Asian Economic Development Model–Japan

The Japanese Model

One of the most interesting economic phenomena of the past sixty years has been the emergence of Asian economic superpowers.  The most successful of them have all studied the development of post-WWII Japan and imitated large parts of it.  This is my take on how the Japanese model works:

Japan found itself at the end of WWII with a lot of its industrial infrastructure destroyed and many of its young adult population killed in the war.  Not endowed with lots of industrial raw materials, its major remaining  tradable economic asset was its labor power.  It had other pluses.  It had strong political cohesiveness,  through the belief in the pivotalposition of Japan in the world order and in the role of the Japanese emperor as the sole global mediator between the human and the divine.  The pre-war industrial conglomerates (zaibatsu), although legally banned, survived in all but name in the now famous post-war keiretsu, so the country had experienced administrators.  In addition, Japan had American help during reconstruction.

The essentials

What are the essential elements of the Japanese model? Continue reading

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model is the keystone of the academic Modern Portfolio Theory developed in the Fifties and Sixties.  Its leading lights, Harry Markowitz, William Sharpe and Merton MIller, received the Nobel Prize in Economics for their role in developing this theory.

Taking a very simple view, the main difference between the CAPM and what I described in my Alpha and Beta post is the explicit introduction of a “risk-free” asset, normally thought of as being treasury bills.

Here’s the Alpha and Beta equation:

stock return = α + β(index return) + ε,

where α is a constant, β is the multiplier that links stock return and market return, and ε is a random error term.  (Although the theory doesn’t require it, the “index” has typically been interpreted as a stock market index, like the S&P 500.)

If we argue that the stock return has two components, the risk-free return (rf)  + the return for taking risk, then the equation can be rewritten as:

stock return = rf + α + β(index return – rf) + ε,

where β (a slightly different β from the first equation, but the same general idea) is a measure of the volatility of a stock vs the market, and α (a different α, sometimes called Jensen’s alpha) is any return that remains, positive or negative. Continue reading

Alpha and Beta

You can often hear an investment professional say, “That’s a high-Beta stock.”  Less frequently, you may see the claim, normally in writing, that someone “is searching for alpha.”   Here’s what they’re talking about:

How It Started

After World War II, as the first commercial mainframe computers were developed, an economist named Harry Markowitz proposed using this new computational power to calculate the risk/reward characteristics of portfolios of stocks.  With this information in hand, you would be able to determine the best portfolio for you to own, i.e., the highest-return portfolio for a given level of risk.

Markowitz used a statistical concept, variance–a measure of how far away from a trend line a stock’s price might temporarily drift–as his definition of the riskiness of a stock (this is a terrible definition of risk, in my view, although it’s, even today, the academic standard).  From this definition, it follows mathematically that the riskiness of a portfolio is the riskiness of the individual stocks in it plus a factor (covariance) of their tendency to move together in herds.

The general idea was that you could quantify, and therefore compare, the riskiness of different portfolios that offered the same return, as well as the returns of portfolios that had the same risk.  So you can “optimize,”  that is, eliminate unnecessary risk by picking the best portfolio–highest return for a given level of risk, or  lowest risk for a given level of return.

There’s a practical problem, though.  If the universe has only two or three stocks in it, calculating this information is straightforward.  If the universe is the S&P 500, however, figuring out all the interrelationships among all the stocks becomes a real pain in the neck.

(There’s a much bigger problem, though.  The virtues of short-term price volatility as a measure of risk is that the data are easily available for many stocks and that variance is part of an established mathematical framework.  So it has been widely adopted by academics and consultants.  Unfortunately, it’s otherwise not very informative, I think.  It’s like saying that the risk in an airplane flight should be measured by the amount of air turbulence en route.  By this measure, the plane that recently took a smooth ride into the Hudson River would be classified as a safe flight.) Continue reading

Shaping a Portfolio–Highly Volatile Companies: Cyclicals, Leveraged, “Near-Death Experiences”

Cyclicality, Leverage, “Near Death”

The three kinds of companies have two things in common:  their earnings can swing wildly, and their stocks even more so.  They can be like playing with fire, so they’re not for everyone.  In fact, they’re not for most people, even though they usually lead the performance of a bull market in its first year or more.  So you might want to stop reading here.  Or you might keep on going just so you’ll know something more about how these stocks work, even if you won’t own them.

Cyclical companies are ones whose sales follow the business cycle up and down, like homebuilders, technology firms, metals miners or car companies.  Sometimes investors will try to distinguish firms that deal in pure commodities, like lumber or basic chemicals, from those with other sources of value-added by calling the former “deep” cyclicals.

There is also a kind of cyclicality within an industry.  Sometimes, the market leader has such a strong reputation for quality and service that the other market entrants end up being “overflow” producers–that is, they get orders only when the leader has run out of capacity and can’t supply new requests–despite having adequate quality and comparable prices.  Even though the industry as a whole may not be particularly cyclical, it can turns out to be a roller coaster ride for the second-tier firms.

