Shaping a portfolio for 2011: investing in a world with inflation

The way I’m reading the US stock market, investors are only now beginning to discount the possibility that the Fed will be successful in creating inflation through its QEII operations.

important stuff

The last time the US saw rising inflation was in the late 1970s and early 1980s—the pre-Volcker era.  This means that virtually no professionals active in the stock market today have actually worked in an inflation-conscious environment.  In other words, many people will talk in confident tones about the characteristics of inflation—just as they spoke about deflation—without having any knowledge other than wheat they obtained from books on the subject.  Some of these ideas may be really wacky—and translate themselves into actions in the market that, in the final analysis, will make no sense.  These oddities will, at some point, present opportunities for profit.  But it’s always dangerous to put yourself in front of a moving train—even if you know it shouldn’t be there or is moving in the wrong direction.

The key to enduring inflation or deflation is consumer expectations.  Changes in expectations translate into changes in purchasing patterns.  In a deflationary mindset, consumers purchase only at the last minute, since the trend of prices is down.  In inflationary times, in contrast, people purchase in advance of their needs, since they believe that prices will be higher if they wait.

For companies, this means, among other things, a change in behavior toward inventories.   In a deflationary environment, companies want to be as lean as possible.  During inflationary times, in contrast, companies try to achieve profits from holding inventories that rise in value before they’re used.

winners and losers

income statement

In a situation where costs are steadily increasing, the key question for profits is whether a firm is able to pass these extra expenses along to customers, and how quickly it is able to do so.  Companies that have  unusual, scarce, or sharply differentiated products will typically do well.  All other things being equal, the shorter the supply chain, the better.

On the other hand, companies in industries like utilities, where prices are highly regulated, may face strong resistance to raising prices at all, or at the very least a significant lag in their ability to do so.  Commodity-like products—ones where there are readily available close substitutes—like consumer staples, will also tend to suffer.

balance sheet

In an inflationary environment, prices rise.  The cost of money, that is, interest rates, is one of those prices.  So companies with fixed-rate debt, which usually means outstanding bonds rather than bank debt, benefit.  So do firms holding large amounts of real estate.  Capital-intensive firms that already have ample capacity, especially in industries where rivals are becoming capacity-constrained and must add plant and equipment at now-higher prices should also benefit.

my thoughts

It’s not clear how or if quantitative easing will work.  It’s also hard to predict exactly how Wall Street will respond, given that only professionals working thirty years ago have seen inflation at work while they’ve been on the job.

Having said that, one sea change already appears to be occurring.   Investors seem to me to be more conscious of the risk in holding longer-term fixed rate bonds—the clearest losers in an inflationary time.  That concern is starting to flow into the stock market, I think, where the closest analogues, that is, the most bond-like securities, are those whose dividend yields are their greatest (or only) attractions.  I think high-yielding cyclical companies will be ok, but utilities and consumer staples are at risk, because they will likely struggle to achieve inflation-matching earnings increases.  This means they must either up the proportion of income they pay out to shareholders, or let their dividend decline in real terms.  Income-oriented investors already seem to me to be shying away from situations where they must forgo dividend growth possibilities in return for high current yield.

WYNN, and indirectly Wynn Macau, report strong 3Q2010 results

After the close on Tuesday, WYNN reported its 3Q2010 earnings results.  Since it breaks out the performance of its US and its (72.3%-owned) Macau operations separately, it also in effect renders an accounting of 1128’s performance, even though Hong Kong securities regulations only call for semi-annual reports.

the numbers

WYNN’s revenues for the quarter reached $1 billion, up from $773.1 million in the comparable period of 2009.  Of the increase of $226.9 million, $222.9 million comes from Macau (remember, accounting conventions in the US–and just about everyplace else–dictate that WYNN show 100% of the revenues and costs of 1128 in the income statement and then subtract the share of profits that belongs to third-party owners in a “minority interest” line at the bottom).

Macau had operating income of $124.7 million for the quarter, up 50% from $83.2 million in the September period of 2009.  Las Vegas had an operating loss of $16.2 million, an improvement from the deficit of $20.9 million it  posted last year.

