Monthly Archives: June 2011

are South Korea and Taiwan emerging markets?: implications for index mutual funds/ETFs

June 12, 2011 By in Current Market Thoughts, emerging markets, ETFs Vs. Mutual Funds, Purchasing power parity (PPP) Tags: , , , , , , Leave a comment

Korea and Taiwan aren’t emerging economies…

Korea has been a member of the Organization for Economic Co-operation and Development, the association of developed nations, since 1996.  Taiwan would presumably be a member, too, if it were not for China’s insistence that Taiwan is not a separate country, but a prodigal province of the mainland.

On a GDP per capita basis, Korea and Taiwan rank #33 and #37 in the world, respectively, just above the Czech Republic, which is also an OECD member.  On a Purchasing Power Parity basis, the two rank #25 and #20 by their per capita GDP–around the same level as the UK, France and Japan.

Looking at their place in world trade, neither is an exporter of raw materials or agricultural products in the way Australia or New Zealand (both classified by index compiler MSCI as developed countries) are.  Instead, both sell advanced technology and machinery products, like computers and smartphones.

…but their stock markets aren’t well-developed.

My experience is that company financial statements aren’t reliable in either country.  Neither governments nor company managements in either country care to have foreigners as shareholders, and treat them poorly.  There’s also a significant amount of intrusion into market workings by politically powerful entities in both.  The fact of this interference isn’t the issue; that happens everywhere.  It’s the extent–and maybe my lack of familiarity with the local rules–that bothers me.  In this regard, both Taiwan and Korea seem to me like Japan, only on steroids.

Every one of these factors is characteristic of emerging markets, not developed ones.

is MSCI about to reclassify both stock markets as developed?

There’s nothing new about what I’ve written above.  It’s been the situation for at least a decade (in stock market terms, it was worse before).

What is new, however, is that both the Wall Street Journal and the Financial Times have published recent feature articles suggesting that the MSCI will reclassify both Korea and Taiwan as developed markets later this month.

that might be an issue for holders of emerging markets index funds/ETFs

I’m most familiar with these entities in the US, but I think what I’m saying holds true for EU funds/ETFs as well:

Mutual funds/ETFs are both instances of a special type of corporation that is exempt from corporate tax.  It gains this exemption by, among other things, distributing all income (net of expenses) and realized capital gains to shareholders–who must pay tax on them.  Typically, distributions are made once annually, shortly after the tax year for the fund/ETF ends.

Together, Taiwan and Korea make up about a quarter of the MSCI Emerging Markets stock index (the largest other index constituents are China and Brazil).  If both countries are reclassified, index funds/ETFs will be required by their charters to sell all their Taiwanese and Korean holdings and reinvest the proceeds back into the revised Emerging Markets index.  That will presumably generate a large capital gain to be distributed to shareholders.

four quirks about a possible distribution

1.  It’s a fact of life about funds/ETFs that the holder who pays tax on a fund’s capital gain is the person who receives the distribution–not necessarily the person who enjoyed the rise in price of the stock that’s been sold.  If you buy a fund/ETF share today and receive a massive capital gains distribution tomorrow, you’re on the hook for any tax due, not the holder of the share while the capital gain was being amassed.

2.  Any distributions are net of any accumulated realized losses.  In the case of the Vanguard emerging markets index fund, which I hold, it had unrealized gains of $7.5 billion on April 30, 2011, the date of the most recent semi-annual report, but accumulated losses of $2.4 billion.

3.  Distributions are usually made at the same time every year.  For US funds, which typically have an October tax year, distributions come most often in late November or early December.  But a distribution can be made earlier–and often is, if the fund manager fears shareholders intend to sell their holdings to avoid receiving a large taxable distribution.  In other words, a Taiwan/Korea-related distribution could come as early as in July.

4.  Virtually everyone who buys a fund/ETF signs up for automatic reinvestment of distributions, so that the distribution itself results in almost no outflows. Only anticipatory sales, made to avoid a distribution, do that.

fund groups aren’t talking

I called up Vanguard the other day to ask about this issue.  My own back-of-the-envelope reckoning is that a distribution from the Vanguard emerging markets fund, if any, will be small (25% of the accumulated unrealized gains of $7.5 billion would be $1.9 billion, less than the $2.4 billion in accumulated losses).  And I own my fund shares in an IRA, so a distribution doesn’t affect me, in any event.  But I was curious.

My Vanguard representative was aware of the issue, but said everything depended on what MSCI does later this month.  I asked for the April 30th tax situation for the fund, but she wasn’t able to find it.  I looked it up online after I hung up.

relevant tax data are easy to find

Look for the latest annual/semiannual/quarterly report for your fund/ETF.   It will have a list of holdings and their market value (but not their individual cost basis).  At the end of the list, there’ll be aggregate cost and market value data.  In a section following right after that, the fund will show its accumulated realized losses.

