I am less bullish now than I was last month (So where do we stand). As I had mentioned, oil price rise was the most significant risk to any bull theory. If oil price substain above $120 for the year - GS is out speculating $150 - equity markets will struggle.
This is a major shock - not because of the absolute price, but because of the speed at which it has gone up - up 70% in 9 months. Any recession requires multiple shocks. We now have multiple ones in the US - (a) the housing blowup starting late 2006 (b) subprime debacle and ensuing credit crunch starting mid 2007, and (c) sharp oil price increase in late 07-early 08. The one that is coming next is a sharp uptick in corporate bankruptcy rates.
US imports 12mn barrels of oil per day * $30 price hike this year (from $100 in Jan 2008 to $130 today) = $130bn of -ve exports = 0.9% hit on GDP on a $15 trillion economy). Oh, by the way, that is what the Fed expected growth will be this year (0.3%-1.2%) before oil prices moved up, so the new forecast should be 0%.
India imports 700 mn barrels of oil per year * $30 price hike = $21 billion hit = 2.1% hit on GDP ($1 trillion economy). Expected growth rate of economy w/o the impact of oil = 8% - 2.1% hit from oil = 5.9% GDP growth. India will grow below 6% if oil remains at $130.
Thursday, May 22, 2008
Wednesday, May 21, 2008
Asset Prices as Driver of Fundamentals
This is quite random stuff, and like everything else, completely wrong.
I am increasingly getting convinced that the price of an asset (like a stock) impacts its fundamentals. Traditional economics will say that price is determined by supply and demand,
i.e. P = f (S, D).
I think
P = f (S, D, P).
And to refine it even more:
P+ = f (S, D, P+)
P- = f (S, D, P-)
i.e. the probability whether the next move in price is up is determined whether its last move was up or not, and vice-versa. (This is not a good mathematical representation of what I have in mind, but lets have it like that for the time being)
This is what price momentum is. Essentially, what this implies is that any fundamental analyst who ignores price momentum because it is a hobby of technical analysts doesn't appreciate that prices impact fundamentals, and misses out on an important variable in his/her thought process.
This will also explain why markets can deviate from prices determined solely by supply-demand arguments. If markets were efficient, there shouldn't be boom and busts. That is clearly not the case.
In the new framework laid out above, markets will necessarily go in a boom-bust phase, depending on the price momentum. A boom-bust market is an efficient market, not an inefficient one.
Isnt this what Greenspan is saying? Boom and bust is a part of capitalism and markets. You can either have a state controlled communist society where prices don't change and neither does anything else (except misery which keeps on increasing) or a market based society with its episodes of booms and busts. There is no third alternative.
I am increasingly getting convinced that the price of an asset (like a stock) impacts its fundamentals. Traditional economics will say that price is determined by supply and demand,
i.e. P = f (S, D).
I think
P = f (S, D, P).
And to refine it even more:
P+ = f (S, D, P+)
P- = f (S, D, P-)
i.e. the probability whether the next move in price is up is determined whether its last move was up or not, and vice-versa. (This is not a good mathematical representation of what I have in mind, but lets have it like that for the time being)
This is what price momentum is. Essentially, what this implies is that any fundamental analyst who ignores price momentum because it is a hobby of technical analysts doesn't appreciate that prices impact fundamentals, and misses out on an important variable in his/her thought process.
This will also explain why markets can deviate from prices determined solely by supply-demand arguments. If markets were efficient, there shouldn't be boom and busts. That is clearly not the case.
In the new framework laid out above, markets will necessarily go in a boom-bust phase, depending on the price momentum. A boom-bust market is an efficient market, not an inefficient one.
Isnt this what Greenspan is saying? Boom and bust is a part of capitalism and markets. You can either have a state controlled communist society where prices don't change and neither does anything else (except misery which keeps on increasing) or a market based society with its episodes of booms and busts. There is no third alternative.
Aban Loyd as a trading stock
I am taking my money out of Aban Loyd. I sold the stock at Rs 3900. Consensus EPS estimate for this stock is Rs 400 for FY09 and Rs 500 for FY10.
I am sure consensus is overestimating EPS because: (a) This company has extremely poor disclosure, nobody knows the numbers for its Singapore subsidiary. Costs for drillers are rising fast - there is a shortage of manpower. I dont think analysts are capturing that properly. (b) I am sure some of the new rigs are going to be delayed, as they have been over the last few years. So revenue and EPS is going to be pushed out. (c) Not sure whether people are capturing drydocking days properly.
