lower oil prices: stock market implications

falling crude oil prices

It late February, the West Texas Intermediate oil price was $110 a barrel.  Now it’s $80.

North Sea Brent crude, which is much easier to refine and therefore sells at a premium, was at $120 four months ago.  Now it’s at $92.

That’s a price drop of around 25%, even though June is seasonally stronger period for demand than late winter.

That’s good news for consumers, especially in the US.

Here’s why.

a thumbnail sketch of the oil market

Petroleum is a peculiar commodity, for several reasons:

–huge size.   The world uses around 80 million barrels daily.  At the current $80 each, that’s $6.4 billion a day in value, or $2.3 trillion a year.

–disproportionately large consumption by the US.  The US makes up about 4.5% of the world’s population–but uses over 20% of the global oil output.  How so?  It’s partly because the US is a rich country.  But it’s mostly, in my view, the result of long-standing (and misguided) policy in Washington to subsidize an inefficient domestic auto industry.  (We’re the only industrialized country without an effective energy policy, and we’ve been like this for forty years–but that’s a topic for another day).

–supply is very inflexible.  Most pools of oil are buried under great pressure deep beneath the earth.  Draining these reservoirs without drilling a gazillion wells in each is a complex process that involves starting–and keeping for years and years–a steady flow of crude from all parts of the field toward the surface.  In almost all cases, stopping, or even trying to slow down, the flow can be disastrous.

As a result, when demand slows, as it is now, the only way producers can sell their surplus output is to lower the price–sometimes by a lot.

implications of falling prices

There are two major ones for stocks:

1.  Most oil (and natural gas) companies make the bulk of their money from developing oilfields and selling the output.  Lower prices translate directly into lower profits.  There may be different shades of bad, depending on whether the producers own the oilfields outright or have production-sharing agreements with third parties.  But it’s not good.

The one exception is companies that whose business is completely “downstream, ” that is, who refine and sell petroleum products, especially gasoline.  They’re buyers of crude oil, so their margins may expand as prices fall.  Ultimately, though, competition forces them to pass on almost all their lower costs to customers.

2.  Falling oil prices are a boon for consumers, particularly in the US.  Sustained over a year, a $30 per barrel reduction in the oil price means an extra $1,700 in spendable income for the typical US household.  That’s the equivalent of a 6%-7% pay raise.

think modest

That’s not enough for the Porsche or the Tiffany tiara you’ve been eyeing.  And the extra income won’t be particularly noticeable to the affluent.  But it will be an important boost, I think, to the everyday buying of ordinary Americans.  So Wal-Mart and Disney (I own DIS) should benefit.  Generally speaking, average citizens should continue to feel better about their economic circumstances, even as the economy shifts into a lower gear (is there one?) and job growth slows.  So retailers who sell low-ticket items should have the wind at their backs.

Are Mac owners wealthier and more glamorous than their PC counterparts? …they certainly spend more

studying web visitors by browser

I use Sitemeter, a service that counts visits and page views on PSI for me.  Among other pieces of information Sitemeter tosses in for free is the operating system visitors use.  In my case, it’s 65% Windows, 22% Mac and the rest Linux.  (In case you’re interested, the blog has several hundred regular readers through email and Twitter, plus a large number I can’t detect who receive it daily through readers.  Half of the blog’s visitors live in the US.  About a quarter come from Europe.  Most of the rest live in the Pacific Basin, with a smattering of page views from Africa and the Middle East.  No Antarcticans that I’m aware of.)  The service costs me less than $100 a year.  Wordpress, which hosts PSI, provides a similar, but less detailed set of data for free.

the Orbitz experience

According to the Wall Street Journalanalysis by Orbitz shows that Mac users who buy hotel rooms from the website pick trendier, and more expensive, hotels than their PC counterparts.  Mac users also spend up to 30% more for their overnight accommodations.

Having figured this out, Orbitz has begun to show Mac users a hipper and more expensive set of hotels when they visit than it offers to PC users.  It does this both by altering the selection of the hotels you see and their placement order on the page.  Orbitz says it doesn’t show the same room at different prices, based on the OS shoppers use.  Mac users just see different merchandise higher on the page.