2008 is a key year

The emerging markets index lost over half its value that year.  Although there’s no way of being certain with any individual fund, twenty some years of managing this type of money tell me that all the redemptions that created Vanguard’s accumulated losses came at the bottom or shortly after–probably in large part from people who bought shares in 2007.

Any fund/ETF that’s large now but was just getting started in 2008 probably has little in the way of accumulated losses to offset realized capital gains.  Entities like this are where the risk of a large taxable distribution are highest, in my opinion.  We’ll know more on June 21st, when MSCI does its next revision of the index.

 

will INTC make tablet/smartphone chips for AAPL: the AAPL point of view

June 10, 2011 By in Industry Analysis, Stock ideas, Technology, Wireless Tags: , , , , , , , 1 Comment

Yesterday I wrote about this topic from the INTC point of view.  My main thought:  INTC is an attractive stock to own whether the answer to this question is yes or no, so you don’t need to figure this out to be a holder of the stock.  Having AAPL as a foundry customer would be a useful vote of confidence in INTC process technology, but it’s not necessary.

For AAPL, the answer isn’t so easy.

If we turn back the clock to the beginning of the year, AAPL was buying the processors for all of its Macs from INTC and having the ARMH-based chips it designs itself made by Samsung.  Why the split?

the semiconductor “arms race”

In simple terms (which is the best I can ever do), ten years or more ago the high cost of owning a fab forced the semiconductor makers to morph from integrated design/manufacturing firms to the current situation, where a large number of companies design chips and another, smaller and very capital-intensive, set makes them.  The design firms generally customize templates created by ARMH.

ARMH-based chips tend to be highly flexible and to consume little electricity.  But they lack raw processing power.   INTC, one of the few companies big enough to follow the older integrated model, makes chips that have immense processing power but aren’t very customizable and use a lot of electricity.  Mobile devices use ARMH chips.  PCs and servers use INTC chips.

ARMH is trying as hard as it can to boost the processing power of its offerings, so they can displace INTC chips in PCs.  The light bulb finally went on at INTC a few years ago that much of its market had changed and th customers no longer were lining up to buy the latest chip INTC engineers chose to fabricate.   INTC is now racing to make chips that customers wnat–that is, ones that are more flexible and use less power.

APPL’s situation

Mac:  Until 2005, IBM made the logic chips AAPL used in its Macs.  But this was, for IBM, a low-profit business that the company wanted to deemphasize.  As a result, IBM was unable/unwilling to produce the volumes AAPL needed.  INTC chips were better, and were readily available.  AAPL switched.

iPad/iPhone:  Several years ago, AAPL started an in-house effort to design ARMH-based chips to use in its smartphones and tablets.  It selected Samsung, another integrated firm and a competitor in the phone/tablet market, as its foundry.

Samsung trouble

But AAPL is now suing Samsung for copying its smartphone and tablet designs.  And, according to the EETimes, APPL is also beginning to shift its foundry business away from its Asian rival–presumably because of this.

Where should AAPL go?

One possibility is a foundry like TSMC, UMC or Globalfoundries (the combination of AMD’s former manufacturing + Chartered Semiconductor).  Another is INTC.

why INTC?

With either “pure” foundries or with INTC, APPL’s intellectual property will be equally safe.

The foundries would presumably be lower cost.  Also, they all have, to different degrees, databases of intellectual property that APPL could use.

On the other hand, INTC has a one-two year lead in process technology.  This means a chip design it produces for AAPL today on its machines would be smaller, faster and use less electricity than the same design made by a foundry.

TSMC is the safe choice

The safe choice for AAPL would be to go with TSMC.  It’s also the option that opens AAPL to the least second-guessing.  The main distinguishing features of the iPhone or iPad using TSMC chips would be the aesthetics of the device’s appearance, the app store and the status value of the Apple brand.

Also, if INTC is the permanent invalid that the stock price suggests, by selecting TSMC AAPL may dodge any future trouble that a weakened INTC may generate (what that might be, I have no idea–the worry would be that something would adversely affect the quality of foundry output).

the risk

On the other hand, it’s possible that some other tablet/smartphone maker–Asus, Acer, even Nokia–might link up with INTC instead.  If the INTC process technology works as claimed, then non-Apple devices would start to appear that process data faster and have longer battery lives than AAPL’s.  The “cool” factor might then start to pack up and leave Cupertino for Finland or Taiwan.

It will be interesting to see which choice AAPL makes.

