Gavyn Davies on Bernanke’s change of heart

keeping inflation low

Since the tenure of Paul Volcker began over thirty years ago, the mantra of the Federal Reserve has been to do what is necessary to keep inflation under control.  Over time, this morphed into the narrower target of keeping inflation under 2%, but the intent has always been to drive inflation lower.  Yes, the Fed has a “dual mandate,” both to conduct monetary policy in a way to achieve maximum sustainable GDP growth and to promote employment.  But the former has invariably trumped the latter.

…until now

In the September 12th pronouncement from its Open Market Committee, the Fed unveiled new monetary stimulus measures targeted at reducing unemployment.  For the first time, they are open-ended both in terms of time and of money.


…especially when there’s a lively debate, even within the Fed, over whether we are in fact already at full employment.  If so, the new measures won’t create any new jobs.  It will only ignite wage inflation, as companies poach employees from rivals in order to expand.

Personally, I don’t know.  I think that if the Fed decision has any immediate implications for financial markets, they’re positive for stocks and neutral (at best) for bonds.  So arguably as an equity investor, I don’t need to know.

Still, I’m curious.  The best I can do is to fall back on the old saw that inflation is better than deflation, since the world’s central bankers have plenty of experience dealing with the former but have gone 0-for when confronted with the latter.

the Davies answer

Gavyn Davies, former chief economist for Goldman Sachs and now a blogger for the Financial Times, has a better answer in his 9/16 post for the newspaper.  It’s worth reading.

The thrust of the post is that, in Davies’ view, Mr. Bernanke’s QE3 decision implies he believes the US is at a tipping point with the chronically unemployed.

As workers remain out of the workforce, the theory goes, their skills gradually erode–and, with them, their chances of finding new employment.  At the same time, former workers’ enthusiasm for the job search effort also wanes.  Eventually, they drop out of the workforce permanently–becoming unfulfilled as persons, burdens on the rest of society for decades and–crucially–inhibitors of future GDP growth.

Recent surveys by the Labor Department suggest the “dropout” rate in the US is starting to accelerate, putting into motion the downward spiral just described.  In Davies’s view, this is what has changed the balance of risks in the Fed’s mind.

the curious case of Chow Tai Fook Jewellery (HK:1929)–Tiffany (TIF), too

…toss in Wynn Macau (HK: 1128), as well.

Chow Tai Fook

Chow Tai Fook is a Hong Kong-based jeweler that IPOed there last December.  The company’s main business is chuk kam (24 karat) gold objects, the stuff that’s sold by weight, not market up by 100% (or more) over direct costs.  It’s not only decoration, but you can bury it in the back yard if you’re wary of banks.  And you can wear your wealth to work, in case you find out you have to flee the country right away.   (You wouldn’t chuckle if you’d lived through 1940-1960s China.)

The firm has expanded from the SAR into the mainland, and from chuk nam to high-end “fine” jewelry designed to flaunt your wealth, not hide/preserve it.  In recent years, the latter has become an increasing percentage of Chinese jewelry consumption.

a December 2011 IPO

The IPO was anything but a rousing success.  The stock was priced at HK$15, to raise US$ 2 billion.  But it came to market just as Beijing’s efforts to slow down the domestic economy were causing affluent mainlanders to cut back consumption.

The issue closed on day one at $13.80–and headed south from there.  It finally bottomed some months ago at HK$8.40.  Ouch!!

…so, what’s curious?

Here’s the thing.

The economic evidence over the past few months is that China is slowing further, despite signals from Beijing of its change to a more expansive government economic policy.

The EU is a mess.

US industry is slowing down and the “fiscal cliff” is getting closer.  Burberry and Tiffany have revised down earnings, in large part because of disappointing sales in China.  So too have tech companies like Intel.


since July 27th,

Chow Tai Fook share are up by 26.5%–vs. the Hang Seng index up 6.9%

BTW, Wynn Macau shares are up by 30.0% over the same time span

TIF began rising a little earlier in the month, but has gained almost 25% from its low–compared with about an 8% rise in the S&P 500.

why this good performance?

It’s a little like the case of Benjamin Button, whose body went through the opposite of what nature usually does.


–If this were ten or fifteen years ago, I’d say investors are seeing through current weakness and beginning to discount in advance the recovery that the government policy change will likely bring.

