we regard it as a pleasant surprise.  So there’s every reason for TV and radio to have a consistent “wet” bias–and they do.

Same thing for shows on politics.  Pundits on the McLaughlin Group, for example, have a startlingly bad record at making political predictions.  The show’s many fans don’t seem to care.  Broad, sweeping views, confidently and articulately presented, are all that matters.

It seems to me the same applies to TV financial shows.

 

2.  The group with the absolute worst forecasting record is professional economists.  In fact, predictions about the course of the overall national and world economies are not only highly inaccurate, they’ve gotten worse over time, not better.

In other words, don’t bet the farm on a macroeconomic forecast.

 

3.  Foxes are better thinkers than hedgehogs.

Silver separates forecasters into successful = foxes (he’s one), and really bad = hedgehogs.

The differences:

hedgehogs

highly specialized

“experts” on one or two narrow issues that define their careers; contemptuous of “generalists”

often in the academic world

all-encompassing theories

theory over facts

believe in a neat universe, defined by a few simple relationships

highly confident, meaning resistant to change

foxes

interdisciplinary

flexible

self-aware and self-critical

facts over theory

think the world is inherently messy

careful, probabilistic predictions.

In other words, be careful of highly confident people with overarching theories and elaborate forecasting systems.

 

 

 

Toshiba and the Japanese business establishment

First there was the Fukushima Dai-ichi nuclear disaster, where nuclear power plants were installed incorrectly and both the utility and government regulators falsified inspection reports to cover this up.

Then there was Olympus Optical, whose tip management lost billions in stock market speculation because it was unwilling to restructure loss-making operations and covered up the fact for over a decade by fabricating its financial statements.

Now there’s Toshiba, which falsified results for years, under pressure from unrealistic profit goals set by a series of CEOs  (shades of Jack Welsh at GE).

 

Not that surprising, in my view, given the Japanese corporate world’s widespread adherence to a samurai-like code of absolute, unquestioning obedience to instructions given by older/more senior managers in one’s company.  After all, many of these enterprises have their origin in samurai cast adrift as regional warlords were marginalized during the early shogun days.

This mindset is also a reason why a lot of Japanese business is still stuck in the 1980s–that the world is changing at a fast clip, but you pretty much have to have white hair before anyone will listen to what you have to say.  To be clear, I don’t think this samurai-ness is a universal attitude in Japan as a whole.  Unfortunately,it thrives in the Tokyo/Osaka-based, export-oriented industrial sector which is the primarily beneficiary of the deep depreciation of the yen engineered by PM Abe.

Why don’t out-of-date sixty- and seventy-somethings just retire and let a younger generation take the reins?

For one thing, speaking as a sixty-something myself, it’s hard to go from being king of the world to being just another nameless retiree.

I think, however,that there may also be a deeper, more damaging reason than the ego problems of the people in charge:

One of the first companies I followed as an analyst was a small copier manufacturer/distributor.  The firm was in enough financial trouble that it bought breathing room by selling a large chunk of its plant and equipment and leasing it back from a bank.  That netted $50 million or so in cash.

Soon afterward, Carl Icahn bought  5%-10% of the company’s stock and threatened to make a hostile bid for the rest.  The firm quickly bought back Icahn’s shares for, as I recall, about a 30% premium.  I was shocked.  I didn’t get it at all.

Only when the firm subsequently went into Chapter 11 did I learn the CEO, a former accountant, had been fiddling with the books for years.  That fact was the real leverage Icahn had over his target, whether he knew it or not.  The CEO couldn’t let an outsider in, because the accounting shenanigans would be discovered and he would be disgraced.

I don’t know, but I suspect–because I’ve seen the same pattern in numerous smaller firms in Japan that Olympus and Toshiba are only the tip of the iceberg in Tokyo.  If I’m correct, Abenomics is even more problematic than I’ve been writing.

 

 

 

 

 

 

the A&P bankruptcy

a Chapter 11 filing

The Great Atlantic and Pacific Tea Company has just filed for Chapter 11 bankruptcy protection.  According to the radio reports I heard yesterday, this is the second time in three years and the fifth overall bankruptcy filing for the venerable supermarket chain.

A&P said it did so in order to preserve the flow of fresh produce and other perishables into its stores.

In one sense, it’s not surprising that supermarket chains might be in trouble, given the relentless expansion of Wal-Mart into grocery over the past couple of decades, the rise of Whole Foods et al, and the change in lifestyle and consumption habits being spearheaded by Millennials.

A&P as a useful template for investors

A&P, however, is also an important illustration of how creditworthiness can deteriorate in ways investors seldom suspect.

the key:  trade creditors’ bankruptcy standing

The key to understanding what is going on is to realize that in Chapter 11, trade creditors go to the bottom of the list of who gets repaid.  They rank ahead only of equity holders, who as a general rule are wiped out completely.  Trade creditors usually fare little better, if at all.The amounts involved can be substantial.  In the A&P case, for example, McKesson is listed as a major unsecured creditor, owed $39+ million.

trade creditors defending themselves

Knowing that any outstanding bills will likely be voided by a bankruptcy court, suppliers of inventory and services watch the creditworthiness of their customers very carefully.  They hire third-party credit services to provide periodic reports, and they monitor any differences in customer payment patterns very carefully.

If a customer shows A&P-like symptoms (according to Bloomberg, A&P had been having net cash outflows of $14.5 million monthly during fiscal 2015), a vendor can take several related actions to lower its risk:

–it can send less merchandise on credit to the worrisome customer

–it can send lower-value or lower-quality merchandise, or only items that have an extremely short sales cycle

–it can refuse to extend credit; it will demand payment in advance.  This is a lot more serious than it sounds, since the customer may be depending on being able to use the cash from a sale for a week before paying the vendor.

(An aside:  I’ve even seen instances where a trade creditor has sued the customer for payment, knowing that a favorable judgment will force bankruptcy.  The idea is that some third party who doesn’t want a Chapter 11 filing–a bank or other long-term debt holder, or an equity holder–will settle the debt while the case in court.)

Of course, none of this is good for the cash-strapped concern.

reversal of form

Once the firm is in bankruptcy, the situation reverses completely.  Suppliers no longer have to worry about having unpaid bills nullified.  And the bankruptcy judge will ensure that trade creditors are put at the front of the line to be repaid.  So just as the flow of new merchandise into a cash-short enterprise slows down as Chapter 11 becomes a realistic possibility, it speeds up again once the company has filed.

 

 

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