“Leveraged” companies are ones who have structured themselves in a way that small changes in sales, positive or negative, create large changes in profits.  The leveraging comes in two forms, financial and operating.

Financial leverage means debt, either bank borrowings or bonds.

Operating leverage means high fixed costs (fixed costs are those that have to be paid, whether there’s any output or not; variable costs are those directly linked with the production of a specific item).

High fixed costs can result for a number or reasons:

1.  it’s the nature of the business, like a semiconductor factory,  a cement plant or a hotel;

2.  the company’s plant and equipment is no longer state of the art and costs more to run than newer assets;

3.  the plant and equipment isn’t configured in the best way.

Companies can mitigate the effect of leverage by entering into long-term arrangements, either formal contracts or informal agreements, that guarantee customers will always buy a certain portion of their output, though usually in return for a price concession.  Japanese blast furnace steel mills, for example, have traditionally done this with their automotive customers.  In most cases, I think, the industry leader does some form of this.

On the other hand, a company can choose to figuratively revel in its leverage and operate mostly/exclusively in the non-contract or “spot” market.  It argues that the higher prices in good times more than offset the lower prices in bad.  UMC, the Taiwanese semiconductor foundry, is a case in point.  Twenty years ago, most gold mining companies operated this way, as well, but they also made sure they had no debt.

I think of “near death” companies as ones that depend on the kindness of strangers, and which are destined to go into bankruptcy in a world ruled by justice rather than mercy (or, what amounts to the same thing, government support for “strategic” industries).  Computer memory chip makers would be a good example.  PALM (a family member owns shares), pre its rescue by Bono, might be another.  Too much leverage, management ineptitude, too much cyclicality are usually the causes of these companies’ problems.

When To Buy Them–and How Much

How much?  In large amounts, never, in my opinion (a value investor would probably be more enthusiastic, though).

For most people, never may still be the right answer.  For those with a relatively high risk tolerance, small amounts, among the top-tier companies, is probably best.

When to buy? These stocks are often the best performers during the first year or so of a new bull market.  Their performance is typically in inverse order to their riskiness/cyclicality. Why? As you will be able to see from any historical record, these stocks as a group are pummelled in a down market, with the most highly leveraged doing by far the worst.  The stocks are usually trading a steep discounts to asset value, with the second-tier companies at the lowest valuations.  As the cycle turns, however, these “worst” companies (more precisely, those who don’t go into bankruptcy first) get disproportionately large sales gains (the industry leader runs out of capacity, so buyers have to turn to the same #2 and #3 they shunned a few months before) and the threat of bankruptcy recedes.  So these stocks benefit not only from sharply increasing earnings, but also from a perceived decrease in risk.

Professionals typically buy the stocks of these volatile companies when they conclude that conditions can’t get any worse and sell them when they conclude that things can’t get any better.  In effect, this means they buy when there are no earnings and no backlog of new orders and sell when the company is raking money in and the future looks great.

To me, it looks like now is the time.

Where Would I Look?

First, let me say I’m only beginning to do the research anyone would need before actually buying one of these, but I think three areas (the “usual suspects,” for me) are potentially interesting:  hotels like HOT, MAR or IHG and casinos (I own WYNN already); semiconductor fountries, especially TSMC ; and industrial machinery companies like CAT or DE.

Usually I get worried about a stock symbol that spells a word–this isn’t a joke–because I think it shows top management is spending more time trying to be cute than running the business.  But CAT is the start of the company’s name, and the management that picked HOT isn’t there any more.  I do have unresolved/unresearched worries about both, though:  CAT’s financing operation and HOT’s timeshares.

If you’re sticking to a plan of index funds + sector funds + individual stocks, you may decide that the cyclical area is too much trouble to deal with directly and find a sector fund to get exposure here instead.

What the Risk-Averse–That’s Almost Everyone– Should Avoid

“Risk averse” doesn’t mean conservative.  It means expecting to be paid for taking risk and not embracing risk as an end in itself.  Anyway, even the deepest value investors I’ve known would say to avoid industries in secular decline.  That would certainly include airlines and newspapers.  I’m sure you can come up with more.

I was listening to CNBC the other day and heard a reporter say a certain group of equity-oriented hedge funds had lost money over the past six weeks or so because they were long (i.e., they owned) high-quality companies and were short (i.e. had borrowed and sold, effectively betting the stock would underperform) low-quality companies.  He didn’t know, but you should, if you’ve read this far, that the hedge funds in question were betting the market would continue to go down.  Why?  because low-quality, leveraged, cyclical companies outperform in the early stages of an up market.

Shaping a Portfolio–Pent-up Demand

“Pent-up” Demand

In weak economic times, individual consumers and corporations become afraid they’ll run out of cash and postpone purchases, creating unfulfilled or “pent up” demand for these items when times get better.

For what might be thought of as capital goods, that is, expensive stuff with a long lifetime, like a new house, a car, a refrigerator, or a new corporate headquarters, a data center, overhaul/replacement of the point-of-sale computer system–these purchases just don’t get made in bad times.

