Monthly Archives: December 2010

a turning point for bond funds? …stocks, too?

December 20, 2010 By in Convertibles, Current Market Thoughts, Preferred Stock, Recent Market Action, securities markets, Shaping a portfolio for 2011, stock market, Strategy Tags: , , , , , , , , Leave a comment

I’ve been noticing commercials on financial TV and radio–why I turn on the functional equivalent of the WWE, I don’t completely understand–for gold.  They tend to go like this:  NOW is the time to buy gold!!!  Why?  …because it’s 4x the price it was ten years ago.

In other words, buy because prices are very high.  That’s crazy.

Bond funds have had a similar pitch over the past few years.  Faced with near-zero, emergency low, interest rates, which imply sky-high bond prices, bond fund managers invented a marketing pitch that became known as the “new normal.”  The thrust is that we are in a post-apocalyptic world, where the earth’s economy has been scorched and will be incapable of growth anywhere on its surface for, say, a decade.  Therefore, buy bonds, avoid stocks.

Interestingly, bond funds haven’t had much trouble popularizing this view.  Bonds, like gold, have performed much better than stocks for a long time.  So bond funds have collected lots of assets and are big advertisers in the media.  And, of itself, the fact that rich and successful people would be predicting a global “lost decade” is a newsworthy story.

As I’ve noted a number of times, one characteristic of this point of view is that it’s very self-serving for bond people.  It’s the only scenario I can think o of where it doesn’t make sense to rebalance your portfolio–to take money out of the strong-performing, high-priced asset, bonds, and put it into the weaker-performing, lower-priced asset, stocks.

Cynics would say that bond managers just told investors a story that would keep them from taking money out of bonds, thus reducing the managers’ income.  They’d probably also point out the quiet diversification of Pimco, the largest bond manager, into stock funds about a year ago.  But, however implausible the idea might have been, it’s possible that bond managers actually believed it.  After all, there’s a powerful psychological tendency, that professional investors have to constantly fight, to screen out facts that call into question the way your portfolio is set up.  And after twenty-five years of almost non-stop success, it must be very hard even to conceive that things might not go your way.

Four factors are beginning to call into question the new normal/by bonds thesis:

1.  Economic growth, which has been very strong in the emerging markets (40%+ of the world), is beginning to pick up in a meaningful way in the US as well.

2.  Stocks are starting to outperfrom bonds in a meaningful way.  According to Barrons, over the past year, actively managed bond funds are up 6%+and their US stock counterparts are up 18%+ (compared with the S&P 500 being up 12%+).

3.  Individual investors have stopped putting new money into bond funds.  For some time, they have been selling municipal bond funds on concerns about credit risk.  But the most recent data suggest withdrawals are spreading to taxable bond funds as well.

It’s not clear what people are doing.  Some data sources show funds beginning to flow into equities.  Others indicate most is being parked in money market funds.

4.  Last week, the Pimco Total Return Fund, perhaps the most famous bond fund in the world (as well as the home of the “new normal”), has announced it will change its investment guidelines so it can put 10% of its money into equity-linked securities, like convertibles.  According to Bloomberg, many other bond funds have been investing in equities for a while and ar leaving Pimco behind in the dust.

my thoughts

I think these developments are bullish for stocks.

In the counterintuitive way that Wall Street thinks, it’s a little worrisome to have the last great equity bear, Pimco, capitulate.  Still, stocks appear cheap, the US is growing again, and the flow of funds data don’t yet show a great deal of investor enthusiasm for equities. It’s not to soon to start to worry that the best may be behind us for this equity cycle (after all, we are about to enter year three of bull market), but it’s way too soon to act.

On a technical note:

If history is any guide, the current active manager outperformance of the S&P 500 can’t continue.  It would explain, however, why professional equity investors appear to have closed up shop for the year a couple of weeks earlier than usual.

I haven’t looked to see what kinds of equity-linked securities bond funds are buying.  But S&P companies typically don’t issue convertibles.  So the risk exposure the funds are taking on may be somewhat different (probably higher) than what one might expect.

the Fedex 2Q11 (ended November 30th) results

December 19, 2010 By in Current Market Thoughts, earnings conference calls, Industry Analysis, Inventory Cycle, Shaping a portfolio for 2011, Stock ideas, Strategy, Transport Tags: , , , , , Leave a comment

the results

Yesterday I listened to the FDX 2Q11 earnings conference call, which was held before the market opened in New York last Thursday.

