the move to Europe

Increasing numbers of US-oriented equity investors are announcing that they’re shifting assets away from the US toward the EU.  Actually, while managers may phrase their statements as intentions, no one is going to reveal plans they have yet to carry out, so we should figure that the announcer have already done the lion’s share of their buying.  Now they wouldn’t mind if other follow their lead.

The rationale for doing so is clear:  US stocks are pricy, the EU is not; and the EU is arguably following on the same general economic trajectory as North America, only with a two-year lag.  If so, buyers get the equivalent of 2013 prices.

The move isn’t without risks, however.  While it does appear that Grexit is already in the rear view mirror–and, admittedly, I’ve been arguing that losing Greece as a member would be a speed bump for the EU, not a catastrophe–there’s some chance worries will resurface later in the year.

The main issue for investors as I see it, however, is a tactical one–how to play the euro.  Here’s where I genuinely don’t know–and why I hesitate to make the load-up-on-the-EU move myself.

Two choices:

–figure that the EU will remain in economic intensive care and that the euro will therefore remain weak.  This implies buying EU-based multinationals with hefty US exposure.  In euros their earnings will look great   …and EU portfolio managers will tilt their portfolios in this direction.  Multinationals have clearly been the way to go since the EU began to slow down last summer.   The problem with this is that the idea may be getting pretty long in the tooth

–figure that the dollar-earners are all played out and buy the next logical development–the revival of the domestic EU economy.  This would mean buying purely domestic firms.  They will do well if the euro begins to strengthen against the greenback and/or if the EU starts to show relative economic strength.

I’m still on the fence.

I have 5%-10% of my IRA/401k money in actively managed Vanguard Europe mutual funds.  That’s a more or less permanent position–meaning I haven’t changed the allocation in years.  A month or two ago I added shares of IHG to my actively managed taxable account.  I’d held IHG for a long while and sold in the middle of last year.  I’ve recently become more enthusiastic about hotels–I added MAR at the same time–and also wanted to added dollar earners based in Europe.

That’s it.

Intellectually, I think adding domestic EU exposure is the right step.  I just can’t bring myself to pull the trigger.

Instead, I’ve stuck with looking for tech/Millennial exposure in the US.  I guess I think it’s too soon.

Any thoughts?

science and math vs. academic finance (pension consultants, too)

“Evaluating Trading Strategies”

The Buttonwood column in the February 21st issue of The Economist talks about a recent article published in the Journal of Portfolio Management, titled “Evaluating Trading Strategies,” authored by Profs. Campbell Harvey of Duke and Yan Liu of Texas A&M.

Long ago, I’d come to think of the difference between academic financial theorists and portfolio managers as somewhat like that between teachers of academic literary theory and actual authors.  That is to say, the two sets of people live in very different worlds, with little in common    …and without that much relevance for each other.

Three exceptions with finance:

–academics are often used as front men for various investment schemes, such as in the case of the ill-fated Long-Term Capital Management, which raised a huge amount of money to implement a strategy of buying illiquid bonds and collapsed shortly thereafter–destabilizing the world financial system in the process

–they often sit as window dressing on the boards of directors of financial companies, and

–their theories inform much of the methodology of the investment consultants on whose advice pension fund managers rely heavily.

its conclusion

The article has an emperor’s new clothes aspect to it.

Simply put, it says that academic finance researchers routinely use a standard for testing for the statistical significance of their findings that is much too weak and alrady discredited in mainstream scienticif research.  Because of this failing, in statistical work in finance large numbers of false.  This is through ignorance, not malice.

As the authors put it:

“So where does this leave us? …Most of the empirical research in finance, whether published in academic journals or put into production as an active trading strategy by an investment manager, is likely false.  …half the financial products (promising outperformance) that companies are selling to clients are false”

Who knows whether this article will have any long-term effects?

In the real world, very few people take academic finance theories seriously–except for pension funds, which rely heavily on consultants who use it to legitimize their advice.  The conclusion that the “advice” is little more than picking numbers out of a hat (arguably even less reliable than that method) has the potential to really shake up this chronically poor-performing sector.

Macau casinos, February 25, 2015

Macau casino stocks in Hong Kong took a drubbing overnight, continuing weakness shown by US parents in Wall Street trading yesterday.  The US stocks are down again as I’m writing this.


