Posts Tagged 'Portfolio management'

“exogenous” events for securities markets: what they are

Published February 24, 2012 Constructing a Portfolio , exogenous events , Portfolio management Leave a Comment
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definition

Exogenous means “coming from outside.”  In economic modelling, it means an influence that arises from outside the scope of model and that is, therefore, neither predicted nor explained by the model.

In financial markets, an exogenous event has come to mean:

–some really bad thing that occurs, which has a significant, enduring negative effect on prices, and

–one that’s outside the realm of everyday competition among firms, the cyclical rhythms of a nation’s business cycle or the interaction among countries.

examples

The two “oil shocks” of the 1970s–both of which helped precipitate severe recessions in oil-importing countries–are the events most often cited as exogenous shocks.  Saddam Hussein’s invasion of Kuwait in 1990 is another, as is 9/11/2001.  So, too, is the near-collapse of the US financial system under the weight of dubious sub-prime mortgages.

A definitional point:  unless we’re talking about an invasion from space or a large meteor hitting the earth, no event can be exogenous for everybody.  When OPEC raised the price of oil from $1.70 a barrel to $30+, it was a bonanza for its members.  For the US and Europe, however, whose industry was deeply dependent on a steady flow of cheap petroleum products, the development was a disaster.

The sub-prime mortgage crisis was an exogenous event for the rest of the world, but an endogenous one for the US.

No one talks about the subsequent plunge of crude oil to below $10 a barrel as an exogenous event, either.  The term seems to be reserved for economic calamities that affect the large stock markets of the world.

exogenous events are predictable…

Anyone reading the founding documents of OPEC realizes that it’s a political organization, not an economic one.  It wanted justice, not monopoly profits.  And, although the full details weren’t apparent except after the fact, the production contracts between the oil majors and OPEC nations, which had sometimes been running for several decades, were extremely one-sided in the former’s favor.

…but they often come as a shock anyway…

Many times, professional investors’ focus is narrowly fixed on the domestic business cycle or the competitive interplay among firms in a given industry.  They don’t have any skill or interest in any other areas.  Experience also shows that “big picture” developments are often irrelevant for stocks.  The quality of the information generated by brokers–the biggest information channel professional investors use–about political/social topics is often very low.

…if nothing else, their timing is hard to gauge

OPEC was founded in 1960 but didn’t begin to make a significant impact on oil prices until 1970.  The roots of the sub-prime mortgage crisis can be traced back to Fed actions in 2002-2003, to G. W. Bush’s housing policy, or even to the Clinton administration.  Rampant housing speculation and sub-prime abuses were readily apparent in 2005-06.

In these cases, however, stock market consequences came much later.

being right can be a cold comfort for professionals

Any portfolio manager who adopted a very defensive posture in 2005 in anticipation of the Lehman collapse would doubtless have lost most of his clients before the event itself occurred in 2008.

In addition, one always has to calculate how the performance gained by being correct in predicting an exogenous event stacks up against the performance lost while waiting for the event to occur.  In my observation of “big picture” portfolio managers, their personal ego satisfaction is often the greatest gain they achieve.

In fact, I once had a PM who worked for me tell me that a stock bought eight years earlier, which had almost immediately dropped like a stone and was subsequently sold, hadn’t been a mistake after all.  How so?  The firm was in the process of being bought, by Warren Buffett, and at a higher price than the initial purchase.  Yes, that’s (more than) a little crazy.  But it shows how insidious cognitive dissonance can be.

That’s not to say we shouldn’t worry about exogenous events.  Quite the contrary, because they do occur.  And not all of them are complete bolts out of the blue.  But factoring them into portfolio strategy is a bit more complicated than it might seem.

the current worry

It’s Iran’s nuclear program.  More about this on Monday.

