Monthly Archives: June 2010

Gold at $1225 an ounce: a good investment?

June 13, 2010 By in Current Market Thoughts, Gold, Industry Analysis, Recent Market Action Tags: , , , , , , , , , 1 Comment

surging gold price

The gold price has risen by almost 20% so far this year.  The advance is an unusual one, however, in two respects:

1.  Historically, the gold price has typically been stable in strong currency terms.  Much of the apparent strength has been related to depreciation of weaker currencies.  In practice, this has meant the dollar price vs. the euro (or its predecessor, the d-mark).  This year, in contrast, the dollar has been relatively strong.  Nevertheless, the dollar price of gold is up sharply.

2.  The advance is being driven not by demand for jewelry, which is usually the case, but by investment demand.  Last year, investment demand worldwide actually exceeded jewelry demand.  It may do so again in 2010.  Government mints are doing a land office business minting gold coins.  The SPDR Gold Trust ETF has over $50 billion in assets. And the Financial Times reports that commercial banks are considering expanding their vault space for storing physical gold for the first time in thirty years.

two big changes in the market

During the almost thirty years I’ve been watching (often from afar) the gold market, it has undergone two significant changes:

1.  The first is a product of the past seven years..  Thanks to the rise of ETFs, gold is much easier to buy today than it once was.  The SPDR Gold Trust ETF alone holds 1300 tons of the yellow metal, or close to half of the world’s gold production in a year.  It is traded not only in New York but also in Hong Kong, Singapore and Tokyo.  Vehicles like this eliminate the need to have a commodities account and solve the problems of physical storage, potentially high bid-asked spreads and the need to assay the gold on sale.

2.  Gold was money thirty years ago, but has been gradually losing that role since.  In developing countries, many citizens would use gold as a substitute for bank deposits.  Some had to little to be able to afford a bank.  Some worried about currency devaluation.  But many also feared either government seizure of their wealth, or attracting unfavorable attention (think:  China) from the authorities as being budding capitalists.

Wealthy individuals around the world have long since replaced gold holdings with financial instruments.  And greater political stability in large markets for gold like China or India has meant less fear-motivated demand for gold.  Jewelry demand (and not simply near-pure gold jewelry) has become the main driver of gold consumption.

why a price surge now?

Not now, though.  What are the main factors in increasing investment demand?

I think the main reason is that gold is the default choice for people who are worried about the current weakness in developed countries’ economies and don’t see what else they can buy.  Cash provides safety but almost no return.  Government bond yields are extremely low–and in the case of the euro have not delivered anticipated safety.  Stocks, after having come close to doubling since the lows in March 2009, are wobbling.  They also do best in times of strong economic growth–so they depend on conviction in economic expansion that investors don’t currently have.

What’s left?  a gold ETF plus …?

the risks

I’ve never been a real fan of gold.  As I’ve argued in other posts on this blog, I think gold price movements are ultimately driven by the ebb and flow of gold mining projects.  When prices are low, mining companies stop exploring.  When prices are high, they reopen shuttered mines and develop new deposits.

I think the case today is different.  I think investor demand is being driven by aversion to other liquid investments.  My worry about gold is what happens as/when sentiment about the course of the economies of the developing world improves.  To a great degree, generation-ago demand from the developing world for gold as money is no longer present.  The fact that gold has been very easy to buy through ETFs also means it is very easy to sell.  Remember, too, that there’s no assurance that the price you get in selling an ETF in times of distress will come close to net asset value.  Like any stock, your price will depend on where buyers are willing to make a bid.

what to buy instead?

From me, the answer should come as no surprise–stocks.

Marriott says room rates are beginning to rise: very bullish news

June 11, 2010 By in Current Market Thoughts, Industry Analysis, Lodging Tags: , , , , , , , Leave a comment

revpar, room rate and occupancy

The most commonly used measure of hotel company revenue is revpar, or average  daily revenue per available room.  It’s not my favorite indicator, although it does have the virtue of being a single number.  There’s no escaping it in the industry, however.  People love jargon–it makes you seem  like an insider.