FDX reported earnings of $1.16 a share on revenues of $9.63 billion.  The revenues were up by 12% year on year, the eps less than half that.  Earnings per share also just barely hit the bottom of the range of $1.15 – $1.35 that FDX guided analysts to when it reported 1Q11 results on September 16th.

Despite the close call, FDX raised its guidance for the full fiscal year from a range of $4.80 – $5.25 a share to a new range of $5.00 – $5.30.

The company did caution that its third fiscal quarter is always vulnerable to bad weather, of which the midsection of the US has already had plenty so far this month.  So it’s not yet clear what the quarterly breakout of the earnings will be.

details

The International Priority (IP) business, notably deliveries from Asia to the US, continued to grow rapidly, with revenues expanding by 14% over a year ago.  Notably, the domestic parts of the FDX distribution chain grew at about the same rate, and benefitted from improved operating efficiencies.

So what went wrong?

1.  After what was reported as only three hours of deliberation, a jury in Indianapolis awarded now-defunct airline ATA $65.9 million in its suit against FDX that it wrongfully terminated a long-term contract with ATA to transport US troops.  A reserve for this judgment–FDX said nothing on the call about a possible appeal–clipped about $.15 from eps.  That’s also the main reason the IP business had flat year-on-year operating income.

2.  FDX overestimated the strength of the IP business during the second quarter.  It extrapolated the frantic rate of shipment growth of the spring and summer into the fall.  But that didn’t happen.  Revenues in the IP segment grew by 23% y-o-y in 1Q2011 after an almost 30% gain in 4Q10–but decelerated to 14% growth in 2Q11.  (True, comparisons are affected by the fact that FDX’s business really began to pick up from recession lows in the second quarter of last fiscal year.  But FDX guidance still anticipated better than what it got.)

3.  FDX is now projecting a better full year than it was three months ago.  I’ll get to this in a minute.  Because of this, it is also projecting bigger bonus payments to employees than it was.  Therefore, it made a higher provision for bonuses in 2Q, and presumably also had to make a catch-up accrual for 1Q.  FDX mentioned this as a factor but gave no further details.

why the slowdown in the international business?

In ordering from suppliers, a merchant faces two complementary inventory risks:

–he can order what he is confident he can sell plus some more, and risk the expense of holding excess inventory for longer than he wants or selling it at clearance prices, or

–he can order only what he knows for sure will sell–or maybe less, and risk losing business as customers come into the store and find the shelves bare.

FDX wasn’t 100% clear on the point, but it seems to believe that retailers got cold feet as they planned for the holiday selling season.  They collectively made the cautious decision that the risk of being out of stock was much more acceptable than the risk of having excess inventories.  So they slowed down the pace of their new orders from Asia.

They are now finding out, too late to do anything about it, that customers are in a much better spending mood than anticipated.  As a result, store inventories will be severely depleted by the end of December.  This means, in FDX’s view (I think they’re right) that there’ll be a mad rush to restock early in the new year.  That will be very good for FDX.

In addition, FDX clearly believes that world economic growth is beginning to gain momentum and will continue to do so for at least this year and next.

my thoughts

I haven’t done enough work on FDX to have an opinion about it as a stock.  Clearly, earnings are going to improve, both as the global economy expands and as the costs of resuming normal operations–restoring pay and benefit cuts for employees and reactivating planes mothballed in the desert during the recession–now being charges against income–fade from the financials over the next couple of quarters.  To me, the real question is how much of that good news is already reflected in today’s stock price.

Be that as it may, FDX is a large, sophisticated company.  Because of the business it’s in, it has unusually good insight into the workings of the world economy.  It sees, directly or indirectly, manufacturers’ production plans and retailers sales experience.  And it must already have a good feel for the tone of business for the next several months.  I happen to think the company’s view of world economic growth is correct.  But, unlike my guesses, theirs is based on a wealth of commercial data that few other entities have.  So I think FDX is evidence that it’s still right to be bullish.

