Monthly Archives: March 2011

post-earthquake supply disruptions from Japan

March 20, 2011 By in Chemicals, Current Market Thoughts, Industry Analysis, Japanese development, Recent Market Action Tags: , , , , , , , , , 1 Comment

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It has only been a little more than a week since the devastating earthquake/tsunamis in Japan.  However, a lot more information about possible supply disruptions is available now.  As an investor, the main conclusions I see, based on what we know to date, are:

1.  Many of the disaster-affected plants that are sole sources for key components supply the auto industry.  A number of auto manufacturers have already announced that they may soon have to shut down either individual production lines or entire factories for lack of parts.  Although I’ve owned auto stocks from time to time, this is not an industry I’m particularly interested in or familiar with.  But one of the main reasons I’m not a fan is that the industry is characterized by chronic (and huge) overcapacity.  So far it doesn’t appear that there’s any one component in potential shortage that’s used in virtually every car in the world.  So the effect of plant closings will be market share shifts, not a shortage of cars or trucks.

2.  It’s possible that electric power will have to be rationed, at least in the Sendai area, for many months.  The Japanese government tendency is always to prefer industry over the consumer.  Public outrage over currency speculators who bid up the yen in the aftermath of the earthquake–they’re being described as criminals who exploit human tragedy, the moral equivalent of gangs that loot stores during a fire in the city–suggests there won’t be any popular opposition to this.  The practical questions for factories where the problem is power (not that the earthquake destroyed the machinery) will be how quickly power lines can be repaired and what the limitations of the Japanese power grid are in delivering electricity from other areas of the country. (I’m assuming that, as the latest reports are suggesting, the Fukushima reactor crisis is finally coming under control.)

3.  With one notable exception, the Japanese technology-related firms that have announced earthquake-related shutdowns make commodity products, like DRAM or NAND flash, where alternate sources of supply are available.  Prices may go up a bit but devices will still get made.

The one exception: bismaleimide-triazine  resin (BT), a compound used to glue semiconductor chips to printed circuit boards.  BT is used in all smartphones and tablets.  90% comes from Japan.  The largest producer, Mitsubishi Gas Chemical, which accounts for about half of what the tech industry uses, has shut down production due to earthquake damage.

The other major Japanese source of BT is Hitachi Chemical.  It’s plants are still operating.  But, according to the Financial Times, the BT made by different chemical companies isn’t simply interchangeable.  Output differs enough that at the very least a period of testing is required before you can use BT from another supplier. The Wall Street Journal says this process could take a month for most kinds of circuit boards.  For cellphones, though, because of their small size and the specific amount of heat a given chip may throw off, the entire design may need to be changed in order to accommodate a different flavor of BT.

But the main issue is there’s no way for the rest of the industry to double production overnight–which is what would be needed to keep cellphone production rolling along at the current clip.

Mitsubishi Gas Chemical will likely make an announcement about the extent of damage to its Fukushima BT plant in the next few days.  All we really know now is that production has been halted.

In the meantime, MGC customers are doubtless talking to Taiwanese and Korean suppliers of chemicals that they wouldn’t have given the time of day to a month ago.   And they may be seeing what they can do to get increased allocations from Hitachi Chemical (good luck with that).

The BT story bears close watching.  If MGC production isn’t restored soon, disruptions to the supply chains of phone makers whose products use the MGC output could be severe.  Pain will be felt not only by the phone manufacturers but by all their component suppliers, as well.

G-7 intervention to stop the yen’s rise: will it work?

March 18, 2011 By in Balance of Payments, comparative advantage, currency effects, Current Market Thoughts, J-curve, Japanese development, Purchasing power parity (PPP) Tags: , , , , , , , , , Leave a comment

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Will G-7 intervention work?

Yesterday, the G-7 group of major industrial countries announced plans for coordinated intervention in the foreign exchange markets in order to halt the rise of the yen against the currencies of other developed nations.  In the wake of last week’s earthquake and tsunamis, the yen had risen by about 5% against the dollar.  Will the G-7 be successful?

The short answer is “…most likely, no.”

How so?

The main reason is that the major international commercial banks, who are the main forces in the global currency markets, are far larger and have greater financial resources than national governments do.  That might not have been true twenty-five or thirty years ago, but it is today.  Even the G-7 nations acting together don’t have the financial firepower to oppose a concerted move by the banks.  In the past, it hasn’t helped either that governments have typically tried to defend currency values that were politically attractive but economically unsound.

Japan the most skillful government player

I’ve been watching the currency markets as a global investor for over twenty-five years.  Over that time, the country that, to my mind, has the best record in influencing the direction of its currency is the Japan.  Understanding it can’t oppose the banks directly, it has waited until a wave of speculation has almost exhausted itself and then applied enough pressure to send the yen in the opposite direction.