I have two–no, three–reactions

–Good for Orbitz.

–More reinforcement for the high-status image of AAPL products.

–The chances of Mac users getting a bargain when shopping online will soon be only slightly north of those of a guy who rolls up to a bricks-and-mortar store in a Panamera and uses an Amex black card to pay.

mor evidence of AAPL status

The Orbitz phenomenon isn’t the only sign cited by the Journal of the higher wealth and higher willingness to spend of Mac users.

–Forrester says the average annual household income of Mac users in the US is $98,000+ vs. $74,000+ for PC households (the US average is about $60,000).

–according to BIGinsight.com, iPhone uses are wealthier than Android or Blackberry users

–social gamers on APPL devices spend 6x as much as Android gamers (Newzoo)

–tablet users, which effectively means iPad users, place bigger online orders than laptop- or desktop-piloting customers (Forrester, Shop.org)

–same thing for iPhone users vs. others (IBM).

my take

Personally, I find the psychology of status goods to be fascinating.  People want to exhibit their wealth by paying (a lot) extra for luxury brands vs. non-luxury-brand merchandise.  Virtually no one thinks this reflects badly on their inner sense of self-worth or on their economic judgment.  In my experience, most luxury buyers are either indifferent or unaware that exhibiting these symbols of lack of price sensitivity is a big minus when trying to negotiate over price.

I think the Orbitz research has no negative effect on AAPL.  Quite the contrary.  It simply burnishes the AAPL brand reputation. That should be good for the stock price.

I use a mix of AAPL, Asus and Samsung computer products.  I’m writing this on a Mac.  But I’m certainly never going shopping on an AAPL product again.

News Corp’s proposed split-up

the NWS split

Monday evening the Wall Street Journal  reported that News Corp (NWS) will be considering splitting the company in two at its next board meeting.  The movie and television units would be placed in one publicly traded company, and the newspaper and publishing divisions in another.   Presumably both new companies would retain the current dual share structure, which ensures effective control by the Murdoch family.  Given that NWS owns the WSJ, the report should be considered highly reliable.

not a new idea

Dividing a conglomerate into smaller, more focused pieces isn’t a novel idea.   But it’s one that has so far been opposed for NWS by family patriarch, Rupert Murdoch.  Maybe he worries that doing so would dilute the extraordinary political influence NWS has been able to wield in the countries where it has operations.

why now?

The rationale for considering a separation now is doubtless the negative political and regulatory fallout from the cellphone-hacking scandal that has engulfed NWS’s newspapers in the UK.  The affair has foiled the company’s plans to acquire complete ownership of BSkyB.  It might also ultimately result in NWS being forced to divest its current controlling interest in the satellite broadcaster.

Demonstrating that its BSkyB equity is held in a corporation completely separate from the Murdoch newspaper operations may be a pivotal consideration in staving off this outcome.  True, the regulators may regard the move as simply a ruse, especially if the successor companies have basically identical boards of directors.  But NWS’ allies in the British government must either think the move has a reasonable chance of success, or that without it the negative outcome for NWS is a foregone conclusion.

the move makes stock market sense

Reorganizing a conglomerate into a number of smaller companies may not always make economic sense.  This is especially true for a firm run in effect as a privately-held firm.  There may be complex borrowing and tax planning arrangements that need to be unwound, for example.  There may be jointly-owned computer control systems that need to be separated.  And what happens, say, to any book deals with Harper Collins that personalities on Fox News may have?

here’s why

But it almost always makes stock market sense, for several related reasons:

1.  In the case of NWS, the publishing/newspaper arm makes very little of NWS’ operating profit.  On the plus side, then, it’s almost inconsequential.  But bitter experience has taught every portfolio manager that when such “inconsequential” businesses lapse into loss, they can punch a huge hole in the bottom of the boat.  That’s one reason for the PE multiple discount at which virtually all conglomerates trade.

2.  Professional equity portfolio managers like to build their own portfolios.  I may decide I want to overweight the media industry, for instance.  Within media, I want to overweight film and TV, and severely underweight newspapers.  This is harder to do with NWS than with “pure” film and TV companies.  Another reason for the conglomerate discount.

