discounting and today’s equity market

Discounting is the term Wall Street uses for the idea that investors factor into today’s prices, to a greater or lesser degree, their beliefs about the future (I wrote a detailed post about the process in October 2012).

 

Two of the major macroeconomic factors the market is wrestling with now are the timing and extent of the Fed’s future moves to raise interest rates from their current emergency lows, and the possibility that Greece will default on its debts and exit the euro.

 

My experience is that almost nothing is ever 100% discounted in advance.  There’s always some price movement when the event actually happens.  Having said that, the coming rise in interest rates in the US has been so anticipated–and talked about by the Fed–for such a long time that there may even be a positive market reaction to the first rise.  This would be on the idea that Wall Street would give a sigh of relief when there’s no more anticipatory tension to deal with.  More likely, there’ll be a mild negative movement, for a short period, but that’s all.

The Greek financial crisis has also been in the news for a long time.  But we don’t have the same extensive history of behavior during past economic cycles to draw on, the way we do with the Fed.  We do have Argentina as a case study in what happens to the defaulting country (personally, I expect the consequences of default for Greece would be pretty terrible for its citizens).  But the focus of investors’ concern is what damage might be done to the EU by Greece’s leaving.  In addition, lots of non-economic factors are involved in this situation.  There’s Greece’s central role in Europe’s beliefs about its own exceptionalism.  There’s the Greek portrayal of the EU’s requirement that Greece implement structural economic reform as a condition for debt relief as 21st-century Nazism.  There’s the status quo in Greece that has benefited from the country’s profligate borrowing.  There’s fear of the unknown that must be urging politicians to paper over Greece’s problems.

In addition, my sense is that the markets’ overriding emotion so far is denial–hope that the whole situation will go away.  Current thinking seems to be that the parties will arrange for some sort of default, along with capital controls to restrict the flow of euros out of Greece, that will allow Greece to stay in the EU.  Still, I find it very hard to calculate odds or even to anticipate what the worst that can happen might be, or the best.  This makes me think that very little of the possible negatives of “Grexit” are factored into today’s prices.

More tomorrow.

Berkshire Hathaway and Kraft

A little less than a month ago, Warren Buffett’s Berkshire Hathaway and Heinz (controlled by Brazilian investment firm 3G) jointly announced a takeover offer for Kraft.  The Associated Press quoted Mr. Buffett as asserting “This is my kind of transaction.”  I looked for the press release containing the quote on the Berkshire website before starting to write this, but found nothing.   The News Releases link on the home page was last updated two weeks before the Kraft announcement.  Given the kindergarten look of the website, I’m not so surprised   …and I’m willing to believe the quote is genuine.  If not, there goes the intro to my post.

 

As to the “my kind” idea, it is and it isn’t.

On the one hand, Buffett has routinely been willing to be a lender to what he considers high-quality franchises, notably financial companies, in need of large amounts of money quickly–often during times of financial and economic turmoil.  The price of a Berkshire Hathaway loan typically includes at least a contingent equity component.  The Kraft case, a large-size private equity deal, is a simple extension of this past activity.

On the other, this is not the kind of equity transaction that made Mr. Buffett’s reputation–that is, buying a large position in a temporarily underperforming firm with a strong brand name and distribution network, perhaps making a few tweaks to corporate management, but basically leaving the company alone and waiting for the ship to right itself.  In the case of 3G’s latest packaged goods success, Heinz, profitability did skyrocket–but only after a liberal dose of financial leverage and the slash-and-burn laying off of a quarter of the workforce!  This is certainly not vintage Buffett.

Why should the tiger be changing its stripes?

Two reasons:

the opportunity.

I think many mature companies are wildly overstaffed, even today.

Their architects patterned their creation on the hierarchical structure they learned in the armed forces during the World War II era.  A basic principle was that a manager could effectively control at most seven subordinates, necessitating cascading levels of middle managers between the CEO and ordinary workers.  A corollary was that you could gauge a person’s importance by the number of people who, directly or indirectly, reported to him.

Sounds crazy, but at the time this design was being implemented, there was no internet, no cellphones, no personal computers, no fax machines, no copiers.  The ballpoint pen had still not been perfected.  Yes, there were electric lights and paper clips.  So personal contact was the key transmission mechanism for corporate communication.

