Monthly Archives: September 2011

is a Chinese bailout of Italy in the cards?

September 13, 2011 By in Asian economic development, China, economics, emerging markets, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , , Leave a comment

the situation

The S&P 500 spiked upward into positive territory toward the close of New York trading yesterday.

Why?

The Italian government announced that:

–it had sent a delegation to Beijing last month to speak with state-controlled investment companies there about making major investments in Italy, and that

–a delegation of Chinese investors arrived in Rome for follow-up discussions last week.

Italy’s in trouble

 

The European Central Bank has been supporting Italian bond prices by buying in the market, but indicates that this help is only temporary.   The consensus view is that, in contrast with Greece, Italy is too big for an EU bailout to handle anyway.

According to the Financial Times, which reported the news online yesterday, China already owns about €75 billion of Italy’s €1.9 trillion in outstanding government bonds.

not a great place to invest, but…

On the surface, Italy wouldn’t seem like anyone’s first choice as a place to invest.  The Rome government is inefficient and dominated by the business and political interests of the Prime Minister, Silvio Berlusconi.  Financial practices in Italy are opaque; industry is dominated by a small coterie of insiders who shape the rules for their own benefit.  The establishment is also very hostile toward foreigners (of course, in China’s case that makes Italy no different from the US or anywhere else in the EU).

On the other hand, Italy may have no choice but to deal with China.

what I think China wants

Italy wants China to buy large amounts of its government bonds.  I think China is willing to do that.

However, that’s not what China itself really wants.  I think bond purchases only come in return for China’s ability to invest in:

—natural resources, a minority stake in the oil company ENI, for example.  Not just a passive interest, either.  China would also want the right to buy specified amounts of output–at market prices–in order to ensure supply of industrial raw materials in times of shortage.  Maybe China would also like to be able to invest side-by-side with ENI in future projects.

—a bank or other financial institution.  It’s a fact of life around the world that no one ever gets to buy a healthy bank.  It’s only ones that have horrible loan books that go on sale.  So buying one that it would immediately have to prop up probably wouldn’t bother China too much.  It’s the inside access to the EU that owning an EU financial institution brings that’s important.

—stakes in industrial companies–state-controlled or not–where China can offer privileged access to the China market in return for technology transfer.  China is already doing this in Japan.  If business could be done in renminbi, so much the better.

will any deals materialize?

It’s hard to say.  But it strikes me that if Italy is serious, the chances of finding mutually acceptable terms are very high.  China is being frozen out of the US and other parts of the EU; Italy has few other options.  China wants access, and is probably less concerned about money; Italy needs cash.

investment implications

There’s at least some chance of a sharply positive turn away from the psychology of worry that now dominates investor thinking about the EU periphery.  Not something to bet heavily on now, I think, but something to monitor carefully.  (The ultimate buying target for us, in my opinion, is well-managed EU multinationals with substantial non-EU businesses.  Speculate at your peril about what trashy Italian companies China might invest in.)

 

 

 

Juergen Stark quits the European Central Bank and stocks sag: why?

September 12, 2011 By in Banks, Current Market Thoughts, Industry Analysis, Recent Market Action, Strategy Tags: , , , , , , , , , , Leave a comment

resignation last Friday

Jürgen Stark, a respected and politically-connected economist representing Germany on the ECB, resigned from that body’s board on Friday at about the time US markets opened for trading last Friday.  You can see the sharp drop in stocks that followed the announcement of this news.  Why?

some background

1.  Deeply scarred by the hyperinflation of the Weimar years after WWI, Germany has always been the strongest advocate of price stability (i.e., no inflation) in modern Europe.  Unlike the US, which is willing to accept a moderate amount of inflation (currently the upper bound is 2% or less–and we wish it could get that high) in return for faster GDP growth, Germany is willing to sacrifice almost any amount of growth to maintain stable prices.

As a result, Germany has traditionally acted as the economic “policeman” of Europe, enforcing sound fiscal and money policy rules and acting as a lightning rod to deflect local political criticism in the rest of the EU for governments taking unpopular but necessary economic actions.