But that doesnt imply that I am bearish on the stock. I think this sector has no problem till oil remains above $80. I simply dont see why I should buy Aban at 10x next year PE when Transocean is available at 11x PE - when Transocean has much bigger deep water fleet that is contracted out (in some cases) till 2016 and a much better disclosure.
The entire offshore drilling sector is getting valued at low multiples, when the visibility into the earnings of companies (esp RIG) is getting longer and longer. These are deep cyclicals, and the market is valuing them like that. But this cycle is just getting longer and longer, as oil hits new highs.
This creates one of the best opportunites to trade. Market is valuing Aban like a deep cyclical while fundamentals are strong for the next 2-3 years. Aban is an extremely volatile stock and gets hammered when market falls. So, there is lots of money to be made with this stock if one trades properly. That is what I have decided I will do with this one. I am going to use this as a test case to figure out how one can trade stocks, as I feel very comfortable with the underlying fundamentals.
I am sure consensus is overestimating EPS because: (a) This company has extremely poor disclosure, nobody knows the numbers for its Singapore subsidiary. Costs for drillers are rising fast - there is a shortage of manpower. I dont think analysts are capturing that properly. (b) I am sure some of the new rigs are going to be delayed, as they have been over the last few years. So revenue and EPS is going to be pushed out. (c) Not sure whether people are capturing drydocking days properly.
But that doesnt imply that I am bearish on the stock. I think this sector has no problem till oil remains above $80. I simply dont see why I should buy Aban at 10x next year PE when Transocean is available at 11x PE - when Transocean has much bigger deep water fleet that is contracted out (in some cases) till 2016 and a much better disclosure.
The entire offshore drilling sector is getting valued at low multiples, when the visibility into the earnings of companies (esp RIG) is getting longer and longer. These are deep cyclicals, and the market is valuing them like that. But this cycle is just getting longer and longer, as oil hits new highs.
This creates one of the best opportunites to trade. Market is valuing Aban like a deep cyclical while fundamentals are strong for the next 2-3 years. Aban is an extremely volatile stock and gets hammered when market falls. So, there is lots of money to be made with this stock if one trades properly. That is what I have decided I will do with this one. I am going to use this as a test case to figure out how one can trade stocks, as I feel very comfortable with the underlying fundamentals.
Oil at 130
Oil is in contango. Surprise for the Fed - which has been looking at future markets over the last few years to justify why it thinks oil prices will head down in the future. Not only have future markets underestimated oil prices , now they are in contango. So I am sure the Fed is in a dilemma.
Why are oil prices going up? I dont see any good reasons for it, except the so called supply-demand imbalance. But gasoline is overflowing - as WSJ points out today, Iran is storing gasoline in tankers because there is not enough demand. Apparent problem is with diesel. But is it suddenly so huge that oil needs to go up by $30 in 1 month? Bulls will argue that problem is not with near-term supply, but with long-term supply demand - as a market in contango indicates.
I think there is one big positive with high oil prices. This is much better than a carbon tax to cut down greenhouse emissions. As altenative energy demand increases and these business models scale up, they will become viable without government subsidies. Global warming activists should be jumping with joy.
Why are oil prices going up? I dont see any good reasons for it, except the so called supply-demand imbalance. But gasoline is overflowing - as WSJ points out today, Iran is storing gasoline in tankers because there is not enough demand. Apparent problem is with diesel. But is it suddenly so huge that oil needs to go up by $30 in 1 month? Bulls will argue that problem is not with near-term supply, but with long-term supply demand - as a market in contango indicates.
I think there is one big positive with high oil prices. This is much better than a carbon tax to cut down greenhouse emissions. As altenative energy demand increases and these business models scale up, they will become viable without government subsidies. Global warming activists should be jumping with joy.
Monday, May 19, 2008
Cutting out of KRBL
I had bought KRBL at 139 a month ago and sold it at 119 last week. This is a very interesting stock as it illustrates the risk that govt can expropriate wealth that capitalists might consider theirs. Some people get govt to transfer public assets to them at low value - witness the real estate deals and how FSI's get increased and tax status changed after the deals have been stuck. Others can't stop govt from stealing what is theirs by passing taxes that are 'legal' - after all the government decides legality.