Old habits die hard.  It’s difficult to conceive of making radical changes if you’ve been brought up in a certain system–especially if the company in question is steadily profitable.  And, of course, the manager who decided to cut headcount risked a loss of status.

Hence, 3G’s success.

plan A isn’t working  

One of the first, and most important, marketing lessons I have learned is that you don’t introduce strawberry as a flavor until sales of vanilla have stopped growing.  Why complicate your life?

Buffett’s direct equity participation in Kraft is a substantial departure from the type of investing that made him famous.  I’ve been arguing for some time that traditional value investing no longer works in the internet era.  That’s because the internet has quickly broken down traditional barriers to entry in very many industries.  It seems to me that Buffet’s move shows he thinks so too.

 

 

 

 

cooling the Chinese stock market fever

In the 1990s, Alan Greenspan, the head of the Fed back then, famously warned against “irrational exuberance” in the US stock market, but did nothing to stop it   …this even though he had the ability to cool the market down by tightening the rules on margin lending.  This is the stock market  analogue to raising or lowering the Fed Funds rate to influence the price of credit, but has never been used seriously in the US during my working life.

The  Bank of Japan has no such compunctions.  It has been very willing to chasten/encourage speculatively minded retail investors by tightening/loosening the criteria for borrowing money to buy stocks.

 

We have no real history to generalize from in the case of China.  But moves in recent weeks by the Chinese securities markets regulator seem to indicate that Beijing will fall into the stomp-on-the-brakes camp.

Specifically,

–at the end of last month, the regulator allowed (ordered?) domestic mutual funds to invest in shares in Hong Kong, where mainland-listed firms’ shares are trading at hefty discounts to their prices in Shanghai

–highly leveraged “umbrella trusts” cooked up by Chinese banks to circumvent margin eligibility requirements have been banned,

–a new futures product, based on small and mid-cap stocks, has been created, offering speculators the opportunity to short this highly heated sector for the first time, and

–effective today, institutional investors in China are being allowed to lend out their holdings–providing short-sellers with the wherewithal to ply their trade (although legal, short-selling hasn’t been a big feature of domestic Chinese markets until now, because there wasn’t any easy way to obtain share to sell short).

What does all this mean?

The simplest conclusion is that Beijing wants to pop what it sees as a speculative stock market bubble on the mainland.  It is possible, however, that more monetary stimulus–to prop up rickety state-owned enterprises or loony regional government-sponsored real estate projects–is in the pipeline and Beijing simply wants to dampen the potential future effects on stocks.

I have no idea which view is correct.

It’s clear, however, that Hong Kong is going to be a port in any storm, and that it is going to be increasingly used as a safety valve to absorb upward market pressure from the mainland.  So relative gains vs. Shanghai seem assured.  Whether that means absolute gains remains to be seen, although I personally have no inclination to trim my HK holdings.

 

 

1Q15 results for Intel (INTC)

the results

INTC reported 1Q15 earnings after the close on Tuesday.   Results were flattish year-on-year, matching analysts’ forecasts.  This was unsurprising, given  INTC had preannounced 1Q15 was not going as well as expected.  The company thinks some, but not much, relief from the current doldrums will appear in the second half.

The culprit has been the traditional PC business.  Small-and medium-sized firms haven’t been converting their old Windows XP desktops to newer machines.  Maybe they’ve decided to wait for Windows 10, or they don’t want to update their (pirated?) Office programs or they just figure they’ll use XP until something breaks.  Whatever the reason they’re not buying.

This hurts INTC in two related ways:  OEMs don’t have to reorder parts   …and they run down their inventory levels to match weaker demand.  INTC thinks the second process was pretty much over by the end of March.

Notebooks and tablets were up, though, and the server-related businesses are going great guns.

picky stuff

INTC now thinks its full-year tax rate will be 25%, not the 27% previously forecast.  This suggests the current mix of business is more Asia, less US than the company previously thought.

INTC is cutting capital expenditure plans.  Weaker PC demand means less need for older factories, which can be refit for more cutting-edge use.  Hence, less need to build from scratch.