 

 

more insider trading arrests

December 17, 2010 By in insider trading, Securities regulation Tags: , , , , Leave a comment

the arrests

Yesterday, the office of the US Attorney for the Southern District of New York announced the arrest of four more individuals, which is accuses of insider trading.  In the same press release, the Justice Department revealed that a fifth individual had already pled guilty to charges of insider trading and is scheduled to be sentenced in December 2013.

Four of them were (they’ve been fired by their companies) employees of technology firms.  The fourth works for the “expert network” firm, Primary Global Research of Mountain View, California.  PGR recruited the others, organized their contact with hedge funds and other investors and paid them a total of $400,000 for their information.  (See my posts from last month for background on this case and on expert networks.)

The announcement of the conviction and delayed sentencing of the fifth person, a global supply manager for Dell, is important for reasons not spelled out in the release.  It signals that he has agreed to cooperate with authorities in return for more lenient sentencing.  Not only will he testify about his illegal activities.  But he has presumably recorded all his PGR-related conversations since being caught some months ago–and been coached by the Feds on how to steer to telephone calls in ways that make it likely the other person will make self-incriminating statements.

I haven’t read the indictment, but the New York Times has a lot of details, if you’re interested.

not “experts” at all

What jumps out at me is that none of the four tech employees is an any way an “expert” in the tech industry.  They’re not researchers.  They’re not engineers.  They seem to have no detailed knowledge of company strategy.  They’re not veteran marketers with an experience-seasoned view on industry trends.  These are their jobs:

–supply chain manager at Dell–paid $145,750 by PGR

–supply chain manager at Advanced Micro Devices–paid $200,000+

–business development at Flextronics, a contract manufacturer with Apple as a client–paid $22,000

–account manager at Taiwan Semiconductor Manufacturing Company–paid $35,000

They were all mid-level employees who had signed confidentiality agreements with their firms.  The supply chain guys would have had access not only to their own management control computers but those of their suppliers and customers.  The Flextronics guy had access to Apple plans and orders.  The TSMC employee had detailed information about orders from the foundry’s customers, which would have represented most or all of the business being done by the fabless semiconductor design firms who use TSMC.

What do the four have in common, other than working for PGR?  They all had physical access to inside information, which they apparently blissfully revealed to outsiders, sometimes in staccato bursts of phone calls just before earnings were reported.

This isn’t a collection of industry experts.  It’s an industrial espionage ring.

It seems to me yesterday’s announcements are confirmation that this ongoing insider trading investigation is not about borderline or inadvertent violations of securities laws.  Rather, it’s about highly organized, years-long, deeply criminal activity.

Chinese mergers and acquisitions in Japan on the rise?

December 16, 2010 By in Asian economic development, book value, China, economics, growth vs value, Hong Kong, Japanese development Tags: , , , , Leave a comment

Bloomberg published an article yesterday in which it pointed out that merger and acquisition activity by mainland China and Hong Kong companies in Japan is up by more than a third so far this year, to $437.7 million.  (The same article gives the figures, but doesn’t do the math, to show that this amount is about 0.5% of the money Chinese companies have spent on m&a globally over the same period.)  Must have been a slow news day.

Is there anything of significance here, though?

Maybe.  …or maybe I’m just having a slow news day.  In any event:

1.  The targets are small companies.  Larger firms are effectively protected against foreign acquisition by legislation enacted during the first of Japan’s “lost decades,” the Nineties.  Unlike most other places, Japanese tax law (as I understand it) no longer regards all bids where the acquirer offers to exchange shares of his stock for those of the target as being tax-free exchanges.  Instead–but only in the case of a bidder offering stock in a non-Japanese corporation–people tendering their stock are subject to special punitive taxes.

One unintended result of this protection, I think, is that ex the auto companies many major Japanese firms have fallen farther behind their global rivals.

2.  American and European “activist” investors–hedge funds and private equity–have been stunningly unsuccessful at plying their trade in the small company arena in Japan over the past twenty years.

Western financial investors have been enticed by very attractive financial metrics (lots of net cash, how price to book, low price to cash flow) and the existence of bunches of “low-hanging fruit,” in the form of very inefficient work practices.

They’ve typically quietly acquired a substantial ownership stake in a target company and then approached management with proposals for change, including cost-cutting and layoffs.  Management refuses.

The westerner starts a proxy fight but gets no support from domestic institutions and loses.