Revpar is the product of two factors multiplied together:  room rate and occupancy rate.  Under a lot of conditions, you really don’t need to break revpar down into the component of any changes that comes from room rate and the one that comes from occupancy.  The present time is an exception.

the occupancy/room rate tradeoff

Staying in a hotel where there’s no one else can be scary.  At the very least, you’ll probably question your judgment in selecting an otherwise empty building.  You may also start to worry about your physical safety.  Not the kind of experience a hotel wants you to have–if it expects any repeat business.

So having a certain level of occupancy–maybe 30%–is crucial.  At the bottom of the economic cycle, if a hotel can’t generate enough customers itself, it will offer steep discounts to airline crews and tour groups, just to create a positive ambience of full-paying guests.  It may also put more rooms out for sale on internet travel sites.

On an incremental basis, it probably costs a four- or five-star hotel a little over $10 on an out-of-pocket basis to rent a room for a night.  That’s mostly changing the sheets and towels and replacing soaps, shampoos and other toiletries.  So it will generate positive cash flow at almost any room rate.  In recession, then, when an area is swimming in empty hotel rooms, a hotel will try to add occupancy and will keep its room rate low.  Trying to raise rates will simply drive customers into the arms of rivals.

Again as a general rule, a hotel will break even on an out-of-pocket basis at 50% occupancy, break even on a financial reporting basis at 60%, and begin to bring in profits in bushel baskets at 70% occupancy.  At some point, possibly when it is confident of rising past financial reporting breakeven, the four-star hotel will not renew its airline and tour group contracts (these customers will start their cyclical shift to lower-rated accommodations).  With a lag, that action alone will begin to raise room rates.

The final step in cyclical recovery comes when the hotel begins to gently raise rates for all customers, rather than just eliminate discounts.

the Marriott announcement

At a Goldman conference on lodging in New York earlier in the week, Marriott’s chief operating officer announced that in May, for the first time in almost two years, its room rates in the US had shown a small (1%) year on year increase.  Revpar was up 9%, meaning occupancy was up about 8% yoy.

He explained hat six weeks earlier, when reporting its March quarter results, MAR has said that its business in the US was recovering much faster than it had expected–it revised full-year revenue guidance up by 4.5%, the highest upward revision it has ever made–and said it was approaching the point where it might begin to see room-rate increases.

That point, to, has now arrived–again, faster than expected.

The rate increase doubtless comes from an improvement in business travel, which always leads more price-sensitive leisure travel in the economic cycle.  It implies that industry in the US is feeling better enough about its profit prospects to be willing to travel more.  Not only that, but it suggests that hotels are full enough with their colleagues that businessmen are being compelled to pay a bit more to be assured of having a room.

This is another piece of news suggesting that the US economy is in better shape than Wall Street currently wants to concede.

Hudson Mezzanine Funding: more trouble for Goldman?

June 10, 2010 By in Current Market Thoughts, hedge funds, Industry Analysis, Investment firms, Recent Market Action Tags: , , , , , , Leave a comment

Hudson Mezzanine Funding

According to numerous press reports (suggesting that in Spitzer-like fashion, the government wants to get this story into the public eye in advance of any possible charges), the SEC is investigating Goldman Sachs for its sale of a collaterized debt obligation linked to sub-prime mortgages called Hudson Mezzanine Funding.

This action follows the indict ment of Goldman on civil fraud charges in April based on another mortgage derivative transaction called Abacus.

As I’ve written before, from what has been made public about Abacus so far, the case against Goldman seems weak to me (remember, I’m an investor, not a lawyer, however).  The accusations appear to rest on the SEC belief that in the Abacus transaction Goldman had an obligation to act as a financial advisor to the participants, not simply as a broker.  The facts, on the other hand, seem to me to show that Goldman functioned merely as a go-between for a deal that the two parties negotiated with each other.

From the leaked information appearing in today’s newspapers, Hudson seems to be a more serious complaint, assuming the press reports are correct, in that:

–Goldman selected the securities for the Hudson deal from its own inventory,

–Goldman asserted in marketing materials that its interests were “aligned” with buyers, since it would own equity in the issue, but failed to disclose that it was taking a much larger short bet against it

–in an internal email, a Goldman salesman describes Hudson as “junk” that his better clients were “too savvy to buy.”