Basmati is an interesting commodity. It is probably the only commodity which India has marketed well enough that it is now a brand. It has also fought hard to make sure other pretenders from Vietnam etc don't steal the brand. India and Pakistan are the largest producers with India accounting for the lion's share. 90% of Basmati production is exported, as the rice is expensive (3x-4x price of normal rice). India exports about 1mn tonnes, at $1000/ton, this is export earnings of $1bn - 4000 crore for the rural economy. Not bad.
KRBL is the largest basmati rice miller and exporter in India. Surely - one would have thought -with rice prices shooting up throughout the world, this company should benefit. And with the stock at 4x Fwd P/E, this should be a multibagger. At least, this is what I thought.
Export taxes: Well, I was wrong. Rice prices are going up and feeding into inflation, so the govt has come up with an export duty of Rs 8000/tonne (or Rs 8/kg) to prevent exports. Last I remember, Basmati was selling for Rs 80/kg, so this is a 10% tax. This will reduce exports of Indian Basmati, which will then get sold locally pressuring domestic rice prices.
Now one can argue that it is all in the interests of the common man, so govt has done a great job. It is making sure that some capitalists dont benefit at the expense of vast majority of poor people. I disagree with this. I think this tax will hit Basmati supply in India - the very outcome that the govt wants to avoid.
Thin margin business: The margins are thin for millers (5%-7% PAT margins), so a 10% tax can effectively destroy their economics. So they will be forced to raise prices, which will hit export demand.
How elastic is the export demand? Some people will argue the following to justify price hikes can be absorbed without impacting demand: a) Basmati is a brand of which India produces the lions share, b) It is the rich man's rice, so price elasticity is less, (c) Indian basmati is anyway more expensive than Pakistani variety, and (d) there is a supply constraint of rice globally.
I dont think thats the case. I think argi commodities have high price elasticities and are almost perfectly substitutable. Besides, if export demand doesn't slacken and domestic rice prices remain high, govt will again increase export taxes. So there is going to be a big demand impact.
Long-term supply reduction: As exports take a hit, millers will dump rice domestically, which will cause a fall in domestic Basmati rice prices. So thats good for the common man.
But what about next year? Millers won't again procure the same quantities of Basmati paddy that they did this year - after all export demand will be down. Some farmers will switch to other crops.
More importantly, this will give an opening to Pakistan, Vietnam and other countries to capture market share in the international Basmati market. If demand is there, and India is willing to fulful that only at exorbitant prices, demand will find other supply sources. The longer the Indian govt persists with this tax, the more likelihood it is that Pakistan takes away the market.
Of course, the govt will say that this is a temporary tax, and as soon as rice prices normalize, this tax will go away. I just look at HPCL and BPCL and think that it might not turn out to be the case.
This tax reduces incentives to create supply. Indians won't buy a lot of Basmati at the price it normally sells, and govt wants to discourage exports. How can govt incentivize people to produce something if they end up losing money in the process?
Basmati is an interesting commodity. It is probably the only commodity which India has marketed well enough that it is now a brand. It has also fought hard to make sure other pretenders from Vietnam etc don't steal the brand. India and Pakistan are the largest producers with India accounting for the lion's share. 90% of Basmati production is exported, as the rice is expensive (3x-4x price of normal rice). India exports about 1mn tonnes, at $1000/ton, this is export earnings of $1bn - 4000 crore for the rural economy. Not bad.
KRBL is the largest basmati rice miller and exporter in India. Surely - one would have thought -with rice prices shooting up throughout the world, this company should benefit. And with the stock at 4x Fwd P/E, this should be a multibagger. At least, this is what I thought.
Export taxes: Well, I was wrong. Rice prices are going up and feeding into inflation, so the govt has come up with an export duty of Rs 8000/tonne (or Rs 8/kg) to prevent exports. Last I remember, Basmati was selling for Rs 80/kg, so this is a 10% tax. This will reduce exports of Indian Basmati, which will then get sold locally pressuring domestic rice prices.
Now one can argue that it is all in the interests of the common man, so govt has done a great job. It is making sure that some capitalists dont benefit at the expense of vast majority of poor people. I disagree with this. I think this tax will hit Basmati supply in India - the very outcome that the govt wants to avoid.
Thin margin business: The margins are thin for millers (5%-7% PAT margins), so a 10% tax can effectively destroy their economics. So they will be forced to raise prices, which will hit export demand.
How elastic is the export demand? Some people will argue the following to justify price hikes can be absorbed without impacting demand: a) Basmati is a brand of which India produces the lions share, b) It is the rich man's rice, so price elasticity is less, (c) Indian basmati is anyway more expensive than Pakistani variety, and (d) there is a supply constraint of rice globally.
