Broadcom (AVGO) and Qualcomm (QCOM)

(Note:  the company formerly known as Avago agreed to buy Broadcom for $37 billion in mid-2015.  Avago retained its ticker symbol:  AVGO, but took on the Broadcom name.  Hence, the mismatch between name and ticker.  That deal is on the verge of closing now. Presumably AVGO’s recent decision to move its corporate headquarters from Singapore to the US is a condition for approval by Washington.)

AVGO and QCOM

AVGO is a company that has very successfully grown by acquisition (my family and I have owned shares for some time).  Its specialty, as I see it, is to find firms with excellent technology that are somehow unable to make money from either their intellectual property or their processing knowhow.  AVGO straightens them out.

QCOM, a firm I’ve known since the mid-1990s, seems to fit the bill.  The company makes mobile processors for cellphones.  It also collects license fees for allowing others to use its fundamental and important cellphone intellectual property.  QCOM has been in public disputes over the past couple of years with the Chinese government, which has forced lower royalty payments, and with key customer Apple, which is threatening to design out QCOM chips from its future phones.  As I see it, these disputes are the reason the QCOM stock price has stagnated over the recent past.

the offer

AVGO is offering $70 a share in cash and stock for QCOM, a substantial premium to where QCOM shares were trading before rumors of the offer began to circulate.  The current price for QCOM (I’m writing this at around 10:30) of $63.90 suggests that the market has doubts about the chances for AVGO’s success.

Standard tactics would be for QCOM to seek another buyer, one that would keep current management in place.  Since an overly pugnacious management has arguably been QCOM’s main problem, my guess is that a second bidder is unlikely to emerge.

If I were to try to participate in this contest (I don’t think I will), it would be to buy more AVGO.  I believe AVGO’s assertion that the acquisition would be accretive in year one.  So it’s likely to go up if the bid is successful.  If not, downward pressure from arbitrageurs would abate.  On the other hand, I don’t see 10% upside as enough to take the risk QCOM will find a way to derail the bid.  After all, it has already found a way to anger Beijing and 1 Infinite Loop.

the stock market crash of 1987

The Wall Street Journal has an interesting article today on the birth of the ETF–and the index fund, for that matter.

Two factors stand out to me as being missing from the account, however:

–when the S&P 500 peaked in August 1987, it was trading at 20x earnings.  This compared very unfavorably with the then 10% yield on the long Treasury bond.  A 10% Treasury yield would imply a PE multiple on the S&P of 10x–meaning either that bonds were dirt cheap or that the stock market was wildly overvalued vs. the bond market.

–a new product, called at the time portfolio insurance, a form of dynamic hedging, had very recently been created and sold to institutional investors by entrepreneurs steeped in academic efficient markets theory.  Roughly speaking, the “insurance” consisted in the intention to stabilize equity portfolio values by overlaying a program of buying and selling futures against the physical stock.  Buy futures as/if the market rises; sell futures as/if the market falls.

One of the key assumptions of the insurers was that willing/eager counterparties for their futures transactions could be found at all times and at theoretically predictable prices.  On the Friday before Black Monday–itself a down day–the insurers’ model required them to sell a large number of futures contracts.  Few buyers were available, though.  Those who were willing to transact were bidding far below the theoretical contract value.  Whoops.

On Monday morning, the insurers, who appear to have had negligible actual market experience, capitulated and began selling futures contracts at whatever price they could get.  This put downward pressure both on futures and on the physical market.  At the same time, pension funds, noting the large gap between the price of futures and the (much higher) price of the underlying stocks, began to buy futures.  But to counterbalance the added risk to their portfolios, they sold correspondingly large amounts of stocks.  A mess.

Arguably, we would shrug off at least part of this today as just being crazy hedge funds or algorithmic traders.  Back in 1987, however, equity portfolio managers had never before seen derivatives exerting such a powerful influence on the physical market.  It was VERY scary.

conclusions for today

Stocks and bonds are nowhere near as out of whack with one another as they were back in 1987.  The nearest we have today to a comparable issue is what happens as worldwide excess liquidity is drained by central banks from money markets.

The trigger for the Black Monday collapse came from an area that was little understood, even by those involved in it–activity that had severe negative unexpected consequences.  The investors who did the best after the crash, I think, were those who understood the most quickly what had happened.