For smaller-value, more frequent purchases, like food or clothing, software upgrades, a new coat of paint–either these purchases aren’t made, or buyers “trade down” to a cheaper substitute.

Trading Down

Trading down is in the eye of the beholder, in many cases.   For the Macy’s customer, trading down may mean Target.  For the Target customer, it may mean Wal-Mart. For the Wal-Mart customer, it may mean the Salvation Army store. Some people may just wear what they own now and buy nothing.  So even though common sense says the high end of the chain loses but there may be someone at the low end who actually benefits from bad times, that beneficiary may be harder to find than you think.

Cutbacks in spending affect maintenance as well as new purchases, urban legends to the contrary.  While some may repaint their houses instead of moving, they are dwarfed by the number of people who will let the old paint job last another year (or two).   It’s the same with supposed purchases of “little luxuries” like a new tie or a lipstick.   Businesses will also stretch their preventative maintenance schedules for things like paint and sealants, and patch up old PCs as they break, or recycle them multiple times, rather than upgrade beforehand or buy a new PC or blackberry for a new employee.

Travel, entertainment and advertising are corporate areas that tend to be particularly hard hit.  Salesmen may make three trips a year to visit clients instead of four, fly coach instead of first class, stay in less luxurious hotels and have smaller entertainment allowances.  Conventions may be smaller, in cheaper venues–or not happen at all.  Marketers who believe advertising has created enormous brand value for them, may figure they can cut back for a short time without damaging the brand.

Each Downturn Is Different

Each downturn has its own peculiarities.  I’ve been a bit surprised that Starbucks and bottled water have been such early casualties of this recession, not that I’m a devotee of either, but because they’re relatively inexpensive.  I’d known that luxury goods companies have a much larger number of “aspirational buyers” than is usually appreciated, so this is not a great area to be in during a downturn, but the sales decline here has been pretty remarkable.  On the other hand, I hadn’t expected business purchases of new blackberrys to be up.

From an investor’s point of view, what I’ve written to this point is mostly information to be filed away and used when the next downturn occurs.  We’re trying to position ourselves to make money as the next upturn plays out.

Figuring the Upturn

For me, the main issue is this:  every downturn causes some behavior changes.  Some people will try Dunkin Donuts’ coffee because it’s cheaper and maybe never go back to Starbucks. Some will discover Target or Wal-Mart and switch allegiance from Macy’s. …or buy a Hyundai or Kia instead of a Toyota or Nissan and stay with Korean cars.  Others will switch back to their former favorites the instant they can afford to.  The big question is what will happen this time.

Remember, too, that we don’t need to have a comprehensive view of what the coming economic upturn will look like.  We’re looking for areas where we may be able to one or two stocks to supplement a mutual fund portfolio tilted toward economy-sensitive industries (namely, materials, consumer discretionary, technology and industrials).

Also, there are a lot of idfferent ways to make money.  Not everyone is going to have the same information or insights.  So there’s no “correct” answer.  There are just your peresonal guesses, the criteria you’re going to use to evaluate them and what needs to happen for you to confirm your beliefs/what would get you to change your mind.  (Please let me know if you have any good ideas.)

What I Think

For what it’s worth, this is what I think:

I think the overall economic recovery in the US won’t be as explosive as recoveries have been in the past.

I expect that white-collar workers below the age of, to pick a number out of the air, forty will have been relatively unaffected by the recession and will have no worries about going back to spending as usual.  One exception to this will be recent college graduates, who will be able to find jobs/find better jobs for the first time since they got their diplomas.  Their spending will also be strong, maybe stronger, for slightly different reasons.

In contrast, I think Baby Boomers will have been badly shaken by their loss of wealth so close to retirement age.  In addition, publicity about the underfunding of pension benefits–both by government and private corporations–and about what happens if your pension fund runs out of money won’t do anything to improve the BB mood.  My guess is that they will travel, replace their Buicks and do little else.  It may be harder than usual for the BB to find work in some industries, since the competition will be hordes of enthusiastic under-employed twenty-somethings.

Unemployment has been centered on construction and manufacturing workers.  I think the job loss in this area is much greater than officially reported, because of the presence of undocumented foreign workers in construction.  When construction resumes, who will be rehired first?  The mix between foreign and citizen will have an impact on the profits of companies that serve this market.

I don’t have any insight, either, into what the prospects for manufacturing industry are.  Among publicly-quoted companies, many have heavy exposure to housing and at least some have financing subsidiaries, where problems may still lurk.  I also think that what ultimately happens with the auto firms has the potential, for good or ill, to influence the multiple investors are willing to pay for US-based manufacturers.

What does all this boil down to?  I think we’ll have surprisingly strong growth in industries geared to the under-forty or under-thirty segment of the population.  I think this means video games, social networking, smartphones and action movies.  Travel-related (translation: hotels) may also do well, and get an added assist from the BB.