Japan’s present stance is a curious one, though.  The current administration in Tokyo, the Democratic Party of Japan, came into office with the intention of reversing the long-standing (and very outdated) policy of the Liberal Democratic Party of always aiming to weaken the yen in order to help the prospects of export-oriented industries.  Nevertheless, when the original DPJ finance minister tried to enforce the new policy, he was replaced with someone more willing to cater to the Keidanren.  The new minister immediately began selling the yen in what I saw as simply a wasteful attempt to establish his pro-industry bona fides.  That was Naoto Kan, who is now the prime minister.  Who knows what he’ll do now.

A second curious aspect of the situation today is that there’s no good reason for the yen to be a strong currency.  The country’s workforce is shrinking.  The government is ineffective and heavily in debt.  The budget is in deficit.  And the country hasn’t shown any real growth in over twenty years.  Japan’s most “positive” feature  vs. the euro or the dollar is that it’s a known quantity and has less near-term potential for negative economic developments than the EU or the US.

Why has the yen been rising, then?  After the Kobe earthquake in 1995, Japan repatriated large amounts of money invested abroad.  Insurance companies needed funds to pay claims.  Parties–individual or corporate–who had no third-party insurance needed money to rebuild.  this activity drove the yen up by about 20% against the dollar in the months following the earthquake.  It’s probably too soon for this to be happening again.  The yen probably started to rise early this week as speculators began to bet the same thing would happen again.

Interestingly, the yen gave back almost all its gains as soon as the G-7 announced its plans and Tokyo was seen selling the yen aggressively in the currency markets.  To me, this suggests that the big players in the market haven’t decided what to do yet.  In the end, though, it will be the banks, not the G-7, that decide whether the yen strengthens or not.

investment implications

What’s the significance of a rise in the yen for investors?

An appreciating currency has two effects:

–it slows economic growth in local currency terms, and

–it reorients what economic energy there is–away from export-oriented industries, and toward domestic-oriented firms and importers.

If you were investing in Japan and thought the yen would rise, you would overweight domestic firms and underweight exporters and other companies with large foreign-currency exposure.  But the most sensible thing for most people to do, as I suggested a couple of days ago, is just to stay away.  (I own two social networking stocks in Japan, DeNA and its smaller competitor, Gree.  For now, I’m keeping them both.  These are youth-culture special situation stocks that are growing very fast, so I think they’ll be relatively unaffected by problems in the overall economy.  But I wouldn’t advise anyone to follow my lead.)

pension consultants and placement agents: the CalPERS report

March 17, 2011 By in Getting financial advice, hedge funds, Investment firms, Private equity Tags: , , , , , Leave a comment

the situation

Imagine you’re a global equity portfolio manager.  You have a top quartile record over virtually any period during the prior ten years.  In fact, there’s no one in the US, and only one in the EU, who can equal or better your numbers.  You have presentation skills polished by intense preparation by experts both inside and outside your firm, as well as your many hours of practice.

You visit a pension consultant in Connecticut.  You show him your numbers, make your presentation, and await his comments.

He has only two:

–your presentation skills are terrible.  Before he can recommend you to any clients, you must take a remedial course from his firm.  It costs $25,000.

–he’s not sure you know enough about foreign markets.  The only way he can gain the confidence he needs is if you subscribe to his firm’s international information service.  He shows you the latest copy.  It’s a worthless collection of news clippings–superficial, and weeks behind what your own information network provides.  It costs $50,000 a year.

Summary:  despite the fact your record is better than that of anyone he is currently recommending to clients (who are, incidentally, paying him large amounts of money to do manager searches for them), those clients will only hear your name if you agree to make an upfront payment (read: bribe) of $75,000 and agree to continuing payments of $50,000 a year.

We decline.

Welcome to the Realpolitik of pension consulting.

the CalPERS report

The consultant I’ve described lacks finesse.  It would be more common for a pension manager to agree buy analytic services from a consultant, who would examine the manager’s product offerings for their potential attractiveness to customers.  Paying the consultant to come to your offices and spend time digging through your products will not only give the consultant the knowledge of your products that might otherwise take five years of you visiting him to impart.  But it might engender a feeling of obligation as well.

The biggest weapon in the consultant’s arsenal, however, is his control over the types of products he will recommend that his client buy.  They will be all highly specialized, offering the maximum potential for the consultant to “add value” by applying asset allocation services to the individual pieces a given asset manager sells, thereby customizing a portfolio.

