Monthly Archives: July 2015

more on gold

July 31, 2015 By in Gold, Industry Analysis, Mining Tags: , , , , , , 1 Comment

just to clear the air

I was interviewing a prominent tycoon in Hong Kong  in the mid-1980s when the topic turned to gold.  He told me that he had long since sold all the gold bars he had once used to store his wealth.  He was now holding currency and currency derivatives instead.  I soon found that this was the norm among the rich and powerful in what had once been the center of gold bug-dom.

This was akin to travelling to southern California and seeing budding cultural trends in the US.  That’s when I began to realize that gold that had lost its function universal function as a store of wealth.  Yes, gold retains this function in third world countries like India, where people don’t trust or can’t afford banks, but–in my view–nowhere else.

As fun as it might be to elaborate on this theme, I want to write more about the mechanics/quirks of the gold market–mostly about production–than about popular delusions.

about supply

–Inventories, held either as gold bars or in jewelry, dwarf production.  As decision of holders in the three biggest markets–India, China and central banks– to liquidate can have a significant effect on price.

–Gold mines typically have pockets of ore that are very rich in gold and others that are relatively thin.  Industry practice is to aim for maximum sustainable mine life.  This means mining larger amounts of relatively poor ore are when prices are high and shifting the mix toward richer ore  when prices are low.  One practical consequence of this practice is that actual production cost figures from the past few years of high prices are going to overstate the cost of production in today’s lower price world. Another is that production amounts tend at least initially to expand when prices fall.

–When mines get in financial trouble they begin to “high grade,” meaning they produce exclusively from their richest ore deposits and they cut the amount they usually spend on maintenance and on developing newer areas to mine.  This is ultimately destructive of a mine’s long-term prospects, but it ups near-term cash flow–and it can go on for an extended period.

–When I began studying gold mining companies in the late 1970s – early 1980s, gold miners were very financially conservative because they understood clearly that their industry was subject to violent ups and downs in price.  Their number one rule was to have no debt and a large cash reserve.  That’s no longer the case.  Heavy borrowing urged by CFOs with academic finance training but little industry experience has meant that mines need to generate enough cash to service debt as well as pay operating costs.  This intensifies the need to generate maximum cash flow, even at the expense of diminishing long-term mine viability.

–Bankruptcies may help the orebodies.  But because they remove the burden of debt service, they make the near-term supply situation worse, not better.

my conclusions

The gold price can go lower, and stay depressed for a longer period, than I think most people expect.

oil and gold: finding the commodity cycle bottom

July 30, 2015 By in Capital-intensive firms, contribution margin, Energy, Gold, Industry Analysis, Mining Tags: , , , , 2 Comments

I got my first couple of portfolio manager jobs in the 1980s because one of my industry specializations as  a securities analyst was natural resources.  Back then, there were an enormous number of mining analysts in an information industry based in London.  The large size and vitality of the analyst community were partly because there had been an enormous spike in the prices of gold and oil in the late 1970s-early 1980s. So investors were willing to pay handsomely for information and interpretation.  Also, the prevalent economic theory of the day, since proved to be woefully incorrect, held that a necessary condition for global economic growth was a continuously expanding supply of mineral resources.

When the Chinese economic expansion-driven commodities boom began a decade and a half later, I found that, unsurprisingly after 15 years of no one being interested, the entire stock market information infrastructure for metals had disappeared.  There were still the odd steel or oil analyst around eking out a living and staggering toward retirement, but little else, either in London or New York.

As far as I can see, from an information perspective the situation is at least as bad today.  In the perverse way that Wall Street works, however, that lack itself is the basis of the positive thesis for mining in general.

industry characteristics

Mineral extraction industries are very capital-intensive.  This means that projects typically require large amounts of up-front money. But they can often continue, once up and running, for long periods without new funds being put in.

Mining projects often have very long lives.

Very often, projects are also huge.  This is partly the nature of the beast, partly a function of the temperament of the people who run minerals companies.  This means that new supply is often added in gigantic chunks.  New supply almost invariably arrives in amounts way above the increase in demand and typically, therefore, marks the high water mark in terms of price.  Boom and bust, boom and bust–the rhythm of these markets.

finding the bottom

Falling prices indicates that there’s more supply than demand.  In theory, that situation can be reversed either by demand expanding or by supply contracting.  In practice, the first rarely happens.