But reacting to government cues is not the winning strategy it once was.  That’s partly because the economic problems the world faces today are more structural than cyclical.  Also, the rise of hedge funds has reoriented markets sharply in the direction of short-term trading than they have ever been.

Besides, luxury goods makers like Hermes and LVMH haven’t experienced the same stock price lifts.

–new bets on China?  But, if so, why no response from Hermes, LVMH or Coach?  Also, why would UK-US (lower-end) jeweler Signet be having better stock performance than the other three?

–influence of EU investors?  My impression has been that a lot of the damage to Hong Kong stocks during the middle months of 2012 was due to panicky selling by EU-based investors.  The clear new bullishness emanating from Europe may be resulting in portfolio managers plowing back into Asia.  That might explain why 1929 or 1128 are doing well.  But why TIF?  …or why SIG and not LVMH?

–minimizing exposure to the EU?  For aesthetic reasons, I like this better than “bets on China,” because it’s a more sophisticated wager–one based on avoiding a bad experience rather than necessarily having a good one.  Still, why TIF?

You could build a “synthetic” TIF-ex-the-EU, by combining SIG +1929.  Not a perfect replacement, but if the main idea is to avoid the EU probably an acceptable one.

my take

I’m sure there’s a method to the apparent madness.  At this point, however, I don’t know what it is.

I could say that professional investors are shifting their portfolios toward secular growth areas (as opposed to more cyclical ones) where they see profit growth will be the strongest next year.  Yes, that’s true, but it’s what most managers always do.  So it’s flirting with tautology.  The crucial question is why jewelry and casino gambling?

Is there something special about these two areas?  …or is there something awful about everything else?

One thing I am convinced of is that solving the puzzle correctly can bring investing rewards.

I own 1128 and 1929 but none of the rest of the names I’ve mentioned here.  I have no burning desire to add to any–although if I can figure out what’s going on I might develop one.

If someone were forcing me to buy  one of the names, it would probably be 1929.  The fact that it’s the most speculative of the stocks is not a coincidence.  I should knock off the caffeine instead.

index funds, passive ETFs and operating leverage

Russell leaves the ETF business

Early this month, the financial press carried stories that Russell Investments, the pension consultant turned money manager, has decided to close its ETF business less than two years after entering the field.

What’s going on?

(By the way, Russell’s is the typical pattern in many commodity-like industries, where latecomers are never able to achieve the scale needed to become profitable.  Presumably, Russell knew this before made its move into ETFs.  It concluded that the possible gains justified the initial outlays.  On the other hand, maybe it didn’t.)

the case for passive products

Arguably, given the repeated failure of active managers in the US equity market to outpace the S&P 500, or other standard benchmarks, passive products are better choices.

At the same time, with passive ETFs or index funds, the possibility–however remote–of market-beating performance is eliminated as a selling point.  Every fund targeting the same benchmark index will have (more or less–a comment on this in a minute or two) the same gross return.  As a result, the only real difference among funds is the size of the fees the fund operator charges.  Lowest fee wins.

basic assumptions

Let’s look at the situation as if we’re a newcomer to the passive fund industry.

We’ll have expenses:

–for a bank to keep custody of assets

–for mathematicians to oversee construction of the portfolio and to monitor the trades the fund makes to deal with purchases and redemptions

–for traders to buy and sell the securities in the fund, and to process customer orders

–for overhead, that is, office space, marketers, boards of directors, lawyers. top management…

To make the numbers easy, let’s say all that costs $1 million a fund a year.  (Unless a firm plans on having a ton of funds, $1 million is going to be much too low.)

Let’s also say that once we have all this infrastructure in place, the variable cost of running a given fund is the electricity needed to power the computers that keep the fund humming.  Call that zero.

charging for our services:  the view from below

Now we’re ready to offer our products to customers.  Customarily we charge a percentage of the assets as our fee.  How do we set that percentage?

well, our fund has to be at least reasonably competitive with other offerings in the market.  Let’s say the most prominent fund among our rivals charges a fee of $.20% of assets.  If we match that fee, then we’ll only achieve breakeven when our assets exceed $500 million.  Until we reach that level, we’ll have to subsidize our operating expenses.

Our other choice is to charge a higher fee, at least initially.  But since low price is the major selling point for the product, it’s not clear that this will be successful.