Net income was $48.7 million, or $.39 per share, after adjusting for a loss of $64.2 million on redeeming a bond issue early.  This compares with net of $39.9 million, or $.33, in the third quarter of 2009.  Given that Macau operations earned about $113.7 million, after tax, in the quarter, this implies the rest of the company lost $65 million.

the details

Quarter on quarter, Macau’s operating results were down by about 11% as the house winning percentage from high rollers returned to a more normal 2.88% of the amounts bet, as compared with the very favorable 3.22% it enjoyed during the three months ending in June.

In Las Vegas, casino income was down, hotel results were flattish, but the popularity of WYNN’s nightclubs more than offset this.

the (near-term) future

October was a huge month for Macau–both the market, where revenues were up 50% year on year (up 20% over the average month of the third quarter), and for 1128, which earned $90 million for the month.  WYNN was unclear whether this figure was EBITDA, which it presumably is, or some even more favorable measure.  Assuming WYNN means EBITDA, that would be a 25% jump over what 1128 earned in the average month of the third quarter.

Steve Wynn thinks the Las Vegas market bottomed in the third quarter and that a slow recovery is now underway.

Planning is just about complete and preliminary construction work for 1128’s expansion in the Cotai area of Macau is starting.  Opening of the new casino complex is slated for 2014-2015.

what about the stocks?

WYNN has a market capitalization of about $13.7 billion.  1128 has a market cap of around $11.7 billion, meaning WYNN’s ownership share of the subsidiary is being valued in the Hong Kong market at $8.5 billion.

The most straightforward conclusion would be that Wall Street is assigning a value to WYNN’s Las Vegas assets of around $5 billion.  Yes, the company is perhaps the only healthy body in a sea of walking wounded.  Yes, there’s the iconic name, the well-maintained facilities, the promise of economic recovery in the US that will likely bring WYNN a larger share of a more profitable Las Vegas.  Still, that seems like a lot to pay–and implies one should hold 1128, the “pure” Macau play, that can easily be bought through any discount broker.

Maybe that’s not 100% right, though.  There are certainly institutional investors whose contracts with clients prevent them from buying foreign stocks.  Hong Kong and Macau are different places with different rules, where it’s sometimes hard for many people to keep up with what’s going on–or even to understand how local investors are likely to react to a given piece of news. In addition, WYNN controls 1128 and receives management fees from it.  For al these reasons, there may be an “intangible” premium attached to owning WYNN.

Having said that, as a growth investor, my preference is for 1128.  My guess is that the parent company premium is as wide as it’s going to get.  This would mean all the upward price momentum will come from developments in Macau, until Las Vegas gives strong signs of profit recovery.  Given the sluggish overall US economy and the large amount of overcapacity in Las Vegas, I don’t think that will be soon.  As it happens, I own a very large (at least, for me) combined position in WYNN and 1128.  I’m going to trim the former.

…oh–the dividends!

WYNN will be paying an $8 per share dividend on December 7th to holders of record on November 23rd.  Given that the company is not paying taxes in the US as present, this makes a lot of sense.

The board of 1128 is considering paying a regular dividend, and has declared an initial payout of HK$.76 on December 3rd to holders of record on November 22nd.  1128 thinks it will easily be able to finance Cotai construction costs of maybe $2.5 billion, and still pay a dividend.

INTC will make chips for Achronix in its newest 22nm fabs

INTC and Achronix

Achronix, a small privately-held fabless semiconductor design firm in Silicon Valley, announced on Monday an agreement that it and INTC have been working on for almost a year.  INTC will manufacture Achronix’s 22-nanometer Speedster 22i, which it calls “the world’s most advanced field programmable gate array (FPGA),” using one of the company’s most advanced fabricating plants, slated to open late next year.

INTC didn’t make an announcement, but did post the news on a company blog.

On the surface this looks like a lopsided deal in Achronix’s favor.  The key feature of FPGAs is that their programming can be improved or upgraded even after the chip is in a device.  So they’re great for putting new technology into telecom or networking equipment.  Achronix claims the Speedster 22i will offer 4x performance vs. competing chips and will use 50% less power, but will cost 40% less.  A lot of this will be due to the INTC process technology.

What does INTC get in return?  The company isn’t really saying and there’s no agreement either among analysts or technology bloggers.

my thoughts

I think there’s a good news/bad news aspect to the answer, which is why INTC is mum.