 


 

 

quantitative easing in Japan: implications

Published February 23, 2012 Asian economic development , economics , Japanese development , Recent Market Action , Shaping a portfolio for 2012 , Strategy Leave a Comment
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quantitative easing in Japan

With all eyes on Greece, one of the less noticed developments in global securities markets is the recent decline of the ¥ versus the US$.  As I’m writing this on Thursday morning, the ¥ has weakened from a high of ¥76 = US$1 reached on February 2nd to the current ¥80 = US$1.

This is not just the result of one of Japan’s periodic, ultimately fruitless, attempts to intervene in currency markets to temporarily weaken the ¥.  Instead, it’s the currency markets reaction to what appears to me to be a substantial shift toward monetary easing by the Bank of Japan.

Why do so?

After over two decades of minimal economic growth and mild deflation, citizens’ tolerance for political and bureaucratic bungling of Japan’s economic policy seems to me to have finally been exhausted.  Voters are deeply unhappy with the administration of the recently installed Democratic Party of Japan.  But no one wants the Liberal Democrats back either.  There’s serious discussion about forming a third political party–really radical thinking in a country where politics has been dominated by a single party, the LDP, for a half century.

There’s also been talk in the Diet of legislation that would take away from the Bank of Japan its Federal Reserve-like role in setting monetary policy.  This threat appears to be what’s prompted the central bank to launch the new program of quantitative easing.  The BoJ is basically saying that it will continue to inject money into the system in large amounts until inflation reappears.  In other words, the new stance is the Fed’s approach, but on steroids.

implications

In the near term, this policy will likely continue to weaken the ¥, removing one source of pressure on the profits of Japanese export-oriented companies.  It’s already prompting investors in the Tokyo stock market to re-orient their portfolios toward export-oriented stocks.  I don’t think this policy move, by itself, has the slightest chance of removing Japan from the morass in which it has been trapped for many years, however.  And substantial negative consequences may lie down the road.

As anyone who has read me on Japan before knows, I think the fundamental issue for that economy is the ground-level social decision made twenty years ago not to adapt to a changing world, but to preserve the traditional social order even if that meant slower economic growth.  After all, the country did hide its banking problems for a decade.  Despite a shrinking workforce, it doesn’t allow immigration.  Its laws cement the management practices of twenty year ago–and most times the actual managers–in place and defends them from virtually all attempts at change. Iconoclasts risk social censure, or worse.

Sounds a lot like the Eurozone, doesn’t it–one currency, but keep the local power brokers in place?

risks

Without substantial structural pro-growth reforms, what’s likely to happen?

For a while, nothing much.  The character of the stock market will continue to change, as investors shift away from smaller, counter-culture secular growth stocks to larger, older exporters.  But for foreign investors, a large part of any local currency gains will be erased by currency losses.  So it will be even harder to make money in Tokyo than before.

The strategy, however, seems to me to be playing with longer-term fire.  The central government has piled up a huge amount of debt, which it can continue to service both because interest rates are extremely low and because–lacking other investment alternatives–Japanese citizens continue to buy tons of government bonds.  Reemergence of inflation will mean, at the very least, rising nominal interest rates, and therefore rising debt service for the government.  In addition, in an all too rigid economy, inflation may spread relatively quickly and begin to have negative effects on the value of Japanese assets.  If so, Japanese investors may shift their money away from government bonds and toward inflation-protection vehicles, like real assets or foreign securities.  That might lead to further currency weakness and compound the government’s funding problem.  So a sovereign debt crisis, while not imminent, may be ultimately waiting in the wings.

what I’m doing in response

I own two Japanese stocks, DeNA and Gree.  I like them both, although each has taken its lumps as the market orients toward exporters.  I’m certainly not going to add new money to Japan.  And I’ve got to consider whether I lessen my exposure.  If DeNA and Gree didn’t have substantial businesses outside their domestic market, I’d be doing that already.