Mr. Stark’s resignation from the ECB for “personal reasons” –but apparently in protest over the ECB’s decision to prop up the finances of weaker EU member states by buying their bonds–suggests the ECB is deciding/has decided to break with the traditional no-inflation-first policy stance.

2.  Mr. Stark is the second German official to resign from the ECB in recent months.  In February, Axel Weber resigned as head of the German central bank and withdrew from consideration to head the ECB–apparently with similar concerns to Mr. Stark’s.

3.  The Stark resignation may cause enough political fallout inside Germany to force the Merkel government to say openly whether it approves of ECB actions.  So far, Germany has been pretending it doesn’t see the drift away from the traditional German policy stance and just, little by little, letting the drift continue.  I’m not an expert on internal German politics.  But it doesn’t seem clear whether Germany would back Ms. Merkel vowing unconditional support for a Greek bailout–meaning German taxpayers would foot a large part of the bill.

stock market reaction

World financial markets are acting as if the Stark resignation is the tipping point that will force the EU to stop hoping the problem disappears and confront the fact that Greece can’t service the large amount of euro-denominated sovereign debt it has amassed since joining the EU.

possible solutions

In general terms, two approaches to resolution are possible:

–the German price stability mentality holds.  If so,

Greece will be allowed to default.  Holders of Greek sovereign debt, including big EU banks which are stuffed to the gills with these bonds, will suffer large losses.  The problem with this solution is that the markets will just turn to the next country with wobbly finances–Portugal or Spain–and the whole destabilizing question of bailout or not arises anew.  Look at the Asian debt crisis of 1997 if you don’t think so.

–the EU as a whole assumes responsibility for the sovereign debt of weaker members.  There’d have to be some mechanism for ensuring that a repeat of their debt expansion doesn’t happen.  To the stronger countries’ eyes–and certainly to Germany’s–this has to look like a rerun of the reunification of the two Germanies after the fall of the Berlin Wall.  A decade of economic stagnation followed.  So this solution (which I think is more likely) probably also entails a bias toward a weaker euro and tolerance of a bit of inflation.

what do investors do?

Solution 1 is bad for Greece, and bad for banks and other financials that hold Greek debt.  It might just shift the focus of worry away from Greece to Portugal or Spain.

Solution 2 is bad for the less-indebted EU members and bad for the euro.

The intersection of the bad-ness is the financial companies in the less-indebted EU countries.  So for traders, selling them is a no-brainer.  Even if these stocks are the epicenter of weakness–and they have been so far–arbitrage tends to drag everything down.  So just selling anything in the EU is a close second choice.

If there’s any silver lining to the selling, it’s that it may force a resolution to the Greek debt issue.  A sharp market decline may provide the political cover EU authorities feel they need before they act in a way that could threaten their ability to be reelected.  Also, as the selling exhausts itself, there may be an opportunity to pick up the stocks of well-run EU-based multinationals at a cheap price.

 

 

 

US stocks are moving in unusual lockstep: what’s going on?

September 11, 2011 By in Current Market Thoughts, Derivative instruments, hedge funds, Portfolio management, Recent Market Action, Strategy, Trading Tags: , , , , , , , 2 Comments

strong correlation

Recently, the 250 largest stocks in the S&P 500 have been marching up and down in formation with one another 80% of the time.  This compares with 30% of the time in normal circumstances, according to a Financial Times report of a study by JP Morgan.

That correlation is higher than during last year’s “flash crash,” when a hapless midwestern portfolio manager ordered his trading room to sell massive amounts of stock index futures without regard to price.   It’s also higher than at the market bottoms in 2003 and 2009.  In fact, the lockstep movement of the biggest S&P names is at its highest since Black Monday in October 1987, a time of immense panic as an unprepared investing world witnessed for the first time the power of stock index futures to move equity prices.

What’s going on?

As the 30% number above indicates, most of the time investors in the American stock markets trade to rearrange their holdings as new information about individual companies emerges.  We sell stocks we think are overvalued and reinvest the proceeds in stocks we think are undervalued.  We also respond to changes in the overall economic environment by buying economically sensitive issues and selling defensive ones, or vice versa.  We typically don’t try to time the market by raising cash.