Analysts had been estimating (guessing/hoping is probably a more accurate description) that the amount lost by gamblers during the current Lunar New Year month would come in at slightly more than half what they left at the tables during the comparable period last year.  With the month nearly gone, data so far indicate that the actuals will come in at somewhat less than half the 2014 take.  Hence the selloff.

If there’s a positive story for the Macau casinos–and I think there is a strong one–it has little to do with whether this month is good or not.

Current weakness is the result of  a campaign by Beijing that’s now deep in its second year.  The idea is to restore faith in the Communist Party by discouraging flashy over-the-top consumption by the politically well-connected.  It’s also aimed at quashing corrupt local government get-rich-quick schemes involving crazy real estate developments and unneeded, heavily polluting basic industry projects.  This two-pronged attack, which has had a negative effect on high-roller gambling in Macau, has lasted much longer than anyone, myself included, had predicted.  The February-to-date casino results seem to indicate that Beijing has not yet taken its foot off the regulatory accelerator.

The positive case has three parts:

–the development of the Cotai Strip along Las Vegas lines is creating a new, more lucrative, less volatile gambling market in Macau.  It’s for middle-class Chinese visitors who want a gambling vacation that also includes resort dining and entertainment.  This business has been expanding very rapidly.  It now accounts for about three-quarters of the SAR’s gambling profits.  Non-gambling attractions in Macau are still in their profit childhood.  In pre-recession Las Vegas, however, resort profit equaled that of the casinos.  So there’s plenty of room for expansion

–at some point–who know when–the current anti-corruption campaign will abate and high-roller business in Macau will begin to stabilize and then gradually expand again.  Beijing’s crackdown began in 2013 but only started to cause serious high-roller attrition in Macau in late spring last year.  So positive year-on-year earnings comparisons are unlikely before autumn.

–the stocks are reasonably priced–cheap, if you believe the first two points.

The Macau casino stocks are now what I would call a value idea–meaning that we have a good sense of what will happen but are pretty much at sea about when.  High dividend yields argue that we’re gin paid to wait.

One technical note:  the stocks hit relative low points about a month ago and have come back to those lows over the past few days.  It would be a sign that they may be finally bottoming if they can stay above the month-ago lows as the weak February results are officially announced.   Technicians would regard a breakdown below these lows would be a good thing in the US, but bad news in Hong Kong.

should brokers be fiduciaries?

…my answer is Yes.

In his recent spate of initiatives, President Obama is proposing that retail brokers be legally declared to be fiduciaries, the way investment advisers already are.   I’ve written about this before, when the SEC carried out a study of the topic, ordered in the Dodd Frank Act, which it published in early 2011.  Nothing happened back then.  Probably the same result this time.

The issue?

As I see it the change would mean that, for example:

–unlike today, your broker would have to point out, when he gives you a computer-generated analysis of your financial needs and a resulting asset allocation, that the names suggested consist solely of funds that pay fees to be on the list–and that potentially better-performing, lower cost funds that don’t pay have been excluded.

–that his (about 90% of traditional brokers are men) favorite fund families, whose offerings he always touts to you, also treat big producers like him (and a companion, usually) to periodic educational seminars at a sunny resorts in return.

More than that, depending on how any new regulations are written, he might also have to tell you that the trade his firm is charging $300 for could be executed just as well at a discount broker for less than $10.

brokers say No!

Brokerage houses are strongly opposed to Mr. Obama.  They’ve apparently already raised enough of a lobbying fuss in a very short time to cause the President to weaken his proposal.

How so?  From a business perspective, wouldn’t it make sense for traditional brokers to hold themselves to a higher standard of conduct?   They might thereby improve their very low standing  in the public mind and possibly stem the continual loss of market share they’re suffered over the past decades.

Two practical problems:

loss of skills

–over the past twenty years, brokers have homogenized their sales forces, moving them away from having their own thoughts and opinions about stock and bond markets to being marketers of pre-packaged products and ideas developed at central headquarters.

The ascendancy of pure marketing over investment savvy may have had sound reasoning behind it (although I regard it as one more triumph for the former in the battle of jocks (traders) vs. nerds (researchers) that I’ve witnessed through my Wall Street career).  However, most of the experienced researchers who had the skills to shape an investment policy and retrain the sales force have been fired either before or during the recent recession.

It’s easier in the short run to lobby against change than to revamp operations–or rehire the newly laid-off nerds needed to accomplish the task.

red ink = loss of bonuses

–in almost any phase of economic (or any other kind of) life, the status quo is extremely powerful.