CalPERS wouldn’t see the sometimes seamy interaction between manager and pension consultant.  But that’s small potatoes compared with what the consultant earns by selling manager selection and asset allocation services.

None of this is mentioned in the just-released CalPERS investigative report on placement agents and consultant services.  In fact, the part about consultants is much like the amuse bouche in a five-course meal.  What the report says is this:

1.  Somehow, while it continued to pay pension consultants as neutral third-parties to find managers and monitor performance, CalPERS ended up hiring the same organizations as money managers, as well.  Talk about the fox guarding the chicken coop.

CalPERS has finally worked out that, in addition to not being a sound action from a fiduciary standpoint, this is a no-win situation for it.  If the performance is outstanding (and my casual reading suggests it isn’t), there’s still the blatant conflict of interest.  If it’s poor, there isn’t even a pragmatic justification for the breach of prudent behavior.

2.  The big issue in the report, though, is placement agents.  These are well-connected individuals who sold their privileged access to CalPERS management for tens of millions of dollars in fees paid by third-party money managers, some of whom gained CalPERS as a client.  This appears to have happened predominantly in CalPERS alternative investment and real estate areas.

The report of the investigation, lead by law firm Steptoe and Johnson, LLP, is a carefully crafted document.

The authors point out that they received “universal and unlimited cooperation”  only from CalPERS and its current employees, less than that from others.   Some relevant people, notably former CalPERS CEO Fred Vuenrostro and former board member Alfred Villalobos, refused to cooperate entirely (understandably, perhaps, in the case of the named individuals because the report notes both are defending themselves against charges brought by the California Attorney General).

As I read it, the report makes several, not entirely consistent, points about the attempts of several of CalPERS key alternative investment managers to buy influence through Villalobos and Vuenrostro:

a.  CalPERS lost no money (not relevant from an economic point of view, but likely a key point under state securities laws)

b.  the main operational failure was on the part of the board of directors in not reining Villalobos and Vuenrostro in, and in some cases, aiding their influence-peddling efforts; the staff of CalPERS consistently resisted unwarranted pressure from Vuenrostro to select certain managers or not negotiate fees diligently

c.  nevertheless, the report also cites the case of the former head of CalPERS’ alternative asset arm, who appears to have accepted inappropriate favors from Apollo Global Management, while CalPERS was negotiating to buy a stake in Apollo

d.  in addition, many of the third-party managers who paid a total of $180 million to placement agents, Apollo Global Management, in particular, remain among CalPERS’ “most trusted external managers.”

e.  again, despite the contention that the staff of CalPERS acted entirely appropriately, the report also says that four alternative asset managers, Apollo, relational, Ares and CIM, “agreed to a total of $215 million in fee reductions for CalPERS.”

my thoughts

At least this behavior is out in the open.

To me, the conclusions in the placement agent part of the report don’t add up.  It may be, however, that CalPERS is so deeply entwined with the alternative asset managers who paid placement agents all that money and who overcharged the agency by close to a quarter billion dollars that it isn’t able to extricate itself.  So it has decided to make the best of a bad situation.  We’ll probably find out more as pending lawsuits wend their way through the legal system.

I’ve updated Current Market Tactics

March 15, 2011 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Recent Market Action, Strategy, Technical Analysis, Trading Tags: , , , , , , , , , Leave a comment

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investment thoughts on Japan, post earthquake

March 15, 2011 By in Asian economic development, economics, Japanese development, Recent Market Action, Strategy Tags: , , , , , , , , , , Leave a comment

the earthquake

The Japanese government is calling last Friday’s severe earthquake and resulting tsunami the worst disaster to befall the country since the Second World War.  Early estimates suggest that at least 10,000 are dead, and perhaps many more.  Hundreds of thousands are homeless.  Severe damage to nuclear power plants in the worst-affected prefectures, north of Tokyo, has necessitated rolling electricity blackouts in Japan for the first time in a half-century.

investment implications

This is a terrible human tragedy.  But today I’m taking off my hat as a human being and putting on my hat as a portfolio manager to write about what I see as the major investment implications of last week’s event.  They are:

1.  The yen will have a short-term tendency to rise, as insurance companies liquidate foreign investments and bring money home to pay earthquake-related claims.  Both individuals and companies will do the same thing.  In the months after the Kobe earthquake of 1995, for example, the Japanese currency rose by about 20% against the dollar.  If so, export-oriented firms will struggle some more.

2.  Technology-related parts shortages are possible, but I think they’ll be less serious and shorter in duration than commonly expected.  Several reasons why:

–In the thirty+ years I’ve analyzed companies it has invariably been the case that the damage to industrial plants due to explosions, wars and natural disasters is initially overestimated–usually by a lot.