The movements analyzed by JP Morgan are different.  They represent asset allocation shifts into stocks (and away from cash and bonds) or away from them (and into fixed income)–rather than rearranging the “cards” in the hand the portfolio manager is playing.

Two–maybe three–points:

1.  US stock portfolio managers don’t act this way.  Yes, almost everyone is able to sell stock index futures against stock positions earmarked for sale, in order to raise cash more quickly.  But the few people who actually do this are too small to create the effect we’re seeing.

2.  The selling we’re seeing is more characteristic of EU-based managers, who tend to manage balanced portfolios (i.e., portfolios that contain both stocks and bonds) and to use top-down asset allocation techniques to decide what they hold.

In addition, if there’s going to be a recession any time soon it’s going to be in the EU, so EU manager selling would make some sense.  Trading-oriented hedge funds may be taking the other side of the transactions.

3.  More important, this behavior is typically a sign of very strong emotion–mostly fear.  In my experience,  a high level of panic is so psychologically exhausting that it can’t be sustained for a long time.  Also, it typically only occurs at significant turning points in the market.  Normally at least a “relief” rally follows.

I don’t expect a big rally this time, however.  To the degree that the current sellers are reallocating assets they own, rather than speculating on the future course of markets, they’ll eventually run out of stuff to sell (or recover their equilibrium) and their influence on the S&P will gradually fade away.  I think a sideways market, where stock pickers rule, will emerge.

I’m often too early, but I’m starting to see hints in the past few days that this is already starting to happen.

 

 

how much is Yahoo worth?

September 9, 2011 By in China, emerging markets, Industry Analysis, internet, Japanese development, Stock ideas Tags: , , , , , , , , , , Leave a comment

YHOO’s financials

This is a first pass through the YHOO financials.  Although the company’s statements have the same strong appeal for a puzzle-solver as sudoku or the NY Times crossword puzzle, I don’t think I’m going to do any more.  Why?  This is a situation where a value investor’s experience and instincts are important, not those of a growth investor like me.

But I do know something about China and about Japan–which, along with the erratic behavior of YHOO’s management, seem to me to be the big wild cards here–so I think my comments have some value.

Here goes:

the parts

YHOO consists of four parts:

1.  Working capital on the balance sheet of $2.6 billion.

2.  A 35% equity interest in Yahoo Japan (4689:JP).  That stock closed at ¥24,500 per share overnight, giving YHOO’s holding of about 20 million shares a value of $6.4 billion.  Despite its large interest, YHOO is more or less a passive investor in 4689, which is controlled by the Japanese internet firm Softbank (42% interest).   [I went to Yahoo Finance first to get the stock price information, but the site didn’t have it.  Google Finance did.]

YHOO recorded about $350 million on its income statement as its share of Yahoo Japan’s earnings last year, but actually only received cash of $61 million in dividends.

3.  A 43%  primary (meaning, as things stand now) equity interest in the Alibaba Group, or 40% fully diluted (meaning after any warrants, stock options, convertibles… are exercised).

YHOO acquired its holding in Alibaba, a private mainland Chinese company, in 2005 in return for $1 billion in cash plus YHOO’s China search business.  Alibaba, which also has Softbank as a minority shareholder, runs the Chinese equivalent of eBay and Paypal.

According to YHOO (p. 76 of the 2010 10-K), Alibaba had revenue of $1.3 billion, up 77% year on year, in 2010 and made a slight accounting loss.

YHOO’s balance sheet carrying value–based on its purchase price–is $2.3 billion.  But Alibaba is growing very fast.  Its revenues today are triple what they were two years ago–no mention of revenues in either the 2005 or 2006 YHOO 10-Ks.

Let’s just make up a number for asset value.  If Yahoo Japan is worth 3x carrying value, Alibaba should easily be worth 4x, probably more.  But 4x carrying value = $9.2 billion.