Tablet demand was up 45% yoy in 1Q15.  This is good news and bad.  Good that someone wants the chips, bad in that INTC is essentially paying users to take them.  Nothing new here.  However, INTC had expected to begin to show profits on them by yearend.  That apparently is not going to happen.  INTC was likely planning to get out of the hole both by raising prices and by driving down unit manufacturing costs.  My guess is that the first isn’t happening yet.  (My view is that whatever it takes to get INTC parts into the hands of manufacturers is the correct strategy.  Ideally, the prior CEO would have understood the movement away from big clunky tethered PCs and reacted years ago.  But that’s water under the bridge.)

the big change (in my view)

INTC has changed the way it is presenting results to investors, effective with 1Q15.  It is folding the loss-making Mobile and Communications Group into the former PC Client Group, now dubbed Client Computing Group.

Some of this is just optics–the MCG lost about $1 billion a quarter during 2014, mostly trying to jumpstart the tablet business.  So we won’t see the red ink any more.

At the same time, through the magic of subtracting mobile losses from PC profits, the server business  becomes the largest single earner INTC has.

conclusions

In a sense, INTC is saying it wants to be known as an internet infrastructure company that happens to make PCs, rather than as a PC firm that happens to make servers.

Who wouldn’t!, a cynic might comment.

I think  the move is more than that, however.  It may also signal a change in behavior.  The new line of business table neatly divides the company into a growth segment–servers, embedded internet-of-things chips, 3-D flash…–and a mature cash cow, Client Computing.

If so, the first will be run as a profit center and measured by growth, the second more or less a cost center and measured by contribution margin (the reason I wrote about this topic yesterday).

During the conference call (as usual, I read the Seeking Alpha transcript) INTC said the servers etc. are accounting for 60% of the company’s profits right now.  If we assume that these businesses can continue to grow at 20% annually and that CCG stays flat, then servers etc. would be 75% of INTC’s profits–and expanding in scale–in 2018.

This would presumably result in a higher PE multiple at come point, as well as higher earnings.  The question I’m currently pondering is whether this prospect makes INTC more attractive than a tech-oriented ETF.

 

contribution margin

three sets of books

A couple of years ago, I wrote a post about the three sets of accounts that a publicly traded company maintains:

–tax books, where the objective is to pay the smallest amount of tax legally possible–in other words, to fool the IRS,

–financial reporting books, where a more liberal view of when and how revenues and expense occur allow a company to put its best foot forward with owners–in other words, to fool shareholders, and

–management control books, also called cost accounting books, which the company uses to actually run its operations.

contribution margin

Contribution margin is a cost accounting concept.

The first thing to note is that despite its name it’s not really a margin–that is, it’s not a percentage.

Instead, it’s the amount by which an activity or a  line of business exceeds its own direct costs and makes a contribution to corporate overhead.  This isn’t the same as making a standalone profit, meaning after covering total costs.

Take a restaurant that’s now open for lunch and dinner and makes money doing so.

Should it open for breakfast, as well?

In the simplest case, the question is whether the restaurant can generate enough revenue to offset the cost of paying for the food and the staff.  If so, it makes a positive contribution margin.  If we were to allocate, say, 20% of the restaurant’s total expense for rent, electricity and depreciation of equipment,  breakfast might be bleeding red ink.  But those costs are there anyway, whether breakfast is or not.  As long as the contribution margin is positive, the firm is better off with breakfast than without.  (Yes, the actual situation is more complicated   …is the wear and tear higher because of breakfast?   …does breakfast cannibalize the other meals?   But I’m keeping it simple to illustrate a point.)

Another case.   Some lines of business may never have been intended to create growing profits, or may no longer be capable of doing so, even if they once were.  A manufacturer may make precision components in-house.  The component division will typically be run as a cost center, not a profit center.  It’s mission will be to provide high quality parts at the lowest price, not to maximize profits.  Its managers will be evaluated by their ability to provide output more cheaply than third-party alternatives can.  Again, the division may not be profitable after allocation of its share of corporate overhead.  Still, it may be very valuable.  Its value will be measured by contribution margin, defined as the difference between in-house and third-party component costs.

Why is this important?