I dont think thats the case. I think argi commodities have high price elasticities and are almost perfectly substitutable. Besides, if export demand doesn't slacken and domestic rice prices remain high, govt will again increase export taxes. So there is going to be a big demand impact.
Long-term supply reduction: As exports take a hit, millers will dump rice domestically, which will cause a fall in domestic Basmati rice prices. So thats good for the common man.
But what about next year? Millers won't again procure the same quantities of Basmati paddy that they did this year - after all export demand will be down. Some farmers will switch to other crops.
More importantly, this will give an opening to Pakistan, Vietnam and other countries to capture market share in the international Basmati market. If demand is there, and India is willing to fulful that only at exorbitant prices, demand will find other supply sources. The longer the Indian govt persists with this tax, the more likelihood it is that Pakistan takes away the market.
Of course, the govt will say that this is a temporary tax, and as soon as rice prices normalize, this tax will go away. I just look at HPCL and BPCL and think that it might not turn out to be the case.
This tax reduces incentives to create supply. Indians won't buy a lot of Basmati at the price it normally sells, and govt wants to discourage exports. How can govt incentivize people to produce something if they end up losing money in the process?
Saturday, May 03, 2008
India's fiscal deficit..
This is my first attempt to understand finances of Indian govt, so this analysis could very well be wrong.
As can be seen from RBI data above (all numbers are % of GDP), there have been two big swing factors that have pushed India's saving and investment rate from 23% in FY02 to 36% in FY07. First has been corporate saving (or corporate profits), which has improved by 4.4%. Second, and even bigger, has been improvement in public sector saving by 5.2%. It has been better fiscal management of the budget and much improved finances of PSU's that has led to the biggest savings which have been used to finance investment.
Now, the fiscal situation threatens to turn ugly. Combined state and fiscal deficit in FY08 was close to 5.5% and will become worse.
First, India imports roughly 1bn barrel of oil. Oil prices have jumped by $20 since budget was presented => a hit of $20bn = 1.6% hit. (assume GDP at $1.2 trillion)
Second, fertilizer prices have gone through the roof. Mosaic CEO was saying that India's fertilizer subsidy this year will be higher than its defence bill. Defense bill is $25 billion for India. Last year fertilizer subsidy was $2billion. That is an extra $23 billion hit on account of fertilizers. That is close to 2% of GDP.
So, in total, these two add up to 3.6% of GDP.
Third, farm loan waiver of $15 billion = 1.2% of GDP. Lets ignore it.
Fourth, pay commision will impact state finances. Lets ignore it.
This will be offset to a very small degree by tax growth, better tax administration etc. Still, a 3% extra hit to fiscal position will happen from oil and fertilizer subsidy, if the prices of these don't moderate over the next year.
It is not that suddenly India growth story is over. In the short run, govt can do a lot of things, esp selling stakes in PSU's to improve its situation. But, if this situation were to persist for 2 years, it would be alarming.
I am not sure how the public sector savings number are computed above, and how it ties to the fiscal deficit of state and centres. Do PSU's get consolidated here, which implies that the oil bonds get taken care of? What about fertilizer subsidies?
As can be seen from RBI data above (all numbers are % of GDP), there have been two big swing factors that have pushed India's saving and investment rate from 23% in FY02 to 36% in FY07. First has been corporate saving (or corporate profits), which has improved by 4.4%. Second, and even bigger, has been improvement in public sector saving by 5.2%. It has been better fiscal management of the budget and much improved finances of PSU's that has led to the biggest savings which have been used to finance investment. 
Now, the fiscal situation threatens to turn ugly. Combined state and fiscal deficit in FY08 was close to 5.5% and will become worse.
First, India imports roughly 1bn barrel of oil. Oil prices have jumped by $20 since budget was presented => a hit of $20bn = 1.6% hit. (assume GDP at $1.2 trillion)
Second, fertilizer prices have gone through the roof. Mosaic CEO was saying that India's fertilizer subsidy this year will be higher than its defence bill. Defense bill is $25 billion for India. Last year fertilizer subsidy was $2billion. That is an extra $23 billion hit on account of fertilizers. That is close to 2% of GDP.
So, in total, these two add up to 3.6% of GDP.
Third, farm loan waiver of $15 billion = 1.2% of GDP. Lets ignore it.