I presume the SEC contention will be that Goldman was in a position to know the contents of Hudson well since it owned them, and made positive public statements about the deal while privately holding a negative opinion and intending to short the security once it came out.

why lead with Abacus and not Hudson?

One possibility, raised right away by the Wall Street Journal, is that the SEC fundamentally misunderstood the nature of the Abacus transaction. 

 Another is that the agency was under political pressure to do something while a financial reform bill was being debated in Congress. 

It may also be that the SEC was only tipped to the existence of Hudson after it went public about Abacus.

why Goldman and not Morgan Stanley or Citigroup?

This morning’s Financial Times, in addition to having a report on Hudson on page 1, contains a very interesting article called “A tricky pick,” in which it discusses the collateralized debt obligation market.  Although the banner on page 1 touts the article as being about “Goldman and the Credit Boom,” the real eye-opener of the story is that it portrays organizations like Morgan Stanley, UBS, Bank of America and Citigroup as engaging in what appears to me to be much more highly unethical and destructive behavior than anything that Goldman has been accused of by the SEC.

My guess is that it’s because Goldman is that compared with a commercial bank, Goldman is relatively simple to understand.  Its activities are more focused and the lines of responsibility for any action are clearer.   Given that the sub-prime derivative business is inherently difficult for non-specialists to get their arms around, why make the task even harder by adding the issue of having to explain a complex  organizational structure?

Also, Goldman has little retail presence.  It does no image advertising.  So few people have strong positive associations with Goldman as “my” bank.  It has also  created resentment, rightly or wrongly,  from seeming to have profited from the financial crisis.  In addition, the company has been described as being “tone-deaf” to public opinion.  Perhaps describing what they do as being “God’s work” isn’t typical of its public relations efforts, but even one gaffe like that can do a lot of damage.

I think the one safe conclusion to draw from all this is that (justifiable) public anger at the financial meltdown isn’t going away.  That implies that neither will the efforts of the SEC to prosecute.  Whether the agancy has the right villain is still open to question, though.

MSFT is issuing an unusual convertible

June 9, 2010 By in Convertibles, Current Market Thoughts, Industry Analysis, Investment firms, Recent Market Action, Stock ideas, Technology Tags: , , , , , , , 2 Comments

the issue

Yesterday, MSFT announced it was selling, in a private (not registered with the SEC) offering, $1.15 billion in senior convertible notes, due (at a time not specified in the press release) in 2013.  The offering has the following terms:

–the notes are being sold at face value

–MSFT will pay no interest

—the notes are convertible into MSFT stock at a price of $33.40 per share, a 33% premium to yesterday’s close

–under normal circumstances, the conversion feature can’t be used until March 15, 2013.

why do this?

a MSFT perspective

MSFT, a company I owned for more than a decade and have followed for over 20 years, is admittedly a quirky company.  But I can’t imagine that the idea for this deal originated with the firm.

As of the most recent 10-Q, MSFT has almost $40 billion in cash on the balance sheet.  It’s generating over $15 billion annually in free cash flow.

Yes, MSFT did try to buy YHOO for about $40 billion a few years ago, but thought better of it when YHOO was subsequently offered to it on a platter at about half that price.  MSFT seems to me much more careful with its money these days, so I don’t think a big acquisition is in the cards.  But even if it were, $1.15 billion–what the company earns every three weeks–would be just a drop in the bucket.  If motivated by the idea of a large purchase, the offer should have been a lot bigger.

I think MSFT sees the deal as free money, the equivalent of picking up a $100 bill you see on the sidewalk.

the buyer

My guess is that the buyer, whose name has not yet been disclosed–and who may remain anonymous–approached MSFT.  In all likelihood, it’s a professional investor who has contracts with some clients that require it hold only  fixed income instruments for them.  The holder forgoes a relatively small amount of interest income in return for the chance at a large capital gain if MSFT stock goes up more than 10% annually for the next three years.

To state the obvious, the buyer must:

–be very bullish about MSFT’s prospects, and/or

–think stocks will do relatively well and MSFT is a comfortable proxy for the S&P as a whole, and/or

–think making money from bonds will be hard over the next few years.

For its part, MSFT continues to buy back its own stock.  It will also try to offset potential dilution from the note offering through options.

oddity or harbinger?

