Growth and commodity prices

What has helped US avoid a recession so far? Exports - to the fast growing emerging markets, read China, India etc.

What has caused commodity prices to go up? a) Loose monetary policy, b) China's growth - it is still growing at 10%+. I was looking at the presentations of various commodity companies - Mittal, Rio, BHP etc - and they all start with China and end with China.

In the previous commodity cycles, did prices fall because excess supply came up, or did they fall because demand didn't materialize? I dont know - my guess is demand growth was much lower than expected, so excess supply got created because suppliers were betting on a higher growth rate in demand.

Is it possible that China slows down just enough for commodity prices to fall, but still grows at a good enough rate to keep US out of recession? For this, Chinese growth will need to shift from investment led growth to consumption led growth. Whether it can happen at all, or if the pass can happen smoothly is a million dollar question.

Have Olympics distorted investment demand patterns in China in a big way this year? We will soon find out.

Fooling some of the people all the time

I have been reading this book by David Einhorn - the most outspoken of the Lehman shorts - and it is terrific. I would highly recommend it to anyone who wants to spend a lot of time investing, for the following reasons.

1. This is probably the only book out there on how to build and research the short case on a stock. 99% of the investing books out there devote their attention on buying rather than selling.

2. This is a very good read for any bank analyst as to how financial companies can fudge numbers if they dont do mark-to-market (MTM). By avoiding timely writedowns and pushing NPAs out in the future, financial companies can engineer their stocks to remain high and raise additional capital at these inflated prices, so that problem loans become a small part of the overall capital base.

3. It is important to understand the true economics rather than the last quarterly financials - whether on the short side or the long side. I have not read a better account of financial forensics.

4. A short idea can also take a long time to play out. The investing philosophy is thus short and hold, rather than buy and hold. As the natural tendency of stocks is to go up, it is risky. So, one needs to be absolutely convinced of the investment thesis to do short and hold, much more than one is convinced on a long idea.

An exchange traded debt sell off?

According to Quantomonline, there are 119 debt securities that are listed on the stock exchanges. I have put their ticker symbols below.

It seems as if there was a sell-off in the exchange traded debt of various securities yesterday, starting sometime around 10 am. AIG, Comcast, CBS, ING, AT&T - financial/non-financial debt all sold off. Someone must be liquidiating.

Now I know inflation is heating up and all these long duration bonds are most sensitive to interest rate changes. But how can one explain that AFE - AIG's senior unsecured debentures maturing in 2034 - are yielding 12%, while its 6-1/4 senior unsecured bonds maturing in 2036 are yielding 7.2%. Even its 2067 bonds are yielding 8.7%. Or for that matter - CCS, CCT and CCW - all Comcast unsecured bonds maturing somewhere around 2055 have different yields. CCS is yielding 8.7% and CCT and CCW are yielding 8.3%, while its 2038 bonds are yielding 7%.

Here is the list to make the portfolio on yahoo or google finance.

AAR ABA AEP-A AFC AFE AFF AKF AKT ALF ALQ ALZ ATT AVF AZM BGM CCS CCT CCW CEG-A CPV CRP CSB DFP DFY EHA EHB EHL EMO EMQ F-A FCJ FCY FCZ FGC FGE FSB FSE GAH GAJ GAR GBM GEA GEC GED GEG GEJ GEP GER GFW GFZ GJM GKM GMA GMS GMW GOM GPD GPJ GPM GPU GPW GRM GUL GUQ GXM HGM HTB HTN IJD IKJ IKL IKM IKR IND INZ ISG ISP LNC-G MLG MPJ NRC NRN NRU NXY-B OUI PFK PFX PHA PLV PMK POH PRD RBV RGM SBCKP SVJ XGM SGZ JSM ISM OSM TDI TDA TVE TVC UDM UZV UZG VNV WRS XCJ

Loading up on CCS

Comcast is the largest cable company in US. Its leverage is 2.5x Net Debt/EBITDA ($30bn debt and $13bn EBITDA in CY08). Interest coverage is quite high at 6x (EBITDA/Interest). As it is a subscription based business model, it is quite recession proof. People might cut their video service as they are thrown out of their homes, or they will stop taking premium services. But the chances that this company goes into bankruptcy is close to 0, if their is anything close to 0 these days.