It’s a mindset thing.  Not every part of a company may be intended to grow.  Rising stars may eventually turn into cash cows as businesses evolve.  It’s important both for company management and investors to understand the role an activity should be playing in the overall enterprise.

 

 

Hong Kong back to earth

After four days of furious buying by mainland institutional equity investors, the Hong Kong market had a down day today.  This comes despite continuing healthy money inflow from the Shanghai-Hong Kong Stock Connect mechanism.  Although I didn’t watch the market closely (too late in the night for me), it seems as if sellers emerged in force in the afternoon when mainland money was unable to push the market much higher in the morning.

As one might expect, the big winners of the past week were the big losers of today.

Although I feel no overwhelming need to buy tomorrow, it looks to me that Stock Connect will end up setting a higher floor under China-related shares in Hong Kong than was possible when locals and US/EU international investors were the main participants in the market.

 

I’ve been a bit bemused at media surprise that many Hong Kong heavyweights have not participated in the rally.  The stocks in question have at least one of the following characteristics:

1.  they have broad global exposure but no particular focus on China,

2.  they’re controlled by UK interests and continue to be symbols of former colonial rule, and/or

3.  in the case of the “hongs” or trading companies, they are the 21st century form of the British-owned opium companies that were Hong Kong’s mainstay in the nineteenth century.  During the Opium Wars of the mid-1800s, Britain invaded China, forcing legalization of trade in the narcotic and effectively seized of Hong Kong Island and a chunk of the mainland from Beijing.  Companies strongly connected with this national humiliation are the last firms mainland investors are likely to buy!

What stocks are mainlanders buying?  They’re what one would expect:

–companies dually listed in Hong Kong and China, but trading at a discount in Hong Kong

–companies with attractive businesses in China, but listed only in Hong Kong.

Trading over the next few days will likely give us a better idea of the staying power and price sensitivity of mainland investors.  For me, the key question is whether Stock Connect buyers will let prices drift down before reentering.

 

the “decimation” of Portland, Oregon’s container business–is this LA’s future?

Last week I wrote about the Los Angeles-area container ports’ continuing problems between the shipping lines and port workers.  My view is that inability to resolve these conflicts is the motivating factor behind the shippers’ support for alternate routes to the east coast of the US, like the expansion of the Panama Canal now under way.  A corollary is that there’ll be a significant supply chain reshuffle for East Coast customers once the canal expansion is completed.

Shortly after that post, I found an article in the Journal of Commerce about the contraction of the container business in Portland, Oregon.  It seems to me to anticipate what is likely to occur in the LA area in coming years.

According to the JOC,  a jurisdictional dispute between the International Longshore and Warehouse Union (ILWU) and the International Brotherhood of Electrical Workers (IBEW) over who controls two electrician positions servicing refrigerated containers has resulted in continuing work stoppages and slowdowns in the Portland port over the past three years.  The jobs were originally IBEW positions.  In 2010, the ILWU demanded–and was given–control over the two slots.  After ILWU members were unable to do the work satisfactorily, the port returned control to the IBEW.  That triggered local work stoppages and slowdowns.  In addition to this, the Portland local of the ILWU participated in the recent four-month work slowdown that affected all West Coast ports.

A month ago, Korean shipper Hanjin, which represented about 2/3 of the port’s container business, ceased operations at Portland.  Last week, German shipper Hapag-Lloyd, which is virtually all of the rest, did so as well.

This leaves Portland with two problems:

–exporters to Asia of agricultural products from Oregon and Idaho, which had been using the return leg of trans-Pacific shipping routes to get their output to market no longer have that possibility.  Their (more expensive) choices:  truck goods to Tacoma, Seattle or LA.

–the ILWU contract calls for full-time workers to be paid $35.58/hour for 37.5 hours per week, whether there is work or not.  If the recently negotiated contract is ratified, those figures will rise to $36.68 and 40 hours.

 

The Oregonian estimates that the loss of Hanjin will eliminate work for 657 longshoremen, being paid $225,000 a day–and put 5,000 more jobs in the community at risk.  The earliest it sees possible replacement traffic is in two years.  By then, however, the Panama Canal expansion should be complete–or very close.