3.  Professionally managed equity portfolios are increasingly “style”-oriented, displaying either growth or value attributes.  This is partly a function of the psychological makeup and training of the managers, partly a marketing constraint forced on them by the pension consultants who recommend them to institutional customers.  Film/TV is arguably a growth industry.  Newspaper/publishing is clearly a value one.  So some managers may want one part, some the other.  But none want the entire bundle.  Conglomerate discount again.

In theory, then, and almost always in practice, the sum of the values of the two post-split pieces will be noticeably higher than the two were together.  That’s the reason the announcement has sparked a rally in the stock.

Often, it happens that operations in each of the pieces become sharper and capital allocation becomes more efficient when they are run by experts in their fields rather than generalists.  It’s unclear whether these favorable developments will also occur, given that the Murdoch family will be fully in control of both sides.  But they may.  And this isn’t the main reason the stock is going up, in any event.

calculating fair value

How to get a fair value for the decoupled pieces?  Compare each with its peers.  I’m not a NWS fan (although I’ve watched the company grow from its Australian roots since the mid-1980s), so I’m not going to do the work.  But it’s a pretty straightforward task, however.  Value Line, which you can probably find in the local library, should give you all the relevant metrics.

the Eurozone haggling process

fully discounting the EU crisis?

I’m beginning to think that we’re at, or close to, the worst point for global stock markets in their discounting of the Eurozone financial crisis.  This doesn’t mean that the crisis itself is over, or even close to that.  It doesn’t mean, either, that European stocks will be good performers in absolute terms or relative to their peers listed in other countries from now on.

what this means

Instead, it means two things:

–I think global markets have already assessed and discounted most of the bad consequences that the euro crisis will have for the wold outside the EU.  After all, the crisis has been going on for almost three years, a longer time–as I pointed out yesterday–than it took the world to do the same thing for Japan in the early 1990s.  This means we are at, or close to, the point where future uncertainties can be shrugged off by other markets.  It may even be that future deterioration of the situation in the EU will also have little effect on trading outside Europe.  Certainly, that’s what happened with the Japenese stock market, which in 1992 was still first or second in capitalization in the world.  It declined into its current irrelevance.

I’m not sure this dire fate awaits the EU.  In fact, although, again, I’m not willing to bet on this outcome, I think there’s a good chance the EU will ultimately become a much closer political union.  But I think the EU and the rest of the world will soon “decouple” in stock market terms.

–It also means I think there’s a chance to make money in carefully selected UK or continental European stocks.  (Given the reports that US-based “vulture” investors are moving en masse to the EU, the reality may be somewhat better than this.)

For example, London-based Intercontinental Hotels Group, whose IHG ADR I own (I’ve mentioned several times in previous PSI posts), is up 20% in dollars (25% in £) over the past year.  That compares with a 3.6% gain for the S&P 500 over the same span, and a £ loss of around 4% for the FTSE 100.  I don’t see why outperformance for IHG shouldn’t continue.

I’m not willing to bet the farm on this hypothesis, but I do think it deserves considering.

the current situation??    …haggling about terms

If I’m right about this, how should I interpret the apparent current impasse between Germany, which wants structural reform in Italy, Spain et al. before it will consider sharing the burden of those countries’ excessive debt, and the rest of the EU, which wants debt relief before structural reform?

I think it all comes down to a process of haggling about terms.  It’s sometimes being conducted in private, sometimes in the press.  It’s the Greek bailout process writ large.  Both sides have already decided it’s in their best interest to come to an agreement that will contain both a measure of debt relief and some relinquishment of national sovereignty.  But neither side can be seen as simply rolling over and accepting the terms the other is demanding.  Both must be viewed by their electorates as having fought hard for every inch of ground won or lost.