 

 

higher taxes on dividends? –implications for stock markets

Published February 17, 2012 cash flow/share vs. earnings/share , Constructing a Portfolio , currency effects , Current Market Thoughts , Dividends , Industry Analysis , Investment firms , Portfolio management , Recent Market Action , Strategy Leave a Comment
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the Obama proposal

President Obama has recently proposed that the current tax preference for corporate dividends paid to individuals be eliminated.  Instead of being taxed at most 15% of the amount received, dividends would be considered ordinary income and taxed by Washington at as high a rate as around 40%.

Personally, I’d prefer an overhaul–and simplification–of the current tax code instead of tweaks around the edges.  Rather than putting a foot into the  the quagmire of possible political motivations, however, let’s just take a look at what I think are likely results for US capital markets if it’s implemented.

what doesn’t change

1.  Tax-exempt and tax-deferred accounts would be unaffected.  For pension plans, 401ks and IRAs, and for non-profits, it will continue to make no difference whether they make money in the form of interest or dividend income, or of short-term or long-term capital gains.

2.  Aging Baby Boomers are developing an increasing preference for steady income over capital gains, which are sometimes there, sometimes not.  That won’t change either.

what does

3.  I think the biggest effect will be on company decisions to start making dividend payments or to increase a payout they already have.

It seems to me that most publicly traded corporations recognize the Baby Boom-induced change in investor preferences now happening in the US.  Understanding that a substantial, and rising, dividend is a positive for their stock, companies have been happy to return profits to shareholders this way.  They do this despite realizing that if you combine federal and state/local income levies, up to 25% of the payout will go to the taxman.

If dividends lose their tax preference, the percentage taken by the taxes will approach 50%.  That means a big drop in what the shareholder will retain, both numerically (a third) and psychologically.  For most companies, I suspect, it will tip the balance in favor of devoting free cash flow to share buybacks rather than dividend increases.

For my money, that takes a lot of the shine away from what I consider to be the most attractive part of the dividend-stock universe–companies with above-average dividends today and for which you can reasonably project a quickly rising free cash flow over the next few years.

4.  If the government continues to  keep interest rates at emergency lows and, by accident or design, it also removes much of the incentive for individuals to buy dividend-paying stocks, how do investors adjust?  Maybe there’s a boost in demand for junk bonds, although income-oriented investors have been buying riskier forms of fixed income for a long time.

I think biggest effect would be for investors to broaden their horizons further.  The 7%-8% yields on EU telecom stocks will suddenly look more attractive, despite currency risks.  So, too, emerging market securities, both bonds and dividend-paying stocks.

5.  Looking at #3 another way,  provided they’re large enough to lower the share count, stock buybacks raise earnings per share.  All other things being equal, that should mean a higher per share stock price.  If so, the higher share price would likely offset some or all of the negative effect of dividends increasing at a slower rate.  In other words, the mix of returns (price appreciation + dividend income) changes, and in a way that increases risk.  But the crucial investment question is whether the total return from both sources will be higher or lower than before.

No one knows the answer.  But if the total return is lower–that is, if the effect of higher taxes on dividends is to decrease the long-term value of US equities–then one would expect US investors of all stripes to look increasingly to stock markets outside the US.  In addition, on the margin, US companies might also begin to look to foreign venues to raise new capital, if they could achieve higher prices for their stock by doing so.

My bottom line:  this proposal is one to watch closely.  Like a snowball that starts rolling down a hill, its consequences could be far greater than just to raise taxes on older, upper middle class city dwellers.

profit margins: how I look at them

Published February 10, 2012 Constructing a Portfolio , economics , margins , Portfolio management Leave a Comment
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what they are

They’re the portion of revenue, usually expressed as a percentage, that remains after costs of s certain type have been deducted.  The most common types of margins used in financial analysis are:

gross margin, meaning what’s left after deducting the direct costs of providing the goods or services

operating margin, meaning what’s left after deducting both direct costs and sales, general and administrative (SG&A) expenses.  Sometimes depreciation is also considered an operating cost, sometimes not, depending on the convention being used.

pre-tax margin, meaning what remains after deducting all costs other than taxes

after-tax margin, meaning income remaining after all costs, including taxes–but not including preferred stock dividends, if any.

do high margins mean a good company?