–Ingeniously jerry-rigged solutions to production bottlenecks are almost always found.

–Ex autos, Japan isn’t the cutting-edge technology giant it was twenty-five years ago.  It’s major IT products are commodity semiconductors, glass for flat panel TVs and monitors, and consumer electronics thingamajigs, like capacitors and connectors.

–The earthquake missed the industrial heartland south of Tokyo, where most of the country’s factories are located.

–Korea, Taiwan and China make adequate substitutes for almost everything (ex autos) that Japan produces.  These areas can take up at least part of any slack from Japan.  For example, TXN, one of the few international firms announcing significant damage, says it has already found replacement manufacturing capacity for 60% of the output from its Japanese fab in Miho.

3.  Electric power may be an issue for some time.  The obvious reason is that it will take a while to fabricate and install new nuclear power plants.  NIMBY is another issue, especially if damaged reactors begin to release radiation.  In addition, I think there are two non-obvious factors at work here as well:

–The main political platform of the post-WWII Socialist Party in Japan was anti-nuclear weapons, based on the damage done at Hiroshima and Nagasaki.  After the Cold War ended, the Socialist became the Social Democrats.  Their anti-nuclear stance transmuted itself into one against nuclear power plants.  The 21st century successor to the Social Democratic Party is the Democratic Party of Japan, which is in power now for the first time since a brief stint (before self-destructing) over twenty years ago.  Will the DPJ be as aggressively pro-nuclear as the Liberal Democrats, the other main party, were?  I don’t know…but probably not.

–The predominant feeling today is that the half-dozen or so nuclear reactors that aren’t completely stable or that have already failed, have done so because no one planned for a 9.0 magnitude earthquake or a tsunami.  I hope that’s right.

But in my experience, Japanese managers are under intense social pressure–in a way I as an American can’t really understand–to produce products that are up to specifications, and delivered on time and on budget.  It’s virtually impossible for a manager to endure the shame of letting down his company, his coworkers, his neighbors, the people he went to school with…by telling his boss he can’t do so.  That’s true, even if the requirements are completely unreasonable.

A manager may resolve this conflict by building a sub-standard product and asserting that it does indeed meet required specifications.  I’ve seen this phenomenon in many Japanese companies, including (unfortunately) one or two that I’ve owned, where apparently no one has checked the manager’s work.  Any hint of this practice in the nuclear reactor post-mortems could delay the approval of new nuclear plants.

Update: the LA Times suggests that two separate worker errors at one of the nuclear power plants owned by Tokyo Electric Power have increased the chances of a significant release of radiation into the atmosphere in Japan–escalating the political and stock market crisis there.  It now seems to me that the odds of an anti-nuclear backlash have risen significantly.

4.  Infrastructure being rebuilt will be state-of-the-art, and very energy-efficient, particularly so if there are delays in adding to electricity-generating capacity.

5.  What the private sector rebuilds, and where, is open to question.  Individuals will likely rebuild their houses, though perhaps on a more modest scale than they had.  But corporations with a freshly signed check in hand may opt to move production overseas, something they might feel constrained from doing under normal circumstances.

early stock market reaction

The Japanese stock market opened on Monday down almost 10% on news of the earthquake/tsunami damage but rallied to close down about 6%.  As I’m writing this on Monday night, another reactor explosion has been announced and the TOPIX is down another 4%.

Some people are arguing that this decline represents a buying opportunity.  They reason that money policy will be accommodative enough, and that reconstruction spending will give the economy a big enough fiscal boost, to break Japan out of the malaise it has been in for two decades.

I don’t agree.  I think that the core Japanese economic problem is its decision to defend the status quo of the 1980s rather than let creative destruction reshape the country to meet current and future needs.  The country has chosen to retain a traditional way of life, even if that means no economic growth.  While this remains so,  I continue to think that Japan is reduced to being a special situations market, not one you need to have general exposure to.  Of course, the current downturn is giving you a chance to buy special situation names relatively cheaply.

In New York, COH and TIF both sold off by more than 5% on Monday, on worries about their Japanese businesses.  I guess I can’t quarrel with that, given that both stocks are up 50% or so in the past six months.   Declines in LVMH or Hermès, which were down on the day by 2.5% and 3.5% respectively, despite the fact that both have arguably more to lose in Japan that either TIF or COH.  On the other hand, the Europeans haven’t been the recent market stars that the American firms have.

The main point with any foreign luxury goods firm in Japan, however, is that the market there went ex-growth during the recent recession.  Western companies have since switched strategies from expansion to extracting their invested capital as quickly as possible.

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