The company has various series of debt. One of the debt series - CCS - trades on stock exchanges like a stock. The company pays its interest like a dividend. The face value of this is $25. This is a 6.625% note due in 2056, but it is callable anytime after May 15, 2012.

Today, this has fallen a lot, for no obvious reason. Comcast stock and other debt of Comcast are trading just fine. At its current price of $19, the yield to call is 15%. The yield to call on other debt securities - depending on maturity and seniority - is not above 8%. The yield to call (rather than yield to maturity) is the right thing to look at, because if on May 2012, this debt is trading at today's price, Comcast will have every incentive to refinance the debt at the lower rates and pocket the difference.

I think this is one of the best investments out there. On a BBB corporate, one is getting a yield of a corporate in distress. I have bought some today at $19. Lets see how it works out.

Dollar crosses 1.60 against Euro

The effect of Fannie and Freddie intervention on the dollar is here - dollar crosses 1.60 for the first time. But it is not that Euro should be strong against dollar - Eurozone is also struggling now. There is going to be competitive devaluation between dollar and Euro starting later this year.

If there is a way to get a fixed deposit in Chinese Yuan, that is probably the best investment right now. Even better would be middle eastern currencies that are pegged to USD. In an year where there are historic macroeconomic events occuring, the pegs could also be broken.

The debate right now isn't between a bull and a bear - it is between a bear and an ultra-bear.

Bharti- RCOM - MTN

The Bharti - MTN, RCOM - MTN saga has been going on-off for the last 3 months. Today ET is reporting that MTN is again sounding out Bharti after its failed talks with MTN. This is now smelling desperation rather than opportunity on the part of the various suitors, and might indicates one of these things:

a) Analysts and stocks are way too optimistic on the growth prospects of the Indian mobile companies. So Bharti and RCom are trying to use their stock to buy out other companies before the tide turns south.

b) Something similar could be said for MTN. It probably is looking to use its expensive stock as currency.

c) Is their really a strategic rationale to have an pan emerging markets mobile service player? There are hardly any revenue synergies in having a Indian subscriber as well as a South African subscriber. Cost synergies will be there - one can better negotiate with equipment vendors - but Bharti is big enough on its own to squeeze 90% of the cost savings out. There will still be different country headquarters etc, so how does one get SG&A synergies?

The stock chart of Vodafone says it all - stock is today where it was in May 98. Bharti would be better served by buying Idea or Vodafone India out if they really want to do a deal - reduce competitor, gain market share etc.

Fannie and Freddie continued...

It is a very confusing situation. If Paulson wants to avoid moral hazard, he has to extinguish current shareholders. He has done that once to Bear Sterns shareholders. Will he do the same with Fannie and Freddie shareholders? If these stocks stay where they are, there is no way these companies can raise the requisite equity. So treasury will step in, which will involve wiping out existing shareholders. Now logic might not work and Paulson might change tracks. But I will go with logic.

The survival of existing shareholders is contingent on stock going up. Stock price is driving the fundamentals. Interesting stuff. Don't think I will, can or should punt.

Fannie and Freddie worth punting?

Should I buy or sell Fannie or Freddie stock today? It is an interesting puzzle. On the positive side, US govt is now backing the debt of these companies. On the negative side, Paulson's track record with Bear Sterns shareholders will give a pause to punters in Fannie and Freddie.

This is what Paulson is saying in his news release:

"Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction." So far in the news release, it seems shareholder survival of the troubled entity is crucial - this is not Bear Sterns.

and later:

"Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed."