Worse than that, there’s a second issue with passive products–the question of how faithfully a given index fund or ETF mimics the benchmark it intends to duplicate.  This is called tracking error.  Passive portfolios don’t usually buy and sell tiny bits of all the stocks in their benchmark.  They transact in small, more liquid subsets of the index that their statistical analysis says will mirror the overall index closely.

Assurance that tracking error is low comes partly from the fund promoter’s promises, but mostly from seeing the fund deliver on those promises over long periods of time.  A startup fund only has the first.

It’s going to be hard to attract assets away from the market leader who has a low tracking error by charging more.

the view from the top

Look at the market leader.  He’s getting in new money on a regular basis from IRA or 401k clients.  If the relevant index is up, say, 20% over the past year (the S&P is a tiny bit better than that), his assets under management–and therefor his management fee–have gone up by that amount just by not losing net customers.  So the market leader is making at least 20% more money than he was in 2011.

What’s his best strategy?  Cut his management fee percentage, of course!

If the market leader decreases his management fee to .175% of assets, he’s still making more money than before.  His product looks even more attractive.  And he’s forcing the startup to cut management fees, too–raising the startup’s breakeven to $570 million, thus lowering the chances that the startup will ever reach profitability.

more wrinkles

There are a few.  But I’ve made my main point–that unless the market leader gets piggish and creates a pricing umbrella under which the competition can prosper–it’s tough for a latecomer to gain any market traction.  That’s natural market evolution.  And it’s what has happened to Russell.

That’s it for today.

watch the currencies!–what they’re saying now

three key pieces of data for investors

Over the last several weeks, two pieces of information have emerged that have potentially great importance for equity investors.  A third may develop from the US Federal Reserve today.

They are:

1.  the Case-Schiller index, which is very influential in the US, despite being a lagging (also called confirming) indicator of the state of the housing market, has finally signalled that overall residential prices have bottomed and are on the mend.  The five-year slump is over.

Although I think the revival of the housing market gives a second wind to the domestic economic expansion, in the counter-intuitive way Wall Street works, it also has a darker side.  Other than Washington suddenly starting to do its fiscal policy job, which would be a huge positive surprise, it’s hard for me to see what new positive market-moving economic development could happen in the US over the coming months.

2.  The European Central Bank has announced a broad support plan for the bond markets of the weaker members of the Eurozone.  Yesterday, the German high court rejected litigants’ assertions that the German government was barred by that country’s constitution from participating in the plan.  Germany is slated to provide over 25% of the financing of the Eurozone rescue plan, so this decision was crucial.

The implication is that EU economies will be stronger over the coming year or so rather than weaker.

3.  The Fed may announce further unconventional measures today to support the US economy.  The Fed has repeatedly said that fiscal policy would be a much more effective engine to spur growth, but apparently sees about the same chance as I do of that happening.

Two measures are possible.  One is additional bond buying, intended to flatten the yield curve.  The second is a commitment to hold short-term interest rates at today’s emergency low levels for the next three years.  Yikes!  Three more years of nearly no income from CDs and money market funds?

I think the second would  have the more significant effect for Wall Street.  It would give two contrary signals:  it would say that there’s no need to flee the bond market anytime soon; and it would imply that the only liquid investment that will provide significant income for savers any time soon is the stock market.

three places to see their effects 

1.  the performance of general stock markets in their local currencies.

The S&P 500 is up 9% over the past three months.  I think the recovery of house prices, which is the major source of wealth for most Americans, is the main reason.  EU growth should also have a positive rub-off effect on US firms involved in foreign trade, as well as the many S&P firms with substantial operations in Europe.

The Eurostoxx 50 is up 19% over the same span.  Broader indices are up in the mid-teens.  Most of the outperformance of the S&P has come in the past month, when Eurozone rescue plans have been publicized. Dollar-based returns on the EU indices are much larger.

2.  You can also changes in the lists of sectoral winners and losers, as I’ve written about on the Keeping Score page on PSI.   Generally, the US investor has shifted away from defensive sectors toward IT and Consumer Discretionary, two moderately bullish areas, while not to sectors like Materials that would benefit from a strong general economic upsurge.

3.  Most US investors generally ignore the third area–currency movements.  I think it’s certainly true this time.  But from mid-July until now, the € has risen from a value of $1.20 each to $1.29, or 7%.  True, the ¥ has been rising since March, when holder had to pay 84 to get $1.  But it has also recently risen above the 78 level that the Tokyo government had been trying to defend.