Two other points:

–I think the EU generally, and Germany in particular, learned a lot from negotiations with Greece.  It came to understand that for a wily haggler like Greece, each apparent agreement only creates a new framework for further negotiation.  The EU also saw that the Greek parliament enacted reform legislation on cost decreases and on taxes–but then never enforced the new laws.  Maybe it’s been ok for Greece to conduct itself like this.  I think, however ,that Germany is determined that nothing similar will happen on the wider Eurozone stage.  Supra-national safeguards must be in place.

Therefore, any definitive agreement may take time–a lot of time.  Germany doesn’t care, because the stakes are so high.  Having gone through its own massive decade-long economic restructuring after the merger of East Germany and West, Germany understands what needs to be done.

–The interests of the EU and the rest of the world may not coincide.

Specifically,

-The EU is currently China’s largest trading partner; privately, China may think that the EU won’t be nearly so important to it ten years from now.  So it’s urging an immediate solution, at least in part because that’s what’s best for China at the moment.

-The US economy is  slowing (to a degree I didn’t foresee), partly because of recession in the EU.  Historically, administrations are reelected when the country is either healthy already or making good progress getting there.  On the other hand, administrations tend to be replaced when the economy is sagging and unemployment is high. There’s no time, nor is there any apparent inclination on either political party’s part, to start the legislative process of helping the US economy evolve.  Therefore, Washington has a strong interest in having a quick solution to the EU crisis, on the idea that this will make the domestic situation look a bit better.

comparing Japan 1992 with the Eurozone 2012

creating an EU timetable

It seems to me that all of the elements of the Eurozone crisis have been out in the open for some time.

The Papandreou government took power in Greece in September 2009 and triggered the crisis by announcing that the national accounts had been falsified for many years by the prior administration.  Greece, as many had already suspected, was in much worse financial shape than the official figures showed.  But that was 33 months ago!

It has been clear from the outset that financial contagion could easily spread from one member of a currency union to the others.  The rolling nature of the Asian financial crisis of the late 1990s showed vividly how this could happen, even outside a tight economic linkage of the typce that binds the Eurozone together.

It has also been evident from the beginning that the Eurozone banks were intimately tied to the weaker countries by their large holdings of those countries higher-coupon sovereign debt.  So they were in trouble, no matter what country they were domiciled in.

We’ve also seen the shoes drop, one by one, as market attention has shifted from Greece to Italy to Spain, just like in Asia–and the PIGS countries have revealed the extent of their financial messes.

We’ve recently seen capital flight, as corporate and individual investors have (sensibly) shifted their euros from banks in weaker countries to those in Germany or other stronger ones.

Finally, I think we’ve reached a political tipping point in Germany, where the political cost of not addressing the woes of southern Europe exceeds the cost of taking action.  Hence the recent moves to consider more than austerity as a solution.

for investors, where to from here?   

I’m looking at the situation as a foreign investor, not as a citizen or resident of the EU.  I’m more concerned with the stock market implications of today’s Eurozone situation than the political and economic.

My question, then, is:

when will the EU’s fiscal problems stop being the dominant factor influencing the movements of its stock markets–and the markets of the rest of the world?

looking at Japan in 1989

We do have one example of this kind of situation during my professional lifetime.  It’s the Japan of late 1989.

That’s when the new head of that country’s central bank began to raise interest rates to force the government to bring highly speculative banking and  financial market activity under control.  The subsequent failure of Tokyo to fix its broken economy ushered in the first of Japan’s two (so far, at least) Lost Decades.

To my mind, Japan’s case was at least as bad as the EU’s.  And Japan more or less deliberately–but very clearly–made a bad choice.  It opted to cover up its problems to preserve a traditional way of life and a traditional power structure, rather than to evolve in a way that would gradually fix them.

It’s not a great roadmap, but it’s the best we have.

what happened in the Tokyo stock market?

The main indices peaked in December 1989, as rates began to rise.

They fell until June 1992, 31 months later.

From that point, the Japanese market drifted, with high volatility, for the remainder of the decade.  This ran counter to a rising trend in the equity markets of other industrialized countries.

The most sobering news is that today, twenty years after the initial bottom, the Tokyo market hasn’t recovered an ground.  On the contrary, it’s half its level of June 1992.  Today, it’s an investing backwater, lost in dreams of the 1980s, and with highly restrictive rules against any foreign attempt to change the status quo.

my conclusions

If Japan is any guide, we should be close to the end of the initial downward phase in Europe.  To me, it makes sense to be on the alert for signs of stabilization.

