Is there a Madoff lurking in your portfolio? How to defend yourself.

In investing at least, fraud is the hardest thing to defend yourself against.

The Wall Street code

Wall Street has a very strict informal code of conduct.  Most market participants in the US are at the same time highly cynical and scrupulously honest.  Multi-million dollar trading business is routinely conducted over the phone, with the understanding that both sides will keep their word.  There’s paperwork, of course, and all conversations are taped.  But even having to go to the tapes can be seen as the breaking down of an implicit bond of trust.  People who don’t tell the truth quickly acquire a reputation and are shunned.

As a result, someone like Bernie Madoff comes as a double shock to market professionals, as jaded as they may want to appear to the outside world:

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Consumer Staples–trading down may be more severe than Wall Street expects

When investors focus on consumer staples, their first thought is that income growth is slow but steady, therefore that the stocks have a defensive character.

Then they look for exposure to emerging markets for the possibility of faster growth, and exposure to foreign countries with harder/weaker currencies than the dollar for the possibility of foreign exchange gains/losses.

Finally, they consider the pattern of raw materials prices, for the possibility of margin expansion or contraction, since staples companies can typically only raise prices in line with overall inflation in their markets.

A recent article in the Financial Times suggests that in the current recessionary environment, there’s another big issue to consider–trading down.  The article reports on a two-year study done of supermarket and drug store loyalty card purchase patterns.  Its conclusion?  Over 50% of previously highly loyal customers from 2007 had wholly or partially shifted away from their previously favorite brands in 2008.

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Technology at a crossroads…(III) Video Games(2 of 2)

A brief recap..

Over the past several years, the sharp rise in video game software development costs has engendered radical changes in the traditional shrink-wrapped software business.  Fifteen years ago, sale of 50,000 units would cover development expenses; today that breakeven level is about 850,000 units, or 17X as many.  These figures compare with “guaranteed” sales to hard core gamers of about 350,000 units.  So risk has increased as well.

In my prior post, I mentioned the video game company boast that the video game industry is bigger than movie box office.  That’s true, and very impressive, but fails to note that until the present recession, half a movie’s revenues would come from DVD sales.

One more preliminary:  from the Atari days onward, there has been a split between games for consoles like X-Box and PS, and those played on personal computers.  The industry has, fairly or not, characterized players of the former as groups of friends having fun together, and players of the latter as solitary individuals unable to get a date for Saturday night.

The extraordinary rise in the processing power of game consoles and the rise of online gaming communities for PC games have blurred the distinction between the users of the two.  It seems to me that market power has shifted decisively toward the consoles.   Of course, if the next Starcraft ever comes out, I may have to revisit my thinking.  The issue is potentially an important one, though–it’s the question of who controls the revenues from the online community surrounding a specific game, as well as whether a console maker collects a per unit royalty (if my figures from the prior post are accurate (and I’m pretty sure they are) unit profits are 25% higher for the developer if no royalty payment is due).

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Technicals and today’s durable goods orders

Technicals

In mid-May, the S&P 500 closed at lows of 884, 883, 887 and 893, before resuming its advance and coming to within shouting distance of 950.  This, in turn, is relatively close to what I think is a reasonable goal of 1050 or so for the S&P at yearend.

From that point, the market has dropped back to the area it explored in Mid-May, closing yesterday at 893.  So it’s very encouraging to see the market bounce off that level again.  Let’s not declare victory, though, until we see how the day ends.

Durable goods

Industry orders for durable goods rose again in May.  New machinery orders were up sharply and demand for both computers and raw materials was also strong.  My guess is that this isn’t all a reflection of end-user demand.  I think some of the strength is manufacturers restoring inventories that they cut too sharply during a period of panic around the end of 2008.  In other words, I think the market is reacting to the tone of the news rather than the specific content.

Why is this important?  If I’m correct, it suggests we’re still in the very early stages of the rising market–that investors understand it’s too soon to be analyzing the numbers too closely and are looking for confirmation of the thesis that the economic world is gradually healing itself.  Then their idea, which I think is the correct one, is that at some point in the next six months or the market has the potential to begin to produce very large positive earnings surprises.  That possibility alone is enough reason to remain fully invested, with a pro-cyclical tilt.

OECD

In support of my idea that what’s going on in the markets is half technical, half concept, I think it’s telling that no one is paying much attention to the fact that the OECD has revised up its economic forecast for this year and next.

Technology at a Crossroads…(IIIa) Video Games(1 of 2)

A big business

Yes, video game companies are classified by S&P as technology companies.

And, yes, video games are a big business.  For the past several years, video game sales in the US have exceeded domestic movie box office.

(And, yes, since I like video games, and am writing a lot about them.  So I have to break this up into two posts.)

Despite its large size and rapid growth, my impression is that most professional investors know almost nothing about the industry.  They consider the video game stocks as places to hide during stormy market weather, since, unlike “real” technology, their profits tend to be driven more by the pattern of new video game machine introductions than the ups and downs of the overall economy.  They also regard Electronic Arts as the dominant force among video game makers, which, while once true, is no longer the case, in my opinion.  I think that if anyone holds that position now, it’s Activision (I own ATVI stock). Continue reading

Technology at a Crossroads…(II) Software

Waves of innovation

Over the past thirty years or so, there have been several  waves of software innovation, each of which has brought a different set of companies to Wall Street’s center stage.  Each wave has lasted a decade or more and radically reshaped our lives.  Each has begun to recede, from an outperforming stock point of view, when the bulk of possible buyers already own and are using the products (not a surprise that relative stock performance slows down as the company matures).

Low Tide Now

I think that we’re in between waves now.  The next wave is doubtless gathering power, though.  “Cloud computing”  is one possibility.  Developments with smartphones, maybe with Google’s help, is another.  But the next wave could equally well come out of nowhere.  The important thing isn’t necessarily to be the first to discover the next trend, but to be aware enough to catch it in the first year or two of its existence.

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Technology at a crossroads, or, Why hasn’t the tech industry performed better? (I)–Hardware

Three posts to come…

I mentioned in a post on Recent market Action in late May that the tech industry had been a laggard during the current market rise.  I said that the IT index is a mix of large-cap companies that have little growth in prospect and some smaller, more exciting names.  I’d like to elaborate on that post.  I’m going to do this in three parts:  hardware, business software and games.

Hardware:  prohibitive cost of chip production

Take hardware first.  To build a new state-of-the-art semiconductor fabrication plant from scratch costs at least $3 billion.  Two or three companies are unlikely to band together to share the expense, for fear that their design and process technology secrets would be stolen by the others if they were to operate in a single plant (Intel told me once that they won’t sell an obsolete fab to anyone, but dismantle it and sell the components piece by piece instead, for security reasons).

Getting the capital to built a new plant is a huge hurdle for almost anyone except Intel.  But that’s not the only stumbling block.

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