cooling the Chinese stock market fever

In the 1990s, Alan Greenspan, the head of the Fed back then, famously warned against “irrational exuberance” in the US stock market, but did nothing to stop it   …this even though he had the ability to cool the market down by tightening the rules on margin lending.  This is the stock market  analogue to raising or lowering the Fed Funds rate to influence the price of credit, but has never been used seriously in the US during my working life.

The  Bank of Japan has no such compunctions.  It has been very willing to chasten/encourage speculatively minded retail investors by tightening/loosening the criteria for borrowing money to buy stocks.


We have no real history to generalize from in the case of China.  But moves in recent weeks by the Chinese securities markets regulator seem to indicate that Beijing will fall into the stomp-on-the-brakes camp.


–at the end of last month, the regulator allowed (ordered?) domestic mutual funds to invest in shares in Hong Kong, where mainland-listed firms’ shares are trading at hefty discounts to their prices in Shanghai

–highly leveraged “umbrella trusts” cooked up by Chinese banks to circumvent margin eligibility requirements have been banned,

–a new futures product, based on small and mid-cap stocks, has been created, offering speculators the opportunity to short this highly heated sector for the first time, and

–effective today, institutional investors in China are being allowed to lend out their holdings–providing short-sellers with the wherewithal to ply their trade (although legal, short-selling hasn’t been a big feature of domestic Chinese markets until now, because there wasn’t any easy way to obtain share to sell short).

What does all this mean?

The simplest conclusion is that Beijing wants to pop what it sees as a speculative stock market bubble on the mainland.  It is possible, however, that more monetary stimulus–to prop up rickety state-owned enterprises or loony regional government-sponsored real estate projects–is in the pipeline and Beijing simply wants to dampen the potential future effects on stocks.

I have no idea which view is correct.

It’s clear, however, that Hong Kong is going to be a port in any storm, and that it is going to be increasingly used as a safety valve to absorb upward market pressure from the mainland.  So relative gains vs. Shanghai seem assured.  Whether that means absolute gains remains to be seen, although I personally have no inclination to trim my HK holdings.



contribution margin

three sets of books

A couple of years ago, I wrote a post about the three sets of accounts that a publicly traded company maintains:

–tax books, where the objective is to pay the smallest amount of tax legally possible–in other words, to fool the IRS,

–financial reporting books, where a more liberal view of when and how revenues and expense occur allow a company to put its best foot forward with owners–in other words, to fool shareholders, and

–management control books, also called cost accounting books, which the company uses to actually run its operations.

contribution margin

Contribution margin is a cost accounting concept.

The first thing to note is that despite its name it’s not really a margin–that is, it’s not a percentage.

Instead, it’s the amount by which an activity or a  line of business exceeds its own direct costs and makes a contribution to corporate overhead.  This isn’t the same as making a standalone profit, meaning after covering total costs.

Take a restaurant that’s now open for lunch and dinner and makes money doing so.

Should it open for breakfast, as well?

In the simplest case, the question is whether the restaurant can generate enough revenue to offset the cost of paying for the food and the staff.  If so, it makes a positive contribution margin.  If we were to allocate, say, 20% of the restaurant’s total expense for rent, electricity and depreciation of equipment,  breakfast might be bleeding red ink.  But those costs are there anyway, whether breakfast is or not.  As long as the contribution margin is positive, the firm is better off with breakfast than without.  (Yes, the actual situation is more complicated   …is the wear and tear higher because of breakfast?   …does breakfast cannibalize the other meals?   But I’m keeping it simple to illustrate a point.)

Another case.   Some lines of business may never have been intended to create growing profits, or may no longer be capable of doing so, even if they once were.  A manufacturer may make precision components in-house.  The component division will typically be run as a cost center, not a profit center.  It’s mission will be to provide high quality parts at the lowest price, not to maximize profits.  Its managers will be evaluated by their ability to provide output more cheaply than third-party alternatives can.  Again, the division may not be profitable after allocation of its share of corporate overhead.  Still, it may be very valuable.  Its value will be measured by contribution margin, defined as the difference between in-house and third-party component costs.

Why is this important?