Traditional retail brokerage is extremely high cost.  Remember, the retail broker himself nets only about half the fees he generates.  The rest goes to support very elaborate–and now seriously outmoded–bricks-and-mortar infrastructure and central overhead.  Lowering fees to get closer to discount broker levels, spending to raise the quality of proprietary products sold or consolidating real estate would all diminish–or even temporarily erase–operating income.  In a culture that values short-term trading profits over all else, it’s hard to develop support for a move like this.


small cap or large, in the US today?

I think today’s US stock market circumstances favor medium-sized companies over their larger brethren.

Several reasons:

–large stocks have outperformed smaller ones for the past several years

–historically, the relationship between PEs for large and smaller cap stocks is all over the map.  One reason for this is that large and small seem to take turns having multi-year runs as the focus of investor interest.  At present, there looks to me to be no overall price advantage for either group.  Not the most ringing endorsement for small, but at least valuations don’t appear stretched

–large stocks are more likely to have exposure to Europe, where currency weakness is wreaking havoc on the results in US dollars of operations there.  Smaller companies are more likely to be predominantly focused on the US, where growth is better –and just now reaching down to second-tier firms—and currency isn’t an issue

–brokerage house analysts, who are a notoriously bullish lot, have been reducing their earnings estimates for 2015 sharply, based on 4Q14 earnings reports and managements’ forward guidance.  Much of the decline is due either to energy or currency, where analysts should arguably have done a better job.  Still, the picture that’s emerging for 2015 from Wall Street is of flat-to-barely-up earnings per share for the year.  This implies to me that portfolio managers will be willing–eager, actually–to give a hearing to niche companies they haven’t needed to bother with until now–provided they can show, say, 10% eps growth.


As a result, in looking for new individual stocks, I’ve been shifting my eye toward smaller cap names (also toward te h, but that’s another post…).

One caveat:  my experience is that small cap is a catchbasin for a class of perennially weak companies that manage to stay in business, but who are unable/unwilling to create earnings growth.  These may also be highly illiquid.  These can be interesting targets for seasoned value investors with long investment horizons.  The rest of us should stay away.


stock buybacks: the curious case of IBM

Regular readers will know that I’m not a fan of stock buybacks by companies.  I believe that even though buybacks are advertised as returning cash to shareholders in a tax-efficient way, their main effect–even if not their purpose–is to keep the dilutive effects of management stock options away from the attention of ordinary shareholders.  Admittedly, I haven’t done a study of all firms that buy back stock, but in the cases I have looked at the shares retired this way somehow end up offsetting new shares issued to management.  As a result, you and I never see the slow but steady shift in ownership away from us and toward employees.

In recent years, activist investors have made increasing stock buybacks a staple of their toolkit for “helping” stick-in-the-mud companies improve their returns.  Certainly, accelerating buybacks can give a stock an immediate price boost.  But since I don’t believe that the usual activist suspects have your or my long-term welfare as shareholders at heart, I’ve had an eye out for cases where extensive buybacks have ceased to work their magic.

I found IBM.

Actually I should put the same ” ” around found that I put around helping two paragraphs above.  I stumbled across an article late last year in, I think, the Financial Times that asserted all IBM’s earnings per share growth over the past five years came–not from operations–but from share buybacks.  A case of what Japan in the roaring 1980s called zaitech.  Hard to believe.

I’ve finally gotten around to looking.  I searched in vain for the article.  I found a relatively weak offering from the New York Times Dealbook, whose main source appears, somewhat embarrassingly for the authors, to have been IBM market-speak in its annual report.  I did find an excellent two-part series in the FT that I’d somehow missed but which appeared earlier this month.  It’s useful not only conceptually but also for IBM history.


The FT outlines the essence of the IBM plan to grow eps from $11.52  in 2010 to $20 by this year–a target abandoned last October by the new CEO..  Of the $8.50 per share advance, $3.50 was to come from revenue growth, both organic and from acquisitions; $2.50 each were to come from operating leverage–which I take to be the effect of keeping SG&A flat while revenues expanded–and share buybacks.

What actually happened from 2010 through 2014 is far different:

–IBM’s revenues, even factoring in acquisitions, fell by 7% over the five years

–2014’s operating profit was 5% higher than 2010’s

–net profit grew by 7.0%, aided by a lower tax rate,

–nevertheless, earnings per share grew by 35%!