Treasury is not buying equity today. They want the stock to go higher and see if these two can raise money through public markets. If the two stocks recover to $25 levels, there might be one new round of equity raise possible through public markets.

Are there brave people out there willing to put more equity into these black boxes at $25? My guess is - there are - at least for one more round. After that, if there is further need, US govt will be forced to step in and nationalize.

The point is - if Paulson wants to prevent shareholders from enjoying the benefits of his largesse, he needs to nationalize Fannie and Freddie today. If he is too worried about moral hazard, he should clearly state that Treasury will invest in these companies but at $1/share. From the opening of his press release, it appears he wants these two to remain public entities owned by shareholders.

I think this is like Lehman on March 18. I dont know about the long-term future of these companies. But the chances they double or triple in next 24 hours is high. There is a huge short interest in them, and short covering itself will propel them higher.

Treasury and Fed back Fannie and Freddie

The treasury is increasing its lines of credit to the two mortgage giants. Also saying govt might take an equity stake in the company, if the companies request. Here is my take:

a) Bondholders: Definitely a plus for the bondholders. Fannie Mae and Freddie Mac debt is now treasury debt. This is moral hazard.

b) Equityholders: Isn't this an admission that the companies are undercapitalized, and might have difficulty raising money on their own in the debt market. If the Bear Sterns precedent is any guide, when Paulson forced Bear's board to accept $2, shouldn't the existing shareholders bail out - now.

There are so many people short these stocks that a short covering rally could easily double them in a day. If the stocks stabilize at $20-$25, raising capital at that price is also possible. This is a situation where the current stock price determines the fundamentals, not the other way round. These stocks can go to $0 and they can also go to $25.

Logic will say they should go to 0 - but logic has its limitations these days. I think that Paulson's idea on how to avoid moral hazard in Bear Sterns is going to come back and bite him someday.

c) Treasury bonds: Suddenly, there are many more treasury bonds out there. So yields should up. Still, Fannie and Freddie were always assumed to have govt backing. Don't think it should be a stomach churning spread widening.

d) Dollar: Do you really want to hold the dollar? This is not the last govt bailout. I think the real risk now is any unorderly fall in the value of the dollar. At some point, people will revolt against the printing machine.

e) Oil: If dollar is at risk of going down, oil is at risk of going up.

Moral Hazard, Fannie Mae and Freddie Mac

Apparently, Hank Paulson is against bailing out the shareholders of the two entities - Fannie Mae and Freddie Mac (WSJ). His argument is that bailing out the shareholders will fan moral hazard. This was the same argument he used to suggest Bear Sterns be sold at $2.

However, he is forgetting about the moral hazard that is being created by bailing out the debt holders. Fannie Mae yields might actually tighten if the US govt gives explicit guarantee to its debt. Similarly, Bear Sterns bondholders benefitted when the bigger JPM took BSC over.

What Paulson and co dont want is for credit costs to jump up even more. If mortgage rates in US were to rise - they haven't really come down despite all the Fed cuts due to spread widening - housing will take a further beating. Paulson, Bernanke and co are deciding right now who wins and who looses.

Oxicash

I remember reading 8 years ago - when I was still at IIT and the 3G spectrum bidding was happening at crazy valuations in Europe - that mobile will one day replace credit cards as the preferred way to pay. That obviously hasn't happened. People still prefer their cards or cash.

Now, it seems that Indian mobile companies are trying to push something similar. Airtel is touting mobile bill pay and cash trasfer using Madhavan and Vidya Balan as brand ambassadors. Today I saw an ad for Oxicash on television - a mobile payment gateway. In a country like India where mobile penetration is trending much higher than card penetration, it can be one of the most lucrative business opportunities if developed properly.