 

 

 

will INTC make tablet/smartphone chips for AAPL?: the INTC view

June 9, 2011 By in Industry Analysis, Stock ideas, Technology, Wireless Tags: , , , , , , , , Leave a comment

recent analysts’ reports

A few days ago,Forbes published an article highlighting a report by Glen Yeung, an analyst from Citigroup, saying that AAPL will use INTC as the manufacturer for the advanced tablet and smartphone chips that it’s designing in-house.  Thsee chips will use ARMH designs, but INTC’s fabrication know-how.  Later on, speculates Yeung, AAPL could shut down its own design effort (more likely sell it to INTC, in my opinion) and rely 100% on INTC for both design and fabrication.

Similar reports have been circulating for at least a month.  In  typical Wall Street fashion, they follow a spate of other analysts’ output claiming exactly the opposite!!  –that AAPL, which uses INTC to power all its Macs, will ditch INTC entirely in the next year or two, in favor of its own ARMH-based chips.

important?

I think this issue is interesting for three reasons:

–stuff like this is fun to talk about,

–what APPL decides now may be important to the market share it eventually stakes out in the tablet business, and

–contrary to what you may think, what AAPL decides makes no difference to the positive case for INTC stock.

I’m going to write about this last point today.

my take on INTC

1.  What catches most people’s eye about an advanced semiconductor plant, other than it requires highly specialized craft skills to run, is that it costs at least $3 billion to build.  That’s the wrong thing to focus on.  What’s more important is that to operate the plant effectively, you have to be able to sell the $7 billion+ of output it is capable of churning out annually.  If you figure the selling price of each unit at $100, that means 70+ million units a year.

If you don’t have a market that size, you’re not only pouring $3 billion down the drain by trying to make chips yourself, you’re ensuring a constant flow of red ink until you shut the plant down.

In other words, in today’s world it only makes sense for Intel, Samsung and third-party foundries like TSMC to build and  operate cutting-edge semiconductor plants.  ( In 2Q11, AAPL sold 3.8 million Macs and 4.7 million iPads;  that works out to about a 34 million units a year.)

2.  INTC is the best operator of advanced semiconductor plants in the world.  It has maybe a two-year lead over TSMC in process technology.

3.  The yin of mobile computing–the small size, low power market that INTC has missed up until now–has created a yang of demand for high power corporate servers and cloud computing that plays to INTC’s traditional strengths.

The fast growth of emerging economies over the past decade has created a large market of first-time computer buyers.  Unlike buyers in the US or the EU, who want tablets and smartphones, these customers want the high power laptops INTC has traditionally excelled at.

These businesses combined make up the majority of INTC’s profits today and are growing very rapidly.

4.  INTC’s stock has been such a poor performer recently that it’s now trading at about 9x earnings and yielding a tad below 4%.  If its consumer business in the developed economies were to completely vaporize today (including, of course, its Mac business with AAPL), I think the stock would still be trading at under 15x earnings and yielding more than Treasury bonds–but would be showing growth of 20%+.

5.  INTC had a management change a few years ago.  The new guys have been working very hard on delivering the small size, low power use chips that smartphones and tablets require.  So far, what they’ve done hasn’t been good enough.  But they’re making fast progress.  And who knows?

I think INTC now has a much better management than investors are giving the stock credit for.  But the real point is that at 9x and a 3.9% yield, the stock looks to me to have factored the worst possible outcome for the company’s business–and then some. So downside seems limited to me (remember, I own the stock), and hte upside oculd be large if INTC’s chips in 2012 onward perform as advertised.  Sure, having AAPL use INTC as a foundry would be a plus, but–yes or no–it doesn’t alter the fundamental positive case for the stock by much.

 

thoughts on the May jobs report (II): stock market implications

June 8, 2011 By in Current Market Thoughts, economics, emerging markets, employment, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , , , Leave a comment

capping the upside

The main conclusion Wall Street seems to be taking from the May jobs report and yesterday’s Bernanke speech (growth is slowing, no new stimulus measures) is, I think, the correct one–that, as investors, we can no longer imagine an unlimited upside to the US economy.  We’re probably not going to be putting 1-2 million now-idle workers back on the job in the coming twelve months.  So the economy won’t be benefiting from a surge in pent-up demand as these extra paychecks are spent.

The reality is that the top 20% of the country by income does the majority of consumer spending, and that another .7% added to the workforce won’t change the GDP numbers in any noticeable way.  It’s the dream that next year’s eps will be at least up x% that’s fading.

looking at the numbers

As I mentioned yesterday, the earnings of the S&P 500 are composed roughly of 50% domestic profits, 25% from the EU and 25% from emerging economies.  If we were to say that US and EU profits will be up by 5% each next year and those from emerging markets will gain 20%, the result is that aggregate S&P earnings would likely rise to $110 from the $100 I’m penciling in for 2011.