It’s a mindset thing.  Not every part of a company may be intended to grow.  Rising stars may eventually turn into cash cows as businesses evolve.  It’s important both for company management and investors to understand the role an activity should be playing in the overall enterprise.



surging Hong Kong stocks

a rising Hang Seng

The Hang Seng index is up by close to 10% over the past five trading days.  The Hang Seng China Enterprises index, which measures the performance of stocks dually listed in Hong Kong and on the mainland, has risen by 13%+.

Both figures understate the performance of many individual issues in the Hong Kong market over that span.  Hong Kong Exchanges and Clearing (HK: 0388), for example, is up by 40% over the past week.  BYD (HK: 0285), the battery/electric car company, has risen by 30%; Air China (HK:  0753) is 40% higher.

The bulk of the money fueling these purchases is coming from the mainland, through the Stock Connect mechanism (see my post on SC) that Beijing established about half a year ago.  The purpose of Stock Connect is to gradually allow larger flows of portfolio capital between Hong Kong and the mainland stock exchanges.  The idea is that at some point the two areas will act effectively as one.

Up until the past few days, SC flows between Hong Kong and Shanghai have been disappointing.  That changed drastically when Beijing gave the okay on March 27th for mainland mutual funds to use the SC mechanism.  I don’t know whether it happened again overnight, but Chinese mutual funds have been forced to stop buying because the daily limit to Stock Connect transfers has been reached early in afternoon trading over each of the past several days.

What is causing the surge?

Two factors:

–sharp upward movement in mainland stock markets had left the Hong Kong shares of dually-listed Chinese companies trading at extremely deep discounts to their equivalent shares in China (shares in Hong Kong still average around 20% cheaper), and

–strict market regulation, properly audited financials and the existence of companies traded in Hong Kong but not available on the mainland all make Hong Kong an interesting destination for Chinese portfolio money.

my take

As long as Hong Kong’s China-related shares trade at a steep discount to their Shanghai counterparts, arbitrage should be a support both for these individual issues and for the Hong Kong market as a whole.

For the first time ever, Hong Kong investors have got to keep a close eye on mainland exchange activity, since arbitrage can work both ways.

To the extent that any Hong Kong stocks are still about the physical place, Hong Kong, and not about the mainland, they’ll likely be significant laggards.

A tiny voice in the back of my head says that there’s something artificial about this week’s sharp rise.  If this were 1980s Japan, I’d be convinced that mutual funds had been strongly urged by some government ministry to use Stock Connect vigorously this week.  Could something like that have happened in China?  Maybe.  I think next week’s stock action will give us a hint as to whether the week’s exuberance is voluntary.

I have a lot of Hong Kong exposure already.  I have no inclination to chase stocks solely on the idea I’ll surf a mega-wave of incoming money.  Still, if this is genuine Chinese investor interest, I think we’re unlikely to see prices back at their week-ago levels any time soon.  And we’re probably going to see pretty regular mainland support for Hong Kong shares.  So I might be tempted to add on weakness.



merger talks off between Intel (INTC) and Altera (ALTR)

CNBC is reporting that INTC has broken off takeover talks with ALTR .  ALTR has supposedly rejected an offer of $50+ per share.

If ALTR’s value were not in its software engineers, that is, intellectual property that drives out of the parking lot every evening, we’d expect that the situation would develop along two parallel lines:

1.  figuring (correctly, in my view) that shareholders who are not part of ALTR’s top management would jump at the chance to sell their stock to INTC for $50, INTC might consider a hostile bid (that is, one not endorsed by ALTR’s CEO), and

2.  ALTR would decline on the news, but remain above its new-leak level as Wall Street would expect, at worst, another suitor to emerge sooner or later.


I don’t think the first will happen in this case.  INTC doesn’t want buildings, land and equipment.  It wants researchers–who might either decamp to work for competitors or even form their own independent software firm if they felt they were being forced against their wills to work for INTC.   Management likely wouldn’t stand in anyone’s way.  Therefore, making a hostile bid risks ending up with an empty shell.

On the other hand, I don’t expect another suitor.  It seems to me that INTC is uniquely able to use ALTR’s intellectual property to create new value  …and I found myself struggling to justify a bid price, even with INTC as the buyer, over $40 a share.


Still, ALTR may not simply drop back to the mid-$30 range.