What establishes the bottom for these markets, in my experience, is a price decline that’s deep enough to force high-cost capacity to close.  This does not mean the price at which companies stop earning a financial reporting profit.  That price is too high.  That’s because it includes as an expense a non-cash allowance for recovering the money spent to open the project.  A company can also be compelled to sell at unfavorable prices by creditors.

What actually matters is the point at which the out-of-pocket cash cost of getting output out of the ground is less than what it can be sold for.  That’s the point at which projects begin to shut themselves down.  They may not do so immediately.  They may continue to bleed in the hope of an imminent turnaround.

For gold, the relevant figure is around $850 an ounce, I think.  Oil is a bit more complicated, but the magic number is likely about $40 a barrel.

More tomorrow.

 

 

how one China-related ETF has fared

July 29, 2015 By in Asian economic development, China, frontier markets, Hong Kong, securities markets, short selling, stock market Tags: , , , , , , , , , Leave a comment

Yesterday I mentioned a Factset article about the trading behavior of China-related ETFs during the current market gyrations in Shanghai and Shenzhen.  It focuses on the Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (ASHS).  Quite a mouthful.

ASHS opened for business last year and has about $41 million in assets.  Its goal is to track the performance of 500 Chinese small caps.  It holds all of the names in the appropriate proportions, to the extent that it can.  Where it can’t, it finds the best proxies available.

Year to date through yesterday, ASHS has risen by 37%+.

The fund melted up in mid-June, however.  Its price rose by 40% from June 8th through June 10th alone, at which time it had y-t-d performance of +113%.

The bottom fell out in the following month, when ASHS lost slightly more than half its value–before bouncing back up by +30% over the past few weeks.

Two points about ASHS:

1.  The fund uses fair value pricing, which is the industry norm in the US.  Fair value pricing, usually performed by a third party the fund hires, does two things:

—-it adjusts the prices of foreign securities in markets that are closed during New York trading for information that has come to light after their last trade, and

—-it gives an estimate for the value of securities that are not trading for one reason or another on a given day.

(Note: in my experience, both types of adjustment are surprisingly reliable.)

This second feature has doubtless come in handy over the past couple of months, since there have been days when as many as half of the Chinese small caps haven’t traded.

 

2.  A mutual fund transacts once a day, through the management company, after the market close and at Net Asset Value.

In contrast, an ETF like ASHS trades continuously during the day, through a number of broker dealers (Authorized Participants), and not necessarily at NAV.

The idea is that these middlemen will use the very cheap brokerage record systems for fund transactions, thus keeping administrative costs down–and that the brokers will use their market making and inventory capability as a way of minimizing the daily flows in and out of the ETF portfolio.

In June, this worked out in an interesting, and ultimately stabilizing way for ASHS.

As I mentioned above, the market price of ASHS rose by 40% over two days in mid-June.  We know that, according to Chinese trading rules, the stocks in the portfolio itself could rise in value by at most 10% daily, or 21% over two days.  I can’t imagine the ASHS fair value pricing service decided that the portfolio was actually worth 40% more than two days earlier when the market signal was twenty-ish.  If I’m correct, the broker dealers decided to meet (presumably large) demand for ASHS shares by letting the premium to NAV expand substantially  …by 20%?…thereby choking some of the demand off, rather than issue a ton of new ASHS shares at a lower price.

According to Factset, the brokers did create new shares.  But they apparently lent at least some of them to short sellers, who sold them in the market, further tamping down demand.

So the Authorized Participants performed their market-making function admirably–presumably making a boatload of money in the process.   But this situation illustrates that the worst fears of possible ETF illiquidity in crisis times may be overblown.

 

 

 

 

 

Chinese stocks—and related ETFs

July 28, 2015 By in China, frontier markets, Hong Kong, Margin, margin trading, Stock Connect, stock market Tags: , , , , , , Leave a comment

I got home late last night and flipped on the TV to watch baseball.  What came on first was Bloomberg TV, where reporters in London (?) and Hong Kong were exchanging near-hysterical comments about the declining Shanghai and Shenzhen stock markets.

The facts couldn’t have been much more at odds with their dire pronouncements.  Yes, the markets were down by 2% – 3%.  Yes, a small number of stocks were limit down.  But the markets were relatively stable and trading was orderly.  Given, however, that the main concern for global investors, as well as Chinese participants in the domestic stock markets, is to have China shrink the still-large amount of margin debt outstanding without a market collapse, overnight market action in Shanghai and Shenzhen  was a very positive development.  As it turns out, although the markets closed down slightly for the day, they were even up at one point.  Volumes were reasonable, too.  Let’s hope this continues.