How did this happen?

Over the five years, until share buybacks came to a screeching halt in 4Q14, IBM spent just about $70 billion on the open market on its own stock.  That’s over 3x the company’s capital expenditures over the same period.  It’s also about 3x R&D expenditure, which is probably a better indicator for a software firm.  And it’s over 3x dividend payments.

The buying reduced the share count by 315 million to 995 million shares.  The actual number of shares bought, figuring a $175 average price, would have been about 400 million.  I presume the remainder are to offset shares issued to employees exercising stock options (although there may be some acquisition stock in there–no easy way to find that out).


What I find most interesting is that, other than a flurry in the first half of 2011, the huge expenditure did no good.  IBM shares have underperformed pretty consistently, despite the massive support given by the company.  And IBM has $13 billion more in debt that it had before the heavy buybacks began.

Where is the company now?

I don’t know it well enough to say for sure, but it appears to me that it has taken recent earnings disappointments to jolt IBM into the realization that the 2010 master plan hasn’t worked.  A half-decade of the corporate equivalent of liposuction and heavy makeup has not returned the firm to health.  Instead, IBM has burned up a lot of time   …and a mountain of cash.

I think it’s also reasonable to ask how ordinary IBM shareholders have benefitted from the $60+ per share “returned” to them through buybacks.  I don’t see many plusses.  The stock dropped by about $20 last October, when IBM officially gave up the 2010 plan, so some investors were fooled by the company’s zaitech.  But spending $60+ to postpone a $20 loss that happened anyway doesn’t seem like much of a deal.

Only the board of directors knows why almost five years elapsed before anyone noticed the plan had long since gone off the rails.

which is the better question: where is the oil price floor or where is the ceiling?

I read sports for a radio station for the blind each Thursday.  I was listening, as usual, to Bloomberg radio in my car while on the way.  I caught the tail end of a conversation in which a guest was apparently trying to explain the difference between a copper mine (a multi-billion dollar, multi-year project) and a shale oil well ( up and drilling for cheap in a month or two).  This came as a revelation to the show’s hosts.  Part was probably showmanship, but it also underlined to me how little knowledge about mining and basic materials industries survives on Wall Street.

A basic rule of any commodities business (regular readers will know I spent six years as an oil and mining analyst and another couple managing money in stock markets with large commodity exposure) is that in times of oversupply the price only stabilizes when it falls (and remains) below the out-of-pocket costs of the most expensive producers.  The bottoming process may take a surprisingly long time.  That’s because producers may choose to operate at a loss for a while, if the costs of starting up again are high (think:  blast furnace steel) and the oversupply is perceived to be temporary.

–In the case of oil, Saudi Arabia is doing all it can to convince the world that the oversupply is not temporary.  That’s one worry out of the way.

–The consensus belief is that the floor is around $40.

Presumably this information is being factored into today’s stock prices.  Therefore, it isn’t so interesting.

the ceiling

The better question, I think, is how high the oil price might go once high-cost supply has left the market.

base metals

For a base metals mining project, reassembling a crew + machinery to restart a shuttered mine is expensive and may take half a year.  And certainly no one is going to begin to develop a new mine until price visibility is very high.

shale oil

For shale oil, on the other hand, startup might only require a handful of people and maybe a month.  In addition, if I thought I could get, say, $70 a barrel for my oil a year or two down the road instead of $45 today, I’d deliberately pull at least some of my wells out of production and wait–assuming I had my debt repayments under control.  For that portion of my output, I’d be ready to turn the spigot instantly.

I don’t know exactly what price level triggers a return of shale oil to the market, creating potential oversupply again.  But production will return very quickly.

The trigger is clearly not as high as $100.  If I were analyzing oil companies for their rebound potential, I’d hope for $70 but base my figures on $60.  The analysis itself would tell me whether $60 is high enough.

My general conclusion, though, is that oil isn’t going back to the levels of a year ago for a long time.

an aside

The best petroleum economists in the world are in OPEC.  It’s impossible that Saudi Arabia doesn’t know with much greater precision what I’ve been writing about.  Why should it be talking of oil at $100 or $200 in the near future?

Maybe for public consumption at home.  A more devious mind would suggest it’s to persuade lawmakers in the US, the most profligate user of oil, not to take the sensible course of raising gasoline taxes and thereby tempering future demand increases.  The country’s lobbyists are doubtless hard at work in Washington, as well.