If we assume that INTC knows what it’s doing, then it thinks that an INTC/ALTR partnership would have transformative value that would make ALTR worth something like double the pre-bid market price (otherwise, why bid $50+? …the other alternative, which I’ve ruled out in the first clause of this paragraph, is that INTC is either foolish or desperate).

INTC sought to capture most of the upside by buying ALTR.  That hasn’t worked.  Presumably, when emotions clear and heads cool, INTC will try to work out a different arrangement (joint venture?) in which ALTR will retain its independence and take a larger amount of any upside for itself.

If this is correct, a big selloff in ALTR over the coming weeks might offer an interesting opportunity to buy.


positioning in a trendless market…

…that is, in the kind of market we have now.

At stock market bottoms, like the epic one we saw in March 2009, the most highly economically cyclical stocks and the ones with the weakest capital structures (i.e., the most out-of-control debt) are invariably the ones that are the most beaten down.  Because of this, they’re the ones that react the most positively to the first rays of hope that the worst economic news is behind us.

As the market and business cycles mature, leadership gradually shifts from these “value” names to secular growth stocks.  The latter are the least cyclically sensitive and are ones whose investment merit consists in their ability to grow earnings (1) faster than the consensus expects and (2) for a longer period of time than is generally recognized.

Entering year seven after the bottom, we’re deep into the growth stock period.  Dyed-in-the-wool value investors will doubtless be poring over the financials of oil and other commodity production companies.  But the strength of the market will be in technology, social media and Millennial-oriented stocks, I think.

A flat market gives us more time to search for them.

We should also be considering what is likely to happen once this up-one-day, down-the-next period is over.  My view is that the current doldrums are being caused by higher-than-normal valuation, not by perceptions of an upcoming economic slowdown.  If I’m correct, as time passes and company earnings grow, price earnings ratios will gradually shrink.  This will restore more attractive valuation  …and the market will begin to rise again.  When this will happen–and what occurs in the meantime–is less clear.  My answers are “late summer” and “nothing much.”  Alternatives might be “after the first Fed interest rate increase” and “the market goes down 5% – 10%.”

In the current market climate, there’s an easy way to check if my portfolio positioning is in line with my theorizing.

On up days in the market, my holdings should do at least as well as the market; on down days my portfolio will likely underperform.  Conversely, if I have a defensive posture, I should outperform on weak days and underperfrom on strong ones.

The portfolio from heaven will outperform around the clock.  A portfolio potentially in need of overhaul will underperform no matter what.

I normally don’t advocate analyzing portfolio performance on a day-to-day basis.  That’s because there’s often a lot of noise in daily price movements.  And short-term trends may make sense to day traders but no one else.  So there’s a risk that we get shaken out of long-term winning positions by getting scared by meaningless short-term craziness.

Still, in the current market circumstances–and if we don’t get emotionally caught up in the price movements–we have a chance to observe over a short period of time whether our portfolios have the structure we intend them to have.




Friday’s bad jobs report

Last Friday morning, the Bureau of Labor Statistics (BLS) issued its monthly Employment Situation report for March.

The numbers were bad.

At a gain of +126,000 positions for the month (+129,000 jobs in the private sector, -3,000 in government), the growth in  jobs was less than half the monthly gains over the past year, which averaged close to +270,000.

Revisions to January and February were also negative.  The February figure was revised down by -31,000 jobs to +264,000 and the January number by -38,000 to +201,000.

Among industries:

–retail trade continued to perk along,

–business and professional services and healthcare continued to expand, although at a slower rate

–most other industries showedd little change in employment, and

–mining fell by -11,000 jobs–presumably as a result of the slowdown in oil and gas drilling.

Although there was no equities trading in the US on Friday, the stock index futures market was open for business until 9:15.  Futures for the S&P 500, NASDAQ and the Dow all dropped by about a percentage point on the ES report.


As I’m writing this at about 8:30 today, futures have recovered around a third of Friday’s decline.


The most likely explanation for the March weakness is the unusually cold and stormy weather in many of the most highly populated parts of the country during the month.  The revisions to the very strong figures of the two prior months–also plagued by awful weather–are curious only in that they suggest that the firms that were suffering most during the quarter also the ones who dragged their feet in reporting.

To my mind, the weak March ES has no real economic significance.