In Japan, the strongest stocks by far after the initial bottom were either multinationals or export-oriented firms.  That is, they were companies headquartered in Japan but with their operations elsewhere.  To the extent the Japanese citizens bought stocks during the first Lost Decade, those are the ones that they–as well as foreigners–favored.  I think the same will be true in the EU.  Companies located in the EU but not in the Eurozone will probably do the best.

The crisis was by no means over in Japan in mid-1992.  In fact, the first inning had barely begun.  But Japan’s problems ceased having a major negative influence on other markets.

Europe is much more entwined in the fabric of world commerce than Japan was in 1992.  The EU may have a tougher time than Japan over the coming years, in the sense that world economic growth will likely not be as strong as it was in the second half of the 1990s.  On the other hand, Japan benefited less from strength elsewhere than the EU is likely to do.  So a general picture for EU stocks–in the absence of a dramatic political evolution of the EU–is probably flattish, with a lot of volatility.

On the crucial question of whether the EU will follow Japan down the same path to economic irrelevance I have no answer.  I didn’t think Japan would be as inflexible as it has been.  But it shows that when a country has deeply ingrained notions of its cultural superiority and the interests of the status quo are very powerful, denial may be the easiest road to follow.

My bottom line:  it’s probably safe to dip a toe in the EU water today, but not much more than that.

A final note:  once Europe leaves center stage, I think market focus returns to economic policy in the US.

China is revamping its QFII program. That’s good news, and bad.

what QFII is

The acronym stands for Qualified Foreign Institutional Investor.  It’s the general name for any formal system for limiting foreigners’ access to domestic capital markets.

QFII arrangements are par for the course in emerging markets. They work as follows:

–A foreign investor applies to the government for permission to enter the market.  The application process itself can be complicated and time-consuming, and acts as a filter to weed out the less resolute.

–The foreigner must typically have a certain length of experience in the asset management business and a certain minimum amount of assets under management.

–A successful applicant is subject to a number of constraints.  Typically, he is given an investment quota,  a specified amount of money that must remain in the country.  Minimum holding periods for any securities purchases may be specified.  Certain industries may be off-limits.  Individual and aggregate maximum levels of foreign ownership of given enterprises may also be specified.

In China’s case, the QFII program has been in place for almost a decade.  QFIIs must have been in business for at least five years, have a clean regulatory record in the markets where they already operate, and have a minimum of $5 billion in assets under management. Foreigners can only buy equities.  In the aggregate can’t own more than 20% of a domestic company’s stock. Until this April, the maximum investment quota for any QFII was $30 billion.

why restrict foreign access to markets?

Every country in the world limits foreign access to capital markets in one way or another.  Control of companies thought vital to the national interest–transport, telecom and media are the usual suspects–is almost always legally barred to foreigners.

Bids in non-vital sectors are also often subject to government regulatory review. These cases often express the national ego rather than economic sense.   It isn’t that long ago, for example, that France disallowed Pepsi’s bid for Danone on the grounds that the yogurt company is a national treasure.  Mainland Chinese companies have extreme difficulty in getting government approval for purchases in the US.  In the early 1980s Washington rejected Fujitsu’s bid for Fairchild Semiconductor, on the grounds that a foreigner shouldn’t control a defense-related manufacturer–but then approved its sale to a French firm, Schlumberger (the purchase worked out very badly, by the way).

Emerging countries have more genuine worries.

–They fear that without ownership restrictions wealthy foreigners will buy the crown jewels of the local economy at bargain-basement prices.  Foreigners have more money.  And they may understand the long-term potential of companies better than locals.

–Emerging nations also have a vivid example of the risks in having open markets that occurred during the Asia financial crisis of the late 1990s. At that time, hedge funds tried to destroy the perfectly healthy Hong Kong economy through massive shorting of the currency and of the local stock market.   It took the deep pockets of mainland China plus the Hong Kong government’s purchase of a quarter of that market’s outstanding shares to see off the threat.

changes to the China system

In April, the individual QFII investment quota was raised from $30 billion to $80 billion.