4.  The rest of YHOO.  This is a shrinking business that generated about $1 billion in cash last year.  If you ran this part of YHOO for maximum cash generation until the flow turned negative and then closed it down, it might be worth $5 billion.  Maybe you could sell it for $3 billion today.

the sum

$2.6 billion + $6.4 billion +$9.2 billion + $5 billion   =   $23.2 billion, or about $18.50 per share.  Even though Yahoo Finance didn’t have a quote for Yahoo Japan, it did list a price target for YHOO shares a year from now.  It’s $17.62.

the issues

I think all the numbers are pretty solid except for Alibaba, which is 40% of the total. That’s an issue.

potential plusses

1.  Top management of YHOO hasn’t covered itself in glory over at least the past half-decade.  Still, the Yahoo brand name is a powerful asset.  Maybe the core company would be worth a lot more if put in more competent hands.  Let’s dream.  Add $5 billion to asset value?

2.  Alibaba is in its early growth days.  I may be undervaluing it significantly.  Add another $5 billion to asset value?

So YHOO’s value might be $26.50 a share?

potential minuses

1.  Masayoshi Son of Softbank controls Yahoo Japan, not YHOO.  Mr.Son was a corporate outsider with a somewhat suspect pedigree when he struck his deal with YHOO.  He’s now firmly inside an establishment that protects its own fiercely against the possibility of foreign interference.  Basically, YHOO has no power in this relationship.

Cellphone-based social networking companies have displaced Yahoo Japan much in the same way that Google and Facebook have supplanted YHOO.  Arguably, even at 15x earnings Yahoo Japan’s stock price is inflated by local stock market investors who see it as a defensive holding during a time of economic turmoil.

Who would buy 4689 from YHOO?  Softbank gains nothing by doing so.  A 1% dividend yield isn’t particularly attractive.  Any private buyer would put himself into the same powerless situation YHOO is in now.  A secondary offering would have to come at a significant discount, I think.  Selling a third of the company this way might take years.

2.  Jack Ma controls Alibaba, including a portion of its Alibaba voting rights that YHOO has ceded to him.  After his unsuccessful attempt to buy back YHOO’s holding earlier this year, Mr. Ma has begun to take important profit contributors out of Alibaba, starting with Alipay, the group’s Paypal equivalent–whether other shareholders like it or not.

In this case as well, I don’t see that YHOO has any real power.  Beijing may well be happy to block any potential sale, especially to another foreigner.  Mr. Ma may also have a contractual right to do so (who knows?).  How big a discount to intrinsic value would you require to put yourself into the poor bargaining position YHOO is in?    …probably a very big one.

3.  taxes.  Suppose both the Alibaba and Yahoo Japan stakes could be sold.  Under normal circumstances at least 20% of the sale price would go to some government tax collector–maybe more.  YHOO says it can’t find a tax-efficient way to get sales done.  Taxes could shave $4 a share off a sum-of-the-parts value.

4.  details of the joint venture contracts.  YHOO says it’s taxes.  I think there are no buyers–although not many sellers have gone broke by underestimating the intelligence of private equity/hedge fund purchasers.  But there may also be “change of control” provisions in the agreements with Yahoo Japan and Alibaba that either prohibit sale to a third party or significantly disadvantage any new owner.  It’s possible that YHOO doesn’t want to own up to any foolish terms it may have agreed to.

my conclusion

YHOO is a $14.50 stock as I’m writing this at about 11am Friday.  An $18.50 target gives me a 28% gain.  It’s possible that the stock could go significantly higher, if either of my plusses pan out.

But I’m unwilling to bet that YHOO’s board will turn competent overnight.  I think that YHOO will need to make significant concessions to Mr. Ma in order to be able to realize any value that’s in Alibaba.  And Alibaba’s most of the growth story. I think potential minuses outweigh potential plusses.

So I’m going to pass on this one.  It will be interesting to see how the bombastic Mr. Loeb fares in his crusade for change–although greenmail rather than change may be his real goal.

 

 


 

 

why the Fed’s Beige Book is more important now

September 8, 2011 By in Current Market Thoughts, economics, Recent Market Action, Strategy, the Beige Book Tags: , , , , , , , , 1 Comment

the latest Beige Book came out yesterday afternoon

I usually don’t pay much attention to the Fed’s Beige Book.  I read news summaries of its conclusions, but not the report itself.  But I found myself reading the entire thing–52 pages–last night.

Why?