To my mind, the Japanese economy still has nothing much going for it.  Seeing that currency rise at all–which normally happens only in a healthy country–really says something.

the message?

If we add a currency gain of 7% to, say, a 14% rise in European stocks, the total return to an American investor in the past month is more than 20%.  If we have indeed made a major turn in the EU, the party is far from over, in my judgment.

Many European stocks still have strikingly high dividend yields–certainly a temptation to income-oriented investors but also a warning of potential risk.

I’ve been advocating having a severe underweight in the EU, with exposure only to companies listed there but with significant operations elsewhere.  I haven’t made any changes yet, but I’ve got to at least reconsider my position.

Conversely, US-listed companies with large businesses in the EU may not be having great local currency sales at the moment, but they’re enjoying a big boost in dollar terms.

The rise in the ¥ tells me that at least a part of what is happening is not foreign currency strength.  It’s dollar weakness.  That may be because of continuing fiscal policy failure here, or just the perception that all the potential good news is already out.

The much greater € strength suggests that real economic improvement is expected in the EU.  I’m still mostly convinced that Greece will be forced out of the Eurozone (and the EU).  But markets may not be willing to wait for this final shoe to drop.

To sum up:  we may be in the early stages of a significant shift in the attitude of global equity portfolio managers about where they want to place their clients’ money.  If so, I think the clearest sign is coming from the currency markets–it’s mildly against the US, strongly for the EU.

the Intel (INTC) 3Q12 preannouncement: studying operating leverage

the preannouncement

As I wrote about yesterday, INTC preannounced weaker than expected 3Q12 earnings.  The main culprit?  …worldwide general economic slowdown.

The company said it now expects revenues of $13.2 billion for the quarter, down by 7.7% from the $14.3 billion it guided to when it announced 2Q12 earnings two months ago.  The gross margin will come in at 62% instead of 63%.  Virtually all other cost items will remain the same.

looking at leverage

This isn’t much data.  But it’s enough for us to see two things about the company, manufacturing leverage and leverage on SG&A (Selling, General and Administrative) expenses.

manufacturing leverage

two kinds of costs

In the simplest terms, in every accounting period employees get paid and the accountants apportion costs for the use of the factory and the machinery in it, whether or not anything gets build.  So, in a sense these are indirect costs of manufacturing.  In the short run, they’re relatively fixed.

In addition, there’s the cost of the materials–electricity, gas, silicon, who knows what else–that get used up in making INTC chips.  These are direct costs.   Their total in any period is variable, depending on how many chips get made.

Accountants assign each chip a total cost that depends on two factors:  the out-of-pocket cash (variable cost) spent making it plus its share of indirect costs, a figure that depends on how busy the factories are.

gross margin

Total cost ÷ sales price = gross margin.

separating the two

Is there a way to find out how much of the total cost is variable and how much depends on how well sales are going in a given quarter?  In INTC’s case, yes.

Management has just told us that sales will be $1.1 billion less than anticipated and that this fact will lower the gross margin by a percentage point.  That’s not because the variable cost of making a chip has changed; it’s because the indirect (or fixed, or overhead) costs of running the factories are being distributed over a smaller number of chips.  (It’s a little more complicated than that, but not a worry in this case.)

Another way of saying this is that in order to get to the new, lower, sales and operating profit estimates, INTC has subtracted the sales price of the extra chips it won’t sell and only the variable cost of making those chips.  If we calculate the change in estimated gross profit and divide by the change in sales, we’ll get a variable cost margin for those “extra” chips.

Here we go:

$13.2 billion x .62  =  $8.18 billion in gross profit

$14.3 billion x .63  =  $9.01 billion in gross profit

The difference is $.83 billion, the gross profit lost from lower sales.   This gross profit   ÷ $1.1 billion in lost sales   =  75.5%.

Therefore, 75.5% is the profit margin from producing/selling an extra chip during the quarter.  That’s the manufacturing leverage INTC gets at current production levels for getting/losing additional sales.

Note, too, that the new operating profit is 9.1% less than the original estimate.  That compares with a 7.7% drop in sales.  So, while there is operating leverage in the manufacturing operation, but at current production levels it’s not huge.