Many growth investors, especially tech-oriented ones, look for high margins as proof that a company owns patents, copyrights or other intellectual property that defend it against competition.  MSFT or INTC might be good examples.

Low margins, these investors believe, are indicators that a firm is in a commodity business.  This means that competition forces revenues down to levels very close to the cost of production.  Profits accrue either to no one or mostly to the low-cost operator.  Entrants in such industries are continually in a dog-eat-dog fight to push their costs below those of rivals.  No one stays in the low-cost seat for long.

Value investors, with their customary dour dispositions, take the opposite view.  They think high margins are like waving a red flag in front of a bull.  Firms that demonstrate them are disasters waiting to happen.  Sooner than you’d expect, they opine, competition will emerge, margins will compress and the stock will implode.

I line up more or less with the value guys on this one, even though I don’t agree with them 100%.  There are some perennial high-margin firms, where competition hasn’t proved an issue over decades.  Nevertheless, it’s hard to argue that either MSFT or INTC have been anything but disasters as stocks so far in this century, despite their near-monopoly positions.

taking margins at face value is foolish, in my view

How so?

–If you assume that margins at any level are fixed, you’ll miss perhaps the crucial element in forecasting future earnings–operating leverage.  This is the idea that some costs are fixed and don’t rise in line with unit volume.  As a result, the expense involved in selling an extra unit may be much less than that of selling the average unit.

–Rising margins almost always do invite competition.   Companies like MSFT are the exception, not the rule, in my view.  In most industries, the best companies will reinvest much “extra” margin in lowering their costs, as a way of discouraging new entrants.

–High margins usually aren’t “free.”  Jewelry or furniture companies, for example, have very high margins.  But they have to maintain very high inventories, which they turn only once or twice a year.  That’s risky.  The high margins in these cases don’t signal “free lunch”; they signal risk.

–I think the distribution company model–low margin, high inventory turnover–is attractive.  Distribution companies can be very high growth, high profit firms.  They can also have lost of operating leverage.  WMT in its heyday is an example, as is any industrial wholesaler.  Anyone fixated on high margins will miss this important class of firms completely.

What do I use instead of margins in projecting the income statement?  I break down unit costs–labor, raw materials,…–as much as I can and forecast each.  Some are simple functions of unit volume.  Many, however, like advertising, administration, or sometimes labor, are relatively unchanged as volume increases.  That’s where operating leverage and earnings surprises lie.

pricing out a polo shirt: investment implications

Published February 7, 2012 Industry Analysis , Stock ideas , Current Market Thoughts , Retail , Luxury goods Leave a Comment
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teardowns in tech…

Teardowns have become a staple of IT investing.  Every time a new consumer device appears, tech websites get hold of one and rip it apart. They then publish lists of the components the device contains, along with cost estimates and a guess at assembly time and expense.

It’s all very interesting information.  Sometimes it can be the key factor in deciding whether to buy or sell the stock of a component manufacturer or designer.  Who wouldn’t like to have his chips in the iPhone4S, for example?  Or, suppose your company had a key chip in an older model but has been bumped out by a rival in the latest one?

…and for garments

The Wall Street Journal had an article last week where it did the same thing for a polo shirt.  Not exactly high tech, but I think it’s still interesting  in showing industry structure and where the money is.

KP MacLane

The article is about KP MacLane polo shirts, created by Katherine and Jared MacLane, two former Hermès sales managers who decided to become fashion entrepreneurs.  They sell their shirts online, at www.kpmaclane.com, for $155 a pop.