Fourth, pay commision will impact state finances. Lets ignore it.
This will be offset to a very small degree by tax growth, better tax administration etc. Still, a 3% extra hit to fiscal position will happen from oil and fertilizer subsidy, if the prices of these don't moderate over the next year.
It is not that suddenly India growth story is over. In the short run, govt can do a lot of things, esp selling stakes in PSU's to improve its situation. But, if this situation were to persist for 2 years, it would be alarming.
I am not sure how the public sector savings number are computed above, and how it ties to the fiscal deficit of state and centres. Do PSU's get consolidated here, which implies that the oil bonds get taken care of? What about fertilizer subsidies?
So where do we stand?
Here is my theory of what is going to happen, some of which are facts and some of which are guesses which might turn out to be wrong.
Growth Rates:
a) Is US amidst a slowdown? Yes. Expect several quarters of -1% - +1% growth. However, it is not falling off a cliff. Strong exports are helping US.
b) Are Europe and Japan going to slow down? Definitely yes. UK, Spain etc have the same housing problem as US. Japan will be impacted, but it has hardly contributed anything to global growth in the past few years, except for its cheap yen. So I wouldnt worry about Japan.
c) Are emerging markets slowing down? Definitely yes. Emerging markets will get a lagged impact of US slowdown. Plus these countries face higher inflation from food as it is a bigger portion of their consumption basket, so their central banks are tightening.
If emerging market growth rate slows, US export growth will also slow down over the next few months. If not offset by something else (like govt spending, or the lagged benefit of substanital monetary policy easing) this could hit expected US GDP growth, and lead us into a vicious cycle.
d) Credit Crunch: Is there a credit crunch? Yes. Are banks more cautious than before? Yes. Will credit growth not be as fast as before? Yes. Does it mean that US falls off a cliff? No. It might merely stabilize for a long period of time. If credit contracts, it is dangerous, which is what we have had over last 9 months with runs on the shadow banking system. If it stabilizes, then we will avoid the worst come outcomes, which is where I think we are.
I believe monetary policy works. I think the US economy stabilizes around here for an extended period of time. The risk is more in Europe and emerging markets.
Inflation and Interest Rate:
a) Commodity Inflation: There has been a surge in commodity prices since Sep 2007 since Fed started cutting rates. For some commodities, rate cuts, dollar depreciation and speculation explain quite a bit of this latest surge. For some others, there could be supply-demand argument. After all, steel companies have negotiated iron-ore price increases with BHP - these are not being set on any exchange. Commodity price inflation is the real wildcard right now in any bull theory.
Of the various commodities, the most easiest and most difficult one to tackle is agflation. All one needs is a few good rains and monsoons in the world and wheat and rice prices go back to normal. All we need is a few rains not to happen and we get political and social unrest to change everything.
b) Will US inflation explode? No, because of various reasons. First, food is not a big part of consumption bucket. Second, rents and house prices are 30% of CPI, which are headed down because of housing oversupply. Third, Fed has cleverly defined a core inflation number and made sure everyone focuses on it over the last 30 years. Fourth and most importantly, the bond market is not very worried. Inflation expectations remain well anchored, and it is expectations that determine future inflation (inflation expectation theory). There is no question that Fed will cut more if credit markets start worsening again.
c) Will European inflation go up? I think inflation dynamics are the same in US and Europe, except that ECB focuses on overall inflation rather than just core inflation. BOE has already started cutting rates. How long ECB resists a rate cut is the million dollar question.
d) Emerging market inflation: This is the biggest problem, considering US is so heavily betting on export growth. Inflation here is driven by commodity prices, which is why they are wild card. If these countries tighten so much that they significantly slow down before US domestic economy has picked up, it will be a blow and lead to a vicious cycle.
Equity Markets:
a) US: Does 0% growth and higher inflation mean that equity markets need to crash and burn. Not necessarily.
First and most importantly, with dividend yield at 2.1%, savings account yield at 2% and headline inflation at 4%, there is no incentive to save. Any long-term cash needs to be parked in an index fund rather than in a bank account.
Second, the Fed is backstopping the equity markets to negate the effect of a decline in real estate wealth on consumers. While consumption elasticity to real estate wealth is higher than stock market wealth (this is a guess), a surging equity market helps.
Third, US markets are not outrageously expensive. Yes there will be earnings downgrades in the later half of this year, so S&P trades at 18x instead of 14x. But 18x is not outrageous - markets have traded here before. And maybe they are actually trading at 18x. Besides, by 2H08, investors will start looking at 2009.