(An aside:  the Bloomberg TV spectacle I witnessed is one more illustration, if anyone needed it, that the recent shakeup of the Bloomberg news organization is taking it further down the road toward infotainment and away from analysis.)

 

I came across a Factset article this morning discussing the performance of ETFs that specialize in small-cap Chinese stocks.  These have been the center of speculative activity in China over the past year.  But they have also been an area subject at times to protracted trading suspensions for some stocks and to days where some have been limit-up or limit-down with no trade.  The short story is that thanks to fair value pricing the ETFs themselves have experienced no problems.  More on this tomorrow.

Chinese stock markets

July 27, 2015 By in characteristics of their financial markets, China, emerging markets, Margin, margin trading Tags: , , , Leave a comment

After recently stabilizing and then rising by about 15%, Chinese stock markets gave up half their gains overnight, causing worry in global financial markets.

For what it’s worth, given that I don’t follow the mainland Chinese stock markets carefully, this is what I think is going on.

Three important factors:

–a government crackdown on real estate speculation has shunted tons of “hot” money into stocks

–Beijing didn’t pay much attention to direct and indirect margin trading ( indirect meaning commercial loans collateralized by stocks bought with loan proceeds, which avoid the letter of the law), thereby allowing speculators to leverage themselves very highly

–stock market rules set limits on the daily movement in individual stocks to + / – 10%.  The way this works is that the exchange attempts to set an opening price at the start of the day.   Let’s say yesterday’s close was 100.  The exchange sees there are sellers at 100 but no buyers.  So it waits a little while and then moves the proposed opening to 99.50. Again sellers but no buyers.  So it moves the proposed opening to 99.  Same thing.  So the proposed opening price continues to ratchet down either until buyers emerge or the proposed price reaches 90.  In the latter case, the price remains at 90 until either buyers appear or the trading day closes.  The same process happens the following day.  (Of course, there might be overwhelming upward pressure as well, in which case the price ratchets up without trade, or stocks might trade–as appears was the case overnight–for part of the day before reaching the daily limit price.)

snowballing downward pressure

A big problem with the daily limit system is that in times of stress often no selling gets done.  For speculators who get margin calls, this means that each day the amount they owe their broker rises (as the market falls) and they can’t take any action to stop the bleeding.  So a horrible sense of panic comes into the market.

The resulting downward spiral is what Beijing was trying to fix when it initiated extraordinary market stabilization measures a short while ago.

The first step in recovery is to stop the market decline.

The second–which is where we are now, I think–is to begin to unwind the enormous margin position that Beijing inadvertently allowed to develop.  The only way to do this is to gradually withdraw the official props under the market, not enough to have the market freeze up again but enough to allow selling to happen.  My guess is that this is what is starting to go on now.  The keys to watch are volume figures and the total value of transactions–the higher, the better.  Unfortunately, I can’t volume figures for today’s trade anywhere.

effects?

In my experience, most emerging stock markets have problems like this in their early days.  Once the crisis is over, authorities usually pay better attention to margin debt.  Invariably, they effectively dismantle the daily limit rule.

Typically, stock market problems have no overall negative effects on the economy.

In the short term, however, margin or redemption selling can create perverse market signals.  Forced sellers liquidate what they can, not necessarily what they want to.  This means, for example, that Hong Kong stocks can come under pressure.  It also suggests that smaller, low-quality stocks may outperform blue chips–the former will be suspended while the latter go down.

This can be a real disaster for margin speculators, who may be left with an account that technically has equity in it but is filled with unsalable junk.  On the other hand, the forced nature of a margin-related selloff can give new entrants a chance to buy high-quality stocks at distressed prices.

One seemingly odd sign that the worst is over will be a collapse in smaller stocks as larger ones are beginning to rise again.  This means that buyer interest is returning to the smaller ones and they’ve resumed trading, which is a much better state than they’re in today.

Another, perhaps lagging, indicator that the worst is over would be Beijing ending the daily trading limit rule.

How long will the cleansing process take?

I don’t know enough detail to have an educated guess.  A couple of months would be my initial estimate.