If we apply a 13x multiple to these earnings, that would imply that the S&P could be trading at 1430 twelve months from now.  That, in turn, would suggest that at, say, 1250 the S&P is a compelling alternative to other publicly traded asset classes.

imponderables (two of them)

1.  is a 13x multiple the right one?  My guess is that it’s a bit too low.  The counterargument is that the US has lost the special place in the world that it has held since World War II as the economic and political leader of the globe (see Jeffrey Sachs’ op-ed about the IMF in the Financial Times on May 31–“A manifesto for the fund’s new supremo” for an example of what many people, especially outside the US, are thinking).

A slow domestic economy suggests interest rates are going to remain lower than Wall Street has thought, and for longer than expected.  This should imply a higher than usual pe multiple for the stock market.  But the idea that the US is politically adrift and lost in dreams of past glory argues in the opposite direction.

Who knows which factor will dominate?  For lack of any better insight, the consensus may well call them a wash.

2.  can the stock market be strong if the economy isn’t?   We have (at least) two relatively recent examples that address this question:

–Japan post-1989.  During the subsequent “lost decade” in Japan, export-oriented industrial companies went from strength to strength in profit terms while domestically-oriented firms collapsed.  The former were outstanding relative performers in a terrible overall market.  But investors made little actual money by holding them.

–US post-1974.  During the subsequent several years, the market went sideways.  But large stocks went down substantially while smaller companies like Wal-Mart or Toys-R-Us went up like rockets.

The difference in these two cases?  In the first, local investors were unable to distinguish between the fortunes of the overall economy and those of individual companies.  In the second, they were.

Today?  Traditionally, American investors have been highly skilled stock pickers–by far, the best in the world at individual stock analysis.  But the rise of trader-run, commodity/derivative-oriented hedge funds since the turn of the century has refocused the market to some degree.  And the firing of the most experienced brokerage house analysts in cost-cutting moves over the same time frame hasn’t helped.

My bottom line: I think individual stock selection will turn out to be very lucrative in the mildly uptrending market I envision.  But the ride could be unusually bumpy, due to political and hedge fund headwinds.

thoughts on the May jobs report: (I)

June 7, 2011 By in Current Market Thoughts, economics, emerging markets, employment, Employment Situation report, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , , 1 Comment

Yesterday,  I wrote about the bare bones of the May Employment Situation report issued by the Bureau of Labor Statistics.  Job growth for the month dropped from the recent rate of around 200,000 job additions to 54,000.

More data:

Commenting on the May Employment Situation, the BLS says there’s no obvious statistical anomaly that might lead one to think the low job additions number will be revised away in coming months’ reports.  Also, if the slowdown were due to economic disruptions in Japan caused by the Fukushima nuclear disaster in March, we should be seeing a decrease in hours worked, as parts-short factories slow production.  We don’t.

Outplacement agency Challenger reported a couple of weeks ago that job security for those currently employed is rising.  In addition, company plans for layoffs are the lowest they’ve been in over a decade.  The anticipated layoff rate is 80% of what it was a year ago, and only about a quarter of what companies were figuring to do  during early 2009 (the low point for the economy).

I’ve also read a report recently (no citation–I’m writing this from a B&B in Colorado and will post a link when I get back home) indicating that companies were increasingly willing to pay to relocate potential hires because they can’t get the skills they need in the local labor market.

Recent earnings reports seem to indicate that US consumers are increasingly trading up, and are spending more (sometimes, a lot more) on discretionary items.  TIF, for example, just posted very strong results.  The company said it was seeing strength across the country and that each month of the April quarter was stronger than the previous one.  More expensive items are the best sellers.

my thoughts

Looking in rough terms, an unemployment rate of 9% means 91% of the workforce is employed.  An unemployment rate of 5% would be full employment.  So, putting aside questions about the long-term vitality of the US economy, which involves “cosmic” considerations about whether/how our legal and political framework encourages economic growth, the near-term unemployment issue involves about 4% of the workforce.

Given the distribution of incomes and wealth in the US, this 4% represents far less than 1% of potential US consumption.

As far as we can determine (the issue is one of corporate disclosure), half the earnings of the S&P 500 come from outside the US.  We can roughly divide that into 25% from the EU + Japan and 25% from emerging markets.  In other words, whether unemployment in the US is 9% or 7% makes virtually no difference to S&P 500 profits over the next year or two (or three or four).

There are investment issues, however.

They have to do with the multiple placed on earnings whose future course is somewhat less certain, and about sector/industry weightings and individual stock selection.

I think there may also be, for lack of a better word, a “transition” issue, as conventional wisdom about the preeminent position of the US economy in the world, and the relationship between the course of the US economy and the S&P 500, are questioned.

More tomorrow.