A semiconductor fab in today’s world costs at least $3 billion to build.  It’s capable of producing about $7 billion in yearly output.  Who can afford to build one?  Who needs that much output?   No one–other than INTC, which has a near monopoly in processors for PCs, Samsung, the dominant force in memory chips, and maybe TXN.

To the degree I’ve thought about these facts–and I haven’t done much–I’d assumed that being big enough to continue to have your own fabs, and to relentlessly push for more advanced fab technology, would prove a critical market advantage.  But it hasn’t.  That’s the bad news.

For most semiconductor design firms, fab ownership is out of the question financially.  They turn to third-parties, the so-called “foundries” like TSMC or UMC, to do their manufacturing for them.  For the fabless firms, then, manufacturing is not a competitive advantage.  What separates winners from losers among them is the flexility of products, the ability to do more creative things within the confines of a standard fabrication technology.  As a result, the fabless industry has made a virtue of necessity and learned how to do a lot more with a lot less.  Arguably, the foundries have done the same.

In other words, the rules of the game for semiconductor device makers–and especially for chips in mobile devices–have changed in a way that puts INTC at a disadvantage.  More bad news.

Where’s the good news?  –it’s that INTC understands what’s going on and has decided to try to change the game once again.   Companies like Achronix get manufacturing prowess that will give their chips features the competition may not be able to match.  INTC learns the mindset of the designer of products for the mobile universe.  Together, the two firms may be able to create system-on-a-chip products that make future generations of the Atom processor more attractive to makers of cellphones and tablets.

My guess is that this move isn’t at all about INTC itself becoming a foundry.  It’s more about changing the chip design culture within INTC to the point where it can meld the best of the fabless world in with its own traditional skills.

If I’m right, this is a real sign of management strength.  It might work.  I don’t see anything in the company’s stock price that suggests this possibility is being discounted at all. Let’s see what happens.

 

 

 

 

money flows and the consensus

The early nineteenth century in Europe was deeply concerned with questions of truth and permanence.  The ponderings (using the term that describes the famous exchanges of Pinky and The Brain) of people like Hegel and Schopenhauer on these topics yielded us the (then) revolutionary ideas of the historical dialectic and the love-hate relationship.  The central idea is that nothing lasts forever, that movements contain the seeds of their own destruction.   One day, out of the blue, true and false change places.

It’s a commonplace that stuff like this happens in the stock market.  After all, the cliché is that the market makes the greatest fools out of the largest number of people.  What’s unusual about the equity world, however, is that the reversals almost always lead the economic changes that will confirm their validity, often by a long time.  Relative valuation explains part of this.  But over the past twenty years, what we in hindsight clearly see as bubbles were able to reach epic proportions and endure for years before reversing themselves.  So that can’t be the entire story.

I think the other piece to the puzzle is money flow.

I first noticed this early in my career as an analyst.  In the late Seventies and early Eighties, there was a dominant technical analyst on Wall Street.  The CIO where I worked, who had been one of the most successful equity investors of the Seventies, hung on his every word.  And it was true that this analyst had an uncanny ability to call even the smallest twist and turn to the S&P 500.

How did he do this?  He was, of course, in constant contact with his firm’s trading desks, so he knew what the firm itself and its customers were buying and selling.  Like any sell-side analyst a large part of his job was marketing, so he spent maybe half his time traveling and meeting with clients.

Clients were always willing, if not eager, to discuss their investment ideas with him, for several reasons:

–everyone likes to have opinions, and to educate and amaze others by giving them, so little coaxing may have been needed,

–as our analyst became more renowned, clients wanted to hear his opinions, and

–because the analyst met with most of the important portfolio managers in the country, he had a very good idea of what they were thinking.  Clients wanted to hear this as well.

I happened to be very interested in technical analysis in those early days (if you’ve read my other posts on technical analysis, you’ll know I concluded it’s most times probably more useful than phrenology, but not by much), so I watched this analyst very carefully.  I even attended a technical analysts’ convention or two, filled with strange characters wearing buckskin jackets, where he spoke.  His method had three parts:

–visit the largest asset management companies and by conversing with as many portfolio managers as possible, determine what the market’s consensus portfolio structure and investment strategy were,

–study price/volume charts and talk with the trading desks to try to figure out how fully the PMs had implemented their ideas, and

–when he determined that most PMs had carried out their investment plans, he would recommend the opposite strategy!