SG&A leverage

INTC has two types of SG&A.  One is R&D.  The other is the typical SG&A that any industrial company has. The two items are roughly equal in size.  This quarter they’ll amount to $4.6 billion.

Let’s subtract that from both the original gross profit estimate and the new guidance.

$8.18 billion  –  $4.6 billion  =  $3.58 billion in operating income

$9.01 billion  –  $4.6 billion  =  $4.41 billion in operating income

Now calculate the percentage drop in operating income that our 7.7% decline in sales produces.

It’s 18.8%!

To recap, the 7.7% fall in sales produces a 9.1% drop in gross profits and an 18.8% contraction in operating profits.  Of the 11.1 percentage point differential, 1.4 comes from the manufacturing process, 9.7 from SG&A leverage.

In other words, the operating leverage at INTC is coming from SG&A, not manufacturing.  If INTC wanted to reduce costs in a way that would affect current reported profits the most, it would attack either R&D or “normal” SG&A.

Intel (INTC) preannounces weaker than expected 3Q12 results

the INTC preannouncement

INTC intends to announce 3Q12 results on October 16th.  But it already knows that its earnings will fall below its previous guidance by a substantial amount.  So, while the company still has to dot the is and cross the ts, it issued a short press release stating this on September 7th.

INTC now expects 3Q12 revenue to be $13.2 billion rather than $14.3 billion, and for its gross margin (that is, its profit margin after subtracting all direct costs of making its products) to be 62% of sales rather than 63%.  Basically, all other costs remain the same.

By my back-of-the-envelope calculation, this means INTC will likely report 3Q12 eps of $.52-$.54, rather than the $.63-$65 or so it had been expecting when it issued its guidance two months ago.  3Q11 eps?  …$.69, on revenue of $14.3 billion.

what’s going on?

The unofficial (though pretty much binding, nonetheless) protocol for such announcements is to list the reasons for the earnings revision in order of importance, with the most important going first.  That would mean:

1.  customers worldwide are not fully replenishing their stock of INTC chips as they sell products containing them.  This is a standard response to weakening demand, especially if PC manufacturers believe they can quickly get supplies if needed.  Let INTC hold the inventories, not them.  Therefore, slower economic activity is resulting in lower sales.

A reasonable guess is that INTC’s 8% slide in sales vs. its prior expectations breaks out into 4% due to weaker end-user demand and 4% defensive behavior by PC makers.

Operating leverage is making the bottom line look considerably worse.

2.  one customer group sticks out:  corporations are slowing their replacement of employees’ aging PCs (but not their spending on servers or on the cloud).

This almost goes without saying.  Corporations rarely outspend their cash flow. If they sense cash flow contracting, they cut discretionary spending.

3.  one geographical area does, too:  slowing demand in emerging markets (which had been a pillar of strength earlier in the year).

Presumably the supply chain is longer in emerging markets than in developed ones, as well as harder to get good information about.  So the slowdown in end-user demand may have been going in somewhat longer in emerging markets than in developed.

To recap, my interpretation of the release is that global economic weakness is the main cause of the preanouncement.  Emerging market slowdown is a factor worthy of note, but the least important of the three elements cited.  Windows 8 isn’t really an issue, since INTC had already accounted for a pre-release buying pause in its previous guidance.

the stock is down almost 8%…

…since the INTC announcement.  As an owner of the stock, I’m not happy.  As an observer of the stock market, I think the selloff is overdone.  But it’s not entirely crazy, either.  I regard INTC as a “show me” stock in the high $20 range.  At, say, $27-$28, I think the “old” INTC business of selling mostly PCs is fully valued.

For the stock to break into $30-land, I think it has to demonstrate some success in penetrating the mobile market–smartphones and tablets.  If you think INTC has no shot–and I think that’s the consensus among Wall Street analysts and the media–the stock is mildly undervalued today, but that’s all.

On the other hand, if you think INTC has a reasonable chance (that’s my opinion) you get the possibility of some upside, a low-risk option on substantial upside if INTC’s newest chips crack the mobile market, plus a dividend yield above 3% while you wait.

Although it sounds odd at first, it’s also possible that the current slowdown is good for INTC, if it buys extra catchup time to get the company’s 14nm chips on the market.

a case of operating leverage

That’s my topic for tomorrow–how this situation presents a good analytic opportunity to see operating leverage analysis in action.