This week, the China Securities Regulatory Commission has proposed further loosening of the rules:

–the minimum assets under management would be lowered from $5 billion to $500 million, thereby allowing many hedge funds to enter the market for the first time

–the cap on aggregate foreign ownership of companies would be raised from 20% to 30%, and

–in addition to equities, QFIIs would be allowed to buy bonds and stock index futures.

this is good news…

…because it represents another step in opening the capital markets of the world’s second-largest nation to economic forces, rather than simply local vested interests.

…and bad

Invariably, countries take measures like this when they feel the local market needs the inflow of funds that foreigners can provide.  It’s typically during weak economic times when the local government senses that domestic investors are much more likely to be sellers of local securities than buyers.

So while the moves by Beijing should be welcomed by long-term investors, they also seem to me to signal that tough sledding is ahead in the near term for holders of Chinese A shares.  For most of us, who are presently excluded from the market anyway, the relevant information is confirmation of what we have most likely already suspected– that corporate profit announcements from China over the next several months will likely be much poorer than the consensus is expecting.

private equity zombies–very hard to kill

what they are

The Wall Street Journal has been writing recently about private equity “zombie” funds.  These are funds that whose managers refuse to liquidate and return the proceeds to the original investors, even though the typical 8-10-year fund life has already passed.

A given private equity investment is supposed to last around five years.  That gives the managers time to make operating improvements and locate a buyer to sell the now-polished-up company to.  Add a year or so to that, so the managers to find enough good investments to use all the fund’s capital.  Add another, in case recession makes buyers temporarily wary.  That’s how you get to 8-10 years of life for the total fund.

In theory, private equity managers have no interest in keeping client money.  True, they get a recurring yearly management fee of around 1% of the assets under management (based, incidentally, on their own estimate of asset value–another bone of contention).  But their big payoff comes from their “carried interest,”  the 20% or so of the capital gains generated by each project that clients cede to them.  Private equity managers only collect this when the project is sold and proceeds returned to the clients.

The details, including the “sell by” date, are all spelled out in the private equity contracts.

How, then, can “zombies” arise?

The combination of two circumstances keeps them lurching around:

–failed investments, ones with no capital gains possibility, and

–clauses in the early private equity contracts that gave the managers (unlimited) extra time to find a buyer.  The intention was good–to not force the private equity managers to sell at a bad time.  In most cases, however, there was no other provision giving clients a course of action if they disagreed with the managers’ assessment.

The result is hundreds of failed private equity funds that refuse to liquidate, because managers want to continue collecting an annual fee.  They claim they’re looking for buyers, but…  The WSJ thinks that what we’re seeing now is just the tip of the iceberg.

two lessons

1.  Buy in haste, repent at leisure.  In the early days of any new investment fad, buyers rush headlong to be one of the first owners of the new thing.  They rarely look carefully.  If they are alerted about possible pitfalls, like no recourse if the private equity manager refuses to give back remaining money, they ignore the warnings.

2.  In desperate times, almost no one remains honest.  I’m an optimist.  I have great faith in human nature.  But in “zombie” circumstances, this is always a foolish bet.  At the very least, a professional with an obligation to protect clients’ assets shouldn’t rely on the kindness of strangers.

why not let sleeping dogs lie?

Institutional investors appear to be making a big push now to get their dud private equity investments resolved, even by selling them for half nothing (assuming they can find a buyer at all).

Why?

Two reasons:

–for taxable investors, an investment loss has an important tax value.  The present value of the loss deteriorates over time, so the sooner it’s used, the more it’s worth.

–keeping a dud investment on your balance sheet makes you look like an idiot.  Well, when you bought the thing, you were an idiot.  That’s the way it is.

But there’s invariably someone on your board of directors who will ask about it at every meeting.  Prospective clients may even make little gasping sounds if they recognize it on your list of holdings.  The black eye you’ve given yourself will only fully disappear when the investment is sold.  This is especially important if you see more of these coming down the track.