I think we’re at a crucial juncture for the world economy–and therefore for world stock markets.  As investors, we’ve got to decide whether the lurch downward we’ve seen in markets over the summer is a one-time event or not.

My central thesis is that we’re seeing a reaction to the fact that pent-up demand accumulated between 2007 and 2009 has finally been met in the past two years and the global economy is settling down to its true underlying run rate.  Admittedly, by historic standards, it’s a pathetic run rate in the developed world, but we just have to accept reality and move forward.

The other possibility is that we’re seeing the early stages of a widespread economic downturn–and of an accompanying bear market that will last a year or so.  If so, we have in store for us at least one, and possibly two, more downward lurches in stock prices of the type we’ve just seen.

The bottom-line issue is whether we need to get more defensive, and by how much.

what the Beige Book is

The Beige Book is a periodic report by the Fed’s twelve geographic regions about business conditions in their home territories.  Admittedly, it’s anecdotal evidence.  But it’s collected by professional economists from long-standing contacts in their local communities.  The contacts are doubtless flattered to be consulted and are far more frank and complete than they would be if your or I, or a financial journalist, called.  The local Fed knows the important questions to ask, and over time will presumably have gotten a good handle on the strengths and weaknesses of the people it talks to.  So it’s valuable and reliable information.

The report itself has a certain homespun quality to it.  There is a general format–summary, followed by sector information–but there’s wide latitude for local judgment on what information is delivered.  Everyone uses the same typeface, but font size, spacing and margins differ noticeably.  The whole report looks like a bunch of term papers from different students clumped together.

what the current report says

1.  The US economy continues to expand, although at a slower pace than earlier in the year.  The Richmond district is the only one that sees activity weakening.

2.  In most regions, employers want to hire experienced engineers, industrial machine operators, IT specialists, truck drivers or other skilled workers–but can’t find them.  Some firms have switched from hiring full-time new employees to using temps because they’re concerned about the slowdown in growth rate they’re seeing.

3.  Consumer spending is up modestly.  Demand for both new and used autos is surprisingly strong, with buyers looking for less expensive and more fuel-efficient models.  Otherwise, consumers are postponing spending on big-ticket, housing-related items, like major appliances or furniture.  Back to school spending is strong.  Jewelry and women’s clothing are selling well.

4.  Tourism has been strong throughout the country.  Hotels are mostly able to raise prices without losing customers.

5.  Manufacturing is still in the plus column, but slowing down.  This is due mostly to decreased demand from government and financial institutions.  Slowdown in Europe may also be a factor.

6.  Housing and construction remain in the doldrums.  Home remodeling is up.

7.  Bank lending remains flat.  Housing-related demand is from refinancing, not new purchases.

8.  Throughout the supply chain, inventories are generally at desired levels.

9.  In addition to concrete factors, such as declining demand from banks or from European customers, the regions all cite factors like “uncertainty about the economy”, “declining consumer confidence,” and “stock market volatility” as reasons their contacts are giving for becoming more cautious than they had been earlier in the year.  Maybe that’s literally what the hundreds of interviewees are saying.

It strikes me as odd, though, that no one mentions the dysfunctional debt ceiling incident or the sovereign debt downgrade that ensued, or the strong linkage between legislative/administration failure in Washington and immediate declines in consumer confidence.

Maybe the Fed doesn’t want to get sidetracked into a political discussion, maybe “uncertainty” and “volatility” are code words that insiders understand, ormaybe it just doesn’t pay to criticize the boss.

my thoughts

The portrait I see being painted in the current Beige Book is of an economy moving sideways or up modestly–not down.  But expectations among businesses have shifted from thinking the type of robust expansion we saw in 2010 to preparing for much more modest growth.

That’s fine with me, if this is as bad as it gets.  Two consequences:

–I can still have a portfolio that’s based on the idea of finding areas of growth in an overall lackluster economic environment.  I won’t be undermined by widespread economic weakness, so I don’t need to become seriously defensive.  But

—it’s no longer a no-brainer that the benign outcome of at-least-flat will occur. 

So I’ve got to monitor the situation more carefully–and think out more completely how I’d alter my holdings were the economy to begin to shrink.