In the simplest terms, his philosophy was that when everyone had bought (or sold) a given stock or sector, then the only possible action left was for the market to sell it.  He just helped the process along.

I think this is as true today as it ever was.  It’s why it’s important at potential turning points–when, as now, a strong consensus has been in place for a long time–to watch the money flows and price action for signs that a reversal is taking place and what the new direction may be.  Flows can reverse very quickly, too.

What happened to our technician?  He came to a typical Wall Street end.  Clients eventually worked out what he was doing.  It didn’t help that as he became more prominent, he inadvertently began to talk about his method more than he should have.  PMs continued to meet with him, but they began to lie to him about their plans.

He ended up telling clients in mid-1982, as a new bull market was beginning, that this was a false dawn and they should sell heavily into the rise.  He was never the same after that.

Are individuals coming back to the US stock market?

some preliminaries…

A little more than a week ago, I wrote a post I called “Thinking about 2011,” in which I discussed the economic and stock market forecast of Jim Paulsen of Wells Fargo.  My understanding of his position is that the US economy is much farther along the road to recovery than one would imagine from the doomsayers of the “new normal.”  In fact, judging by the experience of the past twenty-five years, this recovery is ahead of schedule, not behind.  More than that, things are about to pick up all by themselves.

If so, the soon-to-be-launched quantitative easing by the Fed is not only unnecessary, but it has the potential for creating a lot of inflation–fast.

I said I thought Mr. Paulsen’s analysis was far from consensus.  My friend Bart, a canny veteran still working on Wall Street, wrote a comment to my post saying that Paulsen is a lot closer to the thinking of institutional investors than I realize.  Although confident that Bert is correct, I replied that I didn’t see this consensus being acted on yet in stock or bond prices.

…bringing us to yesterday morning

Monday’s Financial Times contains an article with a London byline titled “Investors increase exposure to equities.”  The story references two data providers:  the Investment Company Institute, the trade association of the mutual fund industry in the US; and EPFR, a Cambridge, Massachusetts-based data aggregator that I’m not familiar with.

According to the FT, EPFR says funds that invest in US equities have had inflows of $13.3 billion since the beginning of September.  Funds focussed on Europe have taken in $1.2 billion over the same time span.  Last week alone, the inflows were $2.7 billion and $840 million, respectively.

The ICI maintains the official figures for mutual funds based in the US (which may be a slightly different universe than EPFR’s).  These data don’t clearly support the EPFR statements.  What they do show, however, is that in mid-October, redemptions of US-oriented equity funds suddenly slowed from a flood to a trickle.  At the same time, inflows to international funds began to accelerate.

I tried to contact EPFR this morning, without success.  By the way, I’ve been pleasantly surprised to find how uniformly cooperative the information sources I contact as an equity market blogger are.  I expect I’ll eventually hear from EPFR as well.  Whether I do or not, though, the point is still that we may have seen an inflection point in investor behavior.

What does this mean?

The change in money flow may mean nothing.  Or it could reverse itself in short order.  After all, at least according to the ICI data, bond fund inflows haven’t diminished a bit.

On the other hand, government bonds have been weak recently, as have bond-like domestic US stocks.

My hunch is that world stock markets may be in the process of changing their character in a meaningful way and that I don’t have the two months for leisurely thought that I thought I had, if I want to keep positioned in stocks with a good chance of outperforming.

The first thing to consider is what kinds of stocks might be vulnerable if:

–economic growth is picking up steam,

–interest rates are rising, and

–inflation may be a problem, meaning the Fed has got to see to it that rates rise some more.

At this point, I still need to be convinced that any of this stuff is really going to happen.  And I don’t want to launch into an overhaul of my positions without thinking about it carefully first.  All I want to do is to identify potential underperformers and figure what I would need to do to get from overweight to a more neutral position.

I’ve also been thinking that many of the same stocks that have done well over the past eighteen months also stand to be outperformers in a higher-growth, more inflationary world.  But I want to make sure of that, too.

More on this topic over the next few days.