Collateral damage:  one of the most important results of Black Monday, I think, was the loss of confidence in traditional investment advisers working for the big brokerage houses that it created.  This was, I think, partly because of individuals’ market losses, but partly, too, to the generally horrible executions received when they sold stocks in the aftermath.  This was the start of a significant acceleration of the shift to discount brokers and to mutual fund products.

the Republican income tax plan and the stock market

The general outline of the Trump administration’s proposed revision of the corporate and individual income tax systems was announced yesterday.

The possible elimination of the deductability from federally taxable income of individuals’ state and local tax payments could have profound–and not highly predictable–long-term economic effects.  But from a right-now stock market point of view, I think the most important items are corporate:

–lowering the top tax bracket from 35% to 20% and

–decreasing the tax on repatriated foreign cash.

the tax rate

My appallingly simple back-of-the-envelope (but not necessarily incorrect) calculation says the first could boost the US profits of publicly listed companies by almost 25%.  Figuring that domestic operations account for half of reported S&P 500 profits, that would mean an immediate contraction of the PE on S&P 500 earnings of 12% or so.

I think this has been baked in the stock market cake for a long time.  If I’m correct, passage of this provision into law won’t make stock prices go up by much. Failure to do so will make them go down–maybe by a lot.

repatriation

I wrote about this a while ago.  I think the post is still relevant, so read it if you have time.  The basic idea is that the government tried this about a decade ago.  Although $300 billion or so was repatriated back then, there was no noticeable increase in overall domestic corporate investment.  Companies used domestically available cash already earmarked for capex for other purposes and spent the repatriated dollars on capex instead.

This was, but shouldn’t have been, a shock to Washington.  Really,   …if you had a choice between building a plant in a country that took away $.10 in tax for every dollar in pre-tax profit you made vs. in a country that took $.35 away, which would you choose?  (The listed company answer:  the place where favorable tax treatment makes your return on investment 38% higher.)  Privately held firms act differently, but that’s a whole other story.

 

The combination of repatriation + a lower corporate tax rate could have two positive economic and stock market effects.  Companies should be much more willing to put this idle cash to work into domestic capital investment.  There could also be a wave of merger and acquisition activity financed by this returning money.

 

 

 

 

the amazing shrinking dollar

So far this year, the US$ has fallen by about 14% against the €, and around 8% against the ¥ and £.

A substantial portion of this movement is giveback of the sharp dollar appreciation which happened last year after the surprise election of Donald Trump as president.  That was sparked by belief that a non-establishment chief executive would be able to get things done in Washington.  Reform of the income tax system and repair of aging infrastructure were supposed to be high on the agenda, with the resulting fiscal stimulus allowing the Fed to raise interest rates much more aggressively than the consensus had imagined.  Hence, continuing dollar strength on a booming economy and increasing interest rate differentials.

To date, none of that has happened.   So it makes sense that currency traders would begin to reverse their bets on.  However, last year’s move up in the dollar has been more than completely erased and the clear consensus is now on continuing dollar weakness.

 

Dollar weakness has caused stock market investors to shift their portfolios away from domestic-oriented firms toward multinationals and exporters.  This is the standard tactic.  It also makes sense:  a firm with costs in dollars and revenues in euros is in an ideal position at present.

It’s interesting to note, though, that over the weekend China lifted some restrictions imposed last year that limited the ability of its citizens to sell renminbi to buy dollars.

To my mind, this is the first sign that dollar weakness may have gone too far.

It’s too soon, in my view, to react to this possibility.  In particular, the appointment of a new head of the Federal Reserve could play a key role in the currency’s future path, given persistent Republican calls to curtail its independence.  Gary Cohn, the establishment choice, is rumored to have fallen out of favor with Mr. Trump after protesting the latter’s support of neo-Nazis in Charlottesville.

Still, it’s not too early to plot out a potential strategy to benefit from a dollar reversal.

 

 

Jeep as a Chinese brand

A mainland Chinese company, Great Wall Motor of China, has recently expressed interest in acquiring either the Jeep brand + manufacturing operations or all of Fiat/Chrysler.

The press has since been filled with commentary whose thrust is that Washington will oppose either sale proposition.