The westerner tries to increase his stake, so he can force changes, but finds that the target’s customers and suppliers counter these efforts by buying up stock that will vote in favor of current management.

The net result:  the westerner is stuck in a highly illiquid position in a poorly managed company–and no one will buy his stock to allow him to exit.

3.  There’s little love lost between Japan and China.  The real issue, I think, is not recent territorial disputes between the two.  It’s the history of Japanese militarism in Asia in World War II and earlier.  …that and gestures like PM Koizumi’s visit to the Yasukuni Shrine in Tokyo, which suggest a lack of remorse for wartime atrocities.

4.  There is one big difference between the western approach to small Japanese firms and the Chinese one.

In the former case, financial investors wanted to change the Japanese operations of their targets in ways that were culturally unacceptable.

In the latter, investors may want to acquire either relatively low-tech craft skill–how to operate a retail chain in an environment with a complex web of distribution partners, how to deliver fresh food frequently to convenience stores.  Or the target may either have Asian distribution rights for western products, or options on those rights, or long relationships that will help substantially in securing those rights.

Chinese investors are willing to leave the Japanese operations of their targets to wither on the vine.  They want technology they can transfer to the mainland.

Investment implications?  No direct ones that I can see.  You certainly don’t want to fool around on the low-tech small-cap Japanese arena, in my opinion.  My guess is that we’ll see very rapid growth in the Chinese companies that benefit from Japanese craft skill.

Two things to note:  the targets are all involved in domestically oriented businesses, suggesting the transformation of the mainland economy in this direction may take place more rapidly than the consensus expects.  Also, it’s interesting that from a quality of life perspective, Chinese investors see the mainland and Japan as not being that dissimilar.

renminbi as an international currency

December 15, 2010 By in Asian economic development, China, currency effects, economics, emerging markets, Hong Kong Tags: , , , , , , , , Leave a comment

My friend Bob suggested I comment on yesterday’s feature article in the Financial Times on the steps China is taking toward the  internationalization of its currency.  What seem to me to have sparked interest in this topic is the recent renminbi bond issues by McDonald’s and Caterpillar.  But this is only the latest step n a journey that arguably began in 2003.

Here goes:

1.  China sees the enormous economic power that comes from your currency being the form in which the world stores its wealth and the medium of payment used in international trade.  It’s like having your own brand name in front of everyone involved in any sort of commerce anywhere in the world every minute of every day.

It also makes you like the owner of a bank–you can issue yourself a loan any time you want, just by (metaphorically) printing up a new batch of money that you then use to pay your creditors.  It’s the mark of a superpower, one China aims to have for itself as it rises to the pinnacle of world influence.

2.  China is no longer happy holding tons of US dollars.

Why the dissatisfaction?  On some very abstract level I’m sure it thinks that economic power ceded to its rival, the US, is power it doesn’t have itself.  But its real concerns are far more pragmatic.

It’s like the old joke that if you owe the bank $1,000, you’re in trouble; if you owe the bank $10,000,000, the bank is in trouble.  China holds trillions of dollars in US Treasury bonds.  It seems to be convinced–and who could blame it–that the US has no intention of honoring this obligation.  As an American, I’d say something a bit less harsh.  I don’t think Washington is malevolent.  I think it’s clueless.  The last dollar debt crises were in 1978 and 1987, so no one remembers.  As an academic might put it, however, this is probably a distinction without a difference.

This money isn’t as usable as China might have thought.  Virtually every attempt Chinese interests have made to spend its dollars on assets in the US has been blocked by Congress on “national security” grounds.  Some of this may be legitimate.  Most isn’t, in my opinion.  But it’s a fact of life.  And it has the effect of channelling the dollars back into Treasuries–that is, back into the hands of Washington, a borrower who inspires no confidence.

Also, from a Chinese domestic political point of view, the large dollar holdings have a ticking time bomb aspect to them.  Powerful interests in Beijing are responsible for holding and investing the country’s reserves.  No one wants his career wrecked by being the person in charge as and when the world loses confidence in the dollar and these holdings rack up hundreds of billions of dollars in losses.

Looking at Chinese foreign aid to Latin America and Africa, not only does this win local favor but it also helps get rid of large chunks of money that might become a future liability.