There certainly is a market for expensive polo shirts.  A Hermès polo, for example, retails for almost 3x as much, at $455.  Unlike KP MacLane’s, the Hermès offering does have a pocket.

selling points

According to the company website, the key selling points for the KP MacLane product appear to be:

–environmentally friendly;

–made in the US;

–upscale, niche;

–fusion of European tradition with American “craftmanship,” “ingenuity” and “pride.”

unit costs

The merits of this polo shirt aside, unit costs are as follows:

materials               $10.35

manufacturing     $11.05

shipping               $8.17, including $3 for an embroidered bag the shirt comes in

total                     $29.57 .

pricing

The MacLanes have set the wholesale price for their shirts at $65, a markup of something over 100%.  The wholesale to retail markup is about another 150%.

why is this interesting?

What do I find interesting about this business?

The MacLanes are a startup, so their unit costs are very high.  If they become a success, they’ll be ordering fabric in much larger lots.  This will mean they get a better price.  The same with the cloth-cutting and sewing.  My guess is that they’ll easily shave $2 each off their materials and manufacturing costs, even if they make no sourcing changes.  That would push their per unit outlays down below $25.

That would only be for starters.  But the MacLanes would certainly never lower their prices.   Any cost declines would only become extra margin for them.

On the other hand–and this is what’s really important–if the MacLanes can achieve a $155 price point, their cost of goods is almost irrelevant.

They currently mark up by $125 over the cost of each shirt.  With the economies of scale in sourcing that I’ve assumed, they would increase the markup to $130.  That’s only 4%.  If the MacLanes had a different objective and decided to source both materials and assembly from China, they could probably get their unit costs to $10 or less.  They’d lose their Made in the USA selling point, of course, which might be fatal; their quality control problems would increase exponentially; and they’d only raise their markup by $15.

In addition, it would also defeat the whole purpose of their business, which is to use marketing to create a non-commodity product, that is, one whose selling price is not based on the cost of production.

In other words,…

…the real money in the garment business is not in the manufacturing.  It’s in the brand creation.  The Hermès polo shirt I mentioned above probably doesn’t have production costs higher than the MacLanes’.  But Hermès has spent years of time, effort and spending on creating a brand image that wealthy people want to embody and are willing to spend extraordinary amounts of money to exemplify.

Notice also that the retail markup is hugely greater than the wholesale markup.  Yes, there’s a greater risk in owning retail outlets and in-store merchandise.  But the control of the brand message and of overall inventory is far superior to what a wholesaler is able to do.

the Internet

The internet is still in relative infancy, so I don’t think all its implications for retail are yet apparent.  Some already are, however:

–The role of physical distribution networks as gatekeepers for new products is diminished.  Entrepreneurs like the MacLanes can reach directly to the consumer through the internet, to create pull-thorough demand for their products at low cost.

–Weak brands, like those of many department stores, will face increasing difficulty, as will the brands they carry that use them as their principal means of distribution.  I think this means strong brands will be forced to establish their own retail outlets.  Weaker brands will fall by the wayside.

–For startups, a sophisticated web presence that clearly defines and exemplifies the brand attributes will be essential.

current investment implications

The number-one lesson is to avoid garment manufacturing in favor of branded retailing.

There’s a secular case in favor of luxury retailing, especially for firms that control the majority of their retail distribution.  The same line of thought argues against generic physical distribution, especially physical distribution of the type department stores have.

On the other hand, the broadening of economic recovery in the US is creating a cyclical investment argument in the opposite direction.

What to do?  Several possibilities:

–let relative valuation decide whether you want to make the secular bet or the cyclical one (personally, although I love luxury retail stocks, I’d prefer he cyclical),

–don’t bet.  Avoid the area entirely if you’re an individual investor; look like the index if you’re a professional,

–look for non-garment retailing, like sporting goods,

–find an indirect way to play the recovery of the average consumer.  This is my choice.  I’m betting on hotels.  I’ve owned IHG for a while and I’ve recently bought MAR.

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