It’s too soon to tell.  But I think it’s something to keep an eye on, as a potential source of support for stocks in general, and for bond-like stocks in the MSFT mold in particular.

finding a stock entry point: figuring the percentages

June 8, 2010 By in buying and selling, Recent Market Action, Trading Tags: , , , , , , Leave a comment

preliminaries

The decision to buy an individual stock, or an ETF or an index fund ,for that matter, is the product of a series of increasingly focused judgments.

The first is the investment plan that sets out an asset allocation among cash, bonds and stocks based on your goals and risk tolerances.

The second level is a comparison of the relative returns you judge are available to you from the different classes of liquid assets, namely, cash, bonds and stocks.  (At present, it seems to me the odds are tilted unusually strongly toward stocks.)

The main benefit of cash in a bank or a money market fund at the moment is that the funds are safeguarded; returns are miniscule, although capital loss is extremely unlikely.  The 10-year Treasury bond yields 3.2%, the 30-year 4.1%.  I find it hard to imagine that interest rates will fall further, creating capital gains for bondholders.  If anything, rates will begin rising in the coming year, producing capital losses.  Stocks?  The long-term average, which I regard as the default number, is around 10%.  I think the year-ahead potential is greater than this, but that’s another story.

The third judgment is whether you perceive a reward from deviating from a benchmark stock index–in the case of US investors, it’s typically the S&P 500–to take the extra risk of buying an individual stock.

figuring the percentages

first pass

Let’s say I decide to add equity exposure to my portfolio.  I figure that earnings on the S&P 500 can be $85 this year and $95 next.  I think the market can trade on 15x earnings, which would be an earnings yield of 6.6%.  That compares very favorably, I think, with the 3.2% interest yield on the 10-year Treasury.

If those numbers are reasonable–I think the earnings could be high and the multiple could be low–then the S&P offers 20% upside over the next half year or so.  Downside?  Le’s say that in the current period of market fear the index could drop another 10%.  I think that’s too much, but it allows me to make a point I think is important.  And when people get scared, who knows what their emotions will lead them to do?

Let’s also say that I think both outcomes, up 20% or down 10%, are equally likely and are the highest probability results.  This means I’m risking the loss of $1 in order to gain $2–2 to 1 odds.  This sounds ok but not fabulous.  Should I wait for better odds?

second pass

Suppose the market drops 5% from here.  Then the situation is 25% gain vs. 5% loss.  5 to 1! This looks much more attractive.  But…

third pass

I’m not the only participant in the market.  Others have pocket calculators and can make guesses about possible market outcomes.  In other words, everyone already knows the market is very attractive down 5% from here.  In all but the most panicked markets, there’ll be someone who says to himself that he’ll get a jump on the crowd by buying down 4%.  After all, a 24% gain (eight years of 10-year bond interest) vs. a 6% loss isn’t bad, either.  There may also be someone who not only thinks about the crowd but about the guy who intends to buy when the market falls 4%.  He may think that a 23% gain vs. a 7% loss, or 3-to-1, is acceptable and place limit orders to buy at 3% below the current market.

comments

The reverse regularly happens when the odds favor selling.  In this case, astute sellers forgo the last few percentage points of theoretical upside to be assured of exiting their positions before a decline commences.

The same kind of calculation applies with individual stocks as with the index.  One difference, though:  the risk/reward ratio has to be higher, I think, than that of the index to justify the extra risk of buying an individual stock.

I’ve always found it harder to figure out the bottom of a trading range than the top.  This may partially be my bullish temperament.   But marking the bottom also requires a good understanding of how much risk the market attaches to the possibility of actually achieving, or breaking through, the top of the range.

In the current situation, for instance, the market may still think that the most likely year-end target for the S&P is 1250-1300.  But it clearly now wants to assign a higher risk to this outcome, as the break below 1100 (which had previously been a solid-looking floor) and the current search for support around 1050 show.  Part of the new anxiety comes from the slowing in the pace of growth in consumption in the US over the past month.  Part doubtless also comes from worry about the impact of a slowdown in Europe on corporate profits here.

Both concerns appear to me to be already overly discounted in today’s prices.  But the market, which is always the final arbiter, disagrees.