3.  For the moment, China has no alternative. Japan never had any interest in having the yen act as a world currency.  Euroland has.  If you remember, China had already begun a couple of years ago to shift its reserve composition away from the dollar, not by selling anything (it owns too much to do so without creating a value-depressing panic), but by focussing on euro instruments for new purchases.  But then Greece announced a year ago that it had been faking its national accounts for years.  This launched the current euro crisis–and gave the dollar a new lease on life.

4.  China’s ideas are colored by having lived through the Asian currency crisis of 1997-98. If you remember, the speculative attack on smaller Asian economies by large commercial banks and hedge funds focussed initially on Thailand, where overleveraging (in US dollar-denominated debt) had created substantial instability.  But toward the end even financially prudent economies like Singapore, and lastly Hong Kong, were also caught up in the turmoil.  The economic “problem” in the latter two cases was only that they were open economies and relatively small–and that international speculators were playing with “house money” they had made in Thailand, Korea and Indonesia.

The lessons  …don’t have an open economy.  Keep strict control of your currency and domestic financial instruments.

5.  China’s defenses created big barriers to use of the renminbi in trade… These included:

–restrictions on who can officially own renminbi

–restrictions on currency flow in and out of China

–restrictions on who can buy renminbi-denominated financial assets, like stocks and government bonds

–restrictions on the exchange of renminbi-denominated financial assets for physical assets in China

–inability to hedge renminbi holdings through currency derivatives

–the fact that the exchange rate is set by government fiat, not market trading.

As a practical matter, trade is relatively easy to deal with.  Let’s say I’m a department store that sources overcoats in China for sale in the US.  If I agree to a renminbi price for the coats, I have a currency risk.  If the renminbi moves up by 20% against the dollar in the time between contract signing and payment for the completed merchandise, I probably can’t raise the selling price of the coats so I may be facing a loss on selling them rather than a gain.  To eliminate this possibility, I lock in a currency rate at contract signing through a hedge.  I can do this, even with the renminbi, but why bother.  Better just to source in dollars.

6. …that China has been addressing, little by little, for some years.

The “why bother” is that China has increasingly signaled that it wants trade to settle in renminbi.  So it has set out to make such settlement progressively cheaper and easier.  In particular:

–in 2003, the mainland allowed Hong Kong banks to accept renminbi deposits

–in 2007, it allowed domestic banks to begin to tap the pool of offshore renminbi by issuing renminbi bonds in Hong Kong (and repatriate the proceeds to the mainland)

–in 2008 with the Hong Kong Monetary Authority, and subsequently with other regional central banks, the Peoples Bank of China set up currency swap lines, that would enable these non-mainland institutions to offer renminbi to local banks (to use in trade settlement)

–in 2009, Beijing allowed renminbi settlement of import/export between Hong Kong plus some ASEAN countries and a number of big trading centers in the export belt of eastern China

–this year, Beijing expanded this program to include all foreign parties and a much larger number of mainland entities.

—–Also, both non-mainland banks and other corporations have been allowed to issue renminbi bonds.  This is what MCD and CAT have done.

As the pool of offshore renminbi the Beijing is encouraging to form gets progressively larger, the costs of doing business–including hedging–in the Chinese currency will fall.  HSBC thinks that within a few years, half China’s trade with emerging markets will be settled in renminbi.  By 2020, the bank projects that its renminbi business in Hong Kong will be as big as all its trade settlement is today.

there is a catch to all this

Once the renminbi leave the mainland, they are only allowed back in to pay for exports.  Otherwise, a holder needs explicit government permission to use the funds in China.  Therefore, internal financial markets are sheltered from any speculative storms that may hit Hong Kong.

So far no one minds.  Global interest rates are low, so there’s little opportunity cost to holding renminbi.  Also, the consensus among individuals is that the renminbi is an appreciating currency, making it an attractive alternative either to HK$ or US$.  In addition, borrowing rates for renminbi are low in Hong Kong than on the mainland.  So firms that can get government permission to transfer the proceeds are better off financing in the offshore renminbi market.

how fast will liberalization proceed?

No one knows.  Some, like the FT, speculate that the fact of liberalization will produce a pace of liberalization that’s faster than Beijing wishes.  I’m more skeptical.  But, since I don’t see any stock that’s a pure beneficiary of a surprisingly sharp pace of liberalization, I haven’t given the matter much thought.