And its not only about the revenues. It can also save a lot of costs for mobile companies. At 250 mn subs and Rs 300 ARPU today, mobile companies rake in $25bn each year today. If they pay 2% to card companies, banks, merchants etc to collect all the money, it is a $500 mn annual drain on the bottomline. When India reaches 800mn subs in the next 10-20 years, the drain will be much much more. Lets see how these experiments turn out to be.

Selling KBE

Fannie Mae and Freddie Mac are falling apart. This is that blow that can level financials for a long time to come. I wonder why Dow Jones and S&P are not falling more. Lost 30% on this in 2 months.

2008 is a seminal year in world history. Socialism is about to get a revival. Protectionist rhetoric is escalating. Govt expenditure is going to expand rapidly to contain the fallout from falling consumption and investment demand - worldwide.

Pension and OPEB

I was looking at Qwest the other day. It trades at 15% FCF yield. $1bn FCF, $4bn+ EBITDA, $7bn market cap, $12bn debt. But then I saw its balance sheet, and I remembered that thing called pension and OPEB.

When I had started working in Citi Asset Management in 2003 in the tech-telecom research team, a big problem with the telcos was the hole in their pension liabilities caused by the 3 year bear market. The pension plans in the US assume a rate of return on their equity and debt holdings, apply a discount rate and get the present value of the assets. They do something similar to calculate the PV of the liabilities (payouts to retirees, inflation on healthcare costs etc). The difference is the unfunded liability for the company. It should be thought of as a debt - company will need to borrow money to bridge the gap. There were several companies that would have declared bankruptcy had they been forced to cover their unfunded pension liabilities - I remember people talking of Lucent as one.

It was in Feb 1999 that S&P first hit 1250. Yesterday, almost 9 years after that event, S&P closed at 1244. During this time, healthcare cost inflation has continued unabated. So while the assets of the pension plan invested in US equities have given 0% return, liabilities have gone up. I am sure that several companies will again start reporting widening pension deficits - particularly the old economy companies such as telecom, auto etc.

True several companies have moved to defined contribution (401-K) rather than defined benefit ones. True several companies have renegotiated benefits with their employees (particularly autos). But their is a huge legacy of the defined benefit plans.

It is the same problem with social security. Projected assets might not meet projected liabilities.

Inflation and Deflation

It seems very likely that at least one of the big global corporations is not going to survive another 12 months. GM, Ford, Chrysler, some major bank etc is likely to blow up. If it happens when the inflation scare is still on, then thats the day when bond yields will go through the roof. Thats the day to buy bonds.

Inflation and deflation are two sides of the same coin. Credit contraction today is leading to asset deflation. In another 12-24 months, assuming commodity prices stabilize, this asset deflation might result in CPI deflation. My guess is this is what happened in Japan, with its asset bubble and crash of the 1980s, followed by liquidity trap and deflation. One needs to look at bonds if there is a possibility of deflation out there.

Some Interesting Stuff

1. GM cuts the price of Chevrolet Spark in India when everybody else is raising because of higher commodity prices. Why? Are market share losses in US going to drive GM's competitive behaviour outside US, or is this purely a decision made by GM India? If it is the former, then think of auto industry as one giant global market, irrespective of the import tarriffs that hinder imports (at least in India). So don't salivate on Maruti at 10x PE. The auto industry is on the path of a worldwide bust.

Is public transit the next big thing to bet on? Need to think about that..

2. Merck India: Merck India has a market cap of 500 crore and cash balance of 350 crore. Its PAT from core business is about 40 crore. So on core business, the stock is trading at just 4x PE.

Well I guess the company deserves it. In 2006, they sold a business to a 100% subsidiary of Merck Germany (the parent company of the listed entity) for 4x PE. That business did a PAT of 20 crore and was sold for 82 crore. Isn't that stealing from the minority shareholders?