Several things strike me as odd about this:

–brands like Volvo and Jaguar have looked a lot more interesting recently since coming into Asian hands, so that shouldn’t be an issue (although this is likely the crux of the matter)

Jeep is now part of an Italian company   …which bought it from a German firm that was slowly sinking under the weight of a senescent Chrysler   …which had been foundering despite a government bailout in the 1970s and a huge injection of badly needed engineering talent under Daimler.  So a firmer economic footing for the whole Chrysler enterprise is unlikely to come without outside-the-box thinking.  Also, it’s hard to make a logical argument that foreign ownership for any part of Chrysler is a problem

–if the Great Wall Motor interest is real, it suggests the company has access to foreign exchange at a time when Beijing is cracking down on reckless foreign m&a by domestic corporations.  That likely means that Great Wall has enough influence in China to be able to expand the Jeep brand’s reach quickly

–I haven’t heard a lot of posturing from Washington.  Either I’m really out of touch on this one, or the anti-Great Wall sentiment is mostly in the minds of reporters.

a rainy Friday in August in New York

August is the month when many senior portfolio managers are away from the office on vacation.  So big decisions on portfolio structure tend not to be made.

Friday is the day of the week when short-term traders’ thoughts turn to flattening their books so they won’t carry risk over the weekend.

It’s raining, which sparks thoughts in traders of sleeping in or leaving work early.

Add all that up, and the heavy betting should be that US stocks will likely move sideways in the morning and fade off toward the close.

That means this is a good day to stand on the sidelines and size up the tone of the market.

 

In pre-market trading, tech is up and bricks-and-mortar retailing (on the earnings miss by Foot Locker) is down.  …nothing new about this.  At some point there will doubtless be a fierce counter-trend rally.  But the negative earnings surprises are still provoking severe selloffs.  So I don’t think today is the day.

Pundits are speculating about the damaging effects on his political agenda of Mr. Trump’s apparent defense of neo-Nazis in Charlottesville.  …but the Trump trade has been MIA since January, with the US a laggard among world stock markets during Mr. Trump’s time in office so far.  Yes, there may be residual hope for corporate tax reform from the administration, which this latest demonstration of the president’s ineptness as a executive could arguably undermine.  My guess is, however, that he is already well understood.

Two questions for today:

–will the market perform more strongly than the season and the weather are suggesting? This would be evidence that there’s still an untapped reservoir of bullishness waiting for somewhat better prices to express itself.

–should we be buying in the afternoon if it’s weaker than I expect?  My answer is No.  I think there is a lot of untapped bullishness, but we’re in a slowly rising channel whose present ceiling is less than 2500 on the S&P 500.   That’s not enough upside for me.  I’m also content to wait for any incipient bearishness to play itself out further.

It will be interesting to see how today plays out.

 

Blue Apron (APRN) at $5+

APRN went public less than two months ago at an offering price of $10 a share.  That was down from pre-offer brokerage chatter (which is  always very optimistic) of $15 – $17.   Given that the average cost for pre-IPO shareholders is just above $1.60, though, any double-digit price must have looked good.

Certainly, the possibility of Amazon/Whole Foods as a competitor was–and still is–a worry.  There are, however, others:

–lack of barriers to entry

–churn:  stories that very large numbers of customers who signed up for trials at promotional discounts balked at continuing at the full price of about $10 a meal

–continuing working capital deterioration.  According to the prospectus, at yearend 2015, APRN had $127 million in unrestricted cash.  By 3/31/17, that figure had shrunk to $61 million, despite APRN taking in $121 million through long-term borrowing and advance subscription payments by customers (listed on the balance sheet as deferred revenue).  Looked at this way, APRN’s operations gobbled up over $180 million in fifteen months.  By 6/30/17, the situation was $30 million worse.

As it turns out, one of my sons had a Blue Apron subscription in the months before the IPO.  I helped prepare some of the meals.  I thought the recipes were excellent but that the ingredients supplied suffered from trying to keep costs down.  So I’m not a fan.  In fact, I’m a bit surprised the IPO went as smoothly as it did.

where to from here?

My initial take is that IPOs like APRN or Snap indicate there’s too much cash sloshing around in the system.  That always seems to end up chasing speculative deals.  My hunch is that APRN won’t be a big success without a significant revamp of strategy.

On the other hand, there’s arguably a price for everything.  In addition, the activist investor that pushed for changes at Whole Foods, Jana Partners, has just disclosed a 2% stake in APRN.

…maybe a turn for the better.  But, as things stand now, I’ll be watching from the sidelines.