Today’s reaction to the report in stock trading on Wall Street will be interesting, though,  It will give us some insight into the mood of the market.  A bullish market would shake the news off and end the day up.  A skittish one would use the figures as an occasion to sell off.  So it will be important, I think, to see whether  the market ends up or down, and where the areas of strength and weakness are.

Intel (INTC) and Altera (ALTR): the numbers

Let’s look at ALTR before word leaked to Wall Street that INTC was considering buying the firm.

the basics

ALTR was trading at about $35 a share, with earnings of, say, $1.75 a share in prospect for 2015   …in other words at about a 20x multiple.  The long-term growth rate of eps is probably in the low teens.   The market cap was $10.5 billion or so.

ALTR is one of two firms that together dominate the highly specialized market for programmable logic devices–a relatively stable, by technology standards at any rate, area.

20x for 10%-12% earnings growth doesn’t sent me running to the computer to place a buy order.

where the value is

small stuff

ALTR had $1.6 billion in net cash on the balance sheet at the end of 2014–that after spending $655 million buying back stock last year.

Yearly SG&A is running at about $300 million.  Let’s say INTC could eliminate half of this by substituting its own corporate infrastructure.  That would be enough to boost eps by 25%, so we’re looking at a 16 multiple on current earnings, which would be more reasonable.

the big attraction–intellectual property

The main source of value for INTC is the company’s accumulated knowledge, experience and computer code for creating and operating PLDs. How do we measure that?

The simplest, and only straightforward, thing to do is to add up R&D expenditures over, say, the past decade and see what that totals.  This will be an understatement, of the value of ALTR’s intellectual property because:

–there will always be some R&D related expenditure elsewhere on the income statement,

–duplicating the firm’s accumulated knowledge means spending in today’s and tomorrow’s dollars–not yesterday’s.  The former is always more expensive, and

–we won’t capture stock based compensation.


1. For ALTR, the 10-year total R&D  is $3 billion.  Arbitrarily add $500 million for stock based compensation.  Add in the net cash.  We get a total of $5 billion in “asset value.”  That doesn’t stack up well with ALTR’s pre-leak market cap.

2. Another approach.  Current R&D expenditure is running over $400 million a year.  Let’s say it would take ten years of spending at the current rate to duplicate ALTR’s intellectual property.  That gets us to $6 billion in “asset value.”

3. Let’s consider the future earnings stream (this is arguably just dart throwing).  Ignoring SG&A synergies, and with 300 million shares outstanding, $1.75 a share in eps translates into net income of $525 million.  Let’s say earnings in eight years are double that, or $1.05 billion.  If earnings progress in a linear fashion (another incredible simplification–but, hey, this is what securities analysts do), then the total earnings over the next eight years will be just over $6 billion.  (Why eight years?  My experience in analyzing corporate behavior in takeovers is that eight years is the outer limit of future earnings that companies are willing to pay for in an acquisition.)


Okay, we’ve got one figure, #1, that’s too low and another, #3, that’s too high- (and a giant leap of faith).  Let’s add them together!

They total $11 billion.

Ta da!

That gets us to around the market cap of ALTR before the leak.  To be clear, I’m not willing to defend to the death anything I’ve written so far.  But Wall Street had to be tacitly thinking something like this for the price of ALTR to be at $35.

the leak   …and a dilemma

Look back at #2 above.  For INTC, the alternative to acquiring ALTR is doing #2.  This would be expensive.  More important, it would be time-consuming–time that INTC probably doesn’t have.  And there’s the risk that its effort wouldn’t be successful.

Therefore, the value of ALTR is higher to INTC than to you or me.  INTC is probably also figuring that it can expand the ALTR business dramatically over the coming years by stuffing every one of its servers full of ALTR chips.  Therefore, $10 billion price leaves room for the acquisition to be accretive to earnings in a few years.  Also, SG&A synergies.

On the other hand, any of us with a loose $10+ billion will probably find a lot of things we’d rather do than plunk it all down to buy ALTR.  For us, $35 a share is a pretty rich price.

this brings us to the leak…

Both sides can make up numbers as well as I can.

Both know there are no other suitors.

Both know that INTC really wants ALTR.

Hence, the leak, which I would bet came from bankers representing ALTR.  The idea is–let the market bid up the price/decide what the price should be.

I’m not sure whether the leak makes the situation better or worse.  My guess is that a deal gets done somewhere between $35 and $40.







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