Going forward - investing in India

There are 4 components of GDP. Which of these is likely to prove the most resilient going forward?

a) Investment growth - This is clearly under threat with rising interest rates and commodity price inflation threatening margins. Domestic savings rate is going to spiral down this year as govt fiscal deficit expands and capital flows are slowing down, so who will finance the investments? Stay away. When a train travelling at 150kmph breaks suddenly, the effects are not pleasant on the commuters.

b) Domestic Consumption growth - This should weather the storm better. Stay away from interest rate sensitives (automobiles). FMCG, telecom, media, retail might do better - but are stocks properly priced? Financials - there has to be a blowup somewhere as credit cycle turns. ICICI is my prime candidate for that . But at 550 - 1.3x P/BV - is the stock interesting? Remember that unlike the west, Indian banks raised significant capital last year, so they are much better capitalized.

c) Net Exports - Rupee is structurally weak. India runs a current account deficit (like USD) and needs capital inflows to support rupee (like USD). Rupee is weakening today (due to widening current account deficit and capital outflows) when RBI is increasing interest rates to battle inflation, and might weaken even more when RBI cuts interest rates 1-2-3 years out - when inflation comes under control, growth slows down and investors take time to rediscover their love for India. Of course a big variable will be oil price.

Problem is - customers are also slowing down. US, UK, Europe are having difficulties. Need to bet on exporters with significant leverage to rupee depreciation, high margins, proven business models. Basically tech.

Tech has huge BFSI exposure and has a potential demand side problem. There are going to be blowups in tech too. Need to wait for those days. Next big event here is Cognizant earnings and whether it cuts its 38% rev growth guidance in the next 2 weeks.

d) Govt Expenditure - Not the time to play govt expenditure growth stories, as fiscal deficit goes through the roof because of oil and fertilizer.

Also as a policy, I am never going to invest in any PSU from here on. I sold HPCL last week - a 4 year investment with -50% returns (excluding dividends), Bank of Baroda - 3 year investment with -10% returns (probably breakeven after dividends). Union Bank is the only one left and I will exit that soon enough. As govt fiscal deficit expands, it can do bizarre things to expropriate the profits of these companies.

What went wrong in the last 3 months?

I had a disastrous qtr in the invested portfolio. From the peak in Jan, the invested portfolio is now down 15%, with almost all the losses coming in May June. For the overall portfolio, losses are close to 8% (as more than 50% is cash). My aspiration is not to beat the markets on a relative basis but on an absolute basis - whatever the conditions. So this is a failure - even if there is relative outperformance against markets that are down 20% or 40%.

I made a wrong bet. In late March - early April, I thought that the entire second half recovery/"govt rebate checks to citizens" optimists in US will give a temporary boost to the US stock market and global equities. I thought that the boost will occur in May and June - closer to the second half - and then the boost will fade in July as earnings disappoint.

What happened was otherwise. Stocks ran up in April. Since ealy May, when I bought some high beta stocks, they have been going downhill. And CY2Q earnings havent even started. 2Q is not the best time of the year usually - all holidays (Thanksgiving, Christmas, Chinese New Year, Diwali) occur in CY4Q or CY1Q.

So what are the learnings from this episode? Bail out quickly if mistakes become apparent. The key trick is not buying but selling, and selling aggressively when proven wrong.

As Bill Gross put it neatly in his May 2008 newsletter, "Investment success depends on an ability to anticipate the herd, ride with it for a substantial period of time, and then begin to reorient portfolios for a changing world. Today’s world, including its inflation rate, is changing. Being fooled some of the time is no sin, but being fooled all of the time is intolerable".

1H08

1H08 - Indian markets down 35%. Amazing. What a turn from January 2008.

CY2Q is often not the best earnings period - the adage "sell in May and go away" has proven very true this year.

This is increasingly becoming one of the most challenging times to invest in the last 15 years. We have the credit crunch - which demands lower interest rates, and inflation - which demands higher. There have been a number of "black swan" events in the last one year, and they are by no means over.

Best thing is to do nothing, unless one has a really compelling idea. Take vacation for 6 months. Inflation is not tamed that easily.