It is not reality but expectations that sets equity prices. In a funny way, these expectations can then actually turnaround to impact reality. If equity prices remain high for a wrong reason but end up benefit consumer spending, it will help the underlying economy, which will then become a justification for higher equity prices.
b) India: Why US is so important for India is because of the amazing correlation between US and Indian stock markets. If US equity markets go up, the likelihood of Indian markets doing the same becomes very high.
There are a lot of concerns with India today. First, growth is expected to slow from 8.5% last year to around 7.5% this year. Second, inflation is high and is now running at 7.5%. Third, there are elections this year. So inflation becomes even more important. Fourth, fiscal deficit is widening each day that oil and fertilizer prices remain high. It has been the turnaround in fiscal deficit that has contributed the maximum to take India's saving rate/GDP from below 30% five years back to 35% today. If fiscal deficit remains persistently wide for a long time (2 years), savings will fall and investment will take a hit.
Does that mean that Indian markets will crash and burn? No. If US markets remain strong and Hong Kong and Brazil move up, India wont remain a terrible laggard. As equity prices go up, they create their own dynamic - where they impact reality as much as reality expects them. In the next post, I will discuss the stocks that are the most leveraged to this dynamic - the brokerage stocks.
Growth Rates:
a) Is US amidst a slowdown? Yes. Expect several quarters of -1% - +1% growth. However, it is not falling off a cliff. Strong exports are helping US.
b) Are Europe and Japan going to slow down? Definitely yes. UK, Spain etc have the same housing problem as US. Japan will be impacted, but it has hardly contributed anything to global growth in the past few years, except for its cheap yen. So I wouldnt worry about Japan.
c) Are emerging markets slowing down? Definitely yes. Emerging markets will get a lagged impact of US slowdown. Plus these countries face higher inflation from food as it is a bigger portion of their consumption basket, so their central banks are tightening.
If emerging market growth rate slows, US export growth will also slow down over the next few months. If not offset by something else (like govt spending, or the lagged benefit of substanital monetary policy easing) this could hit expected US GDP growth, and lead us into a vicious cycle.
d) Credit Crunch: Is there a credit crunch? Yes. Are banks more cautious than before? Yes. Will credit growth not be as fast as before? Yes. Does it mean that US falls off a cliff? No. It might merely stabilize for a long period of time. If credit contracts, it is dangerous, which is what we have had over last 9 months with runs on the shadow banking system. If it stabilizes, then we will avoid the worst come outcomes, which is where I think we are.
I believe monetary policy works. I think the US economy stabilizes around here for an extended period of time. The risk is more in Europe and emerging markets.
Inflation and Interest Rate:
a) Commodity Inflation: There has been a surge in commodity prices since Sep 2007 since Fed started cutting rates. For some commodities, rate cuts, dollar depreciation and speculation explain quite a bit of this latest surge. For some others, there could be supply-demand argument. After all, steel companies have negotiated iron-ore price increases with BHP - these are not being set on any exchange. Commodity price inflation is the real wildcard right now in any bull theory.
Of the various commodities, the most easiest and most difficult one to tackle is agflation. All one needs is a few good rains and monsoons in the world and wheat and rice prices go back to normal. All we need is a few rains not to happen and we get political and social unrest to change everything.
b) Will US inflation explode? No, because of various reasons. First, food is not a big part of consumption bucket. Second, rents and house prices are 30% of CPI, which are headed down because of housing oversupply. Third, Fed has cleverly defined a core inflation number and made sure everyone focuses on it over the last 30 years. Fourth and most importantly, the bond market is not very worried. Inflation expectations remain well anchored, and it is expectations that determine future inflation (inflation expectation theory). There is no question that Fed will cut more if credit markets start worsening again.
c) Will European inflation go up? I think inflation dynamics are the same in US and Europe, except that ECB focuses on overall inflation rather than just core inflation. BOE has already started cutting rates. How long ECB resists a rate cut is the million dollar question.
d) Emerging market inflation: This is the biggest problem, considering US is so heavily betting on export growth. Inflation here is driven by commodity prices, which is why they are wild card. If these countries tighten so much that they significantly slow down before US domestic economy has picked up, it will be a blow and lead to a vicious cycle.
Equity Markets:
a) US: Does 0% growth and higher inflation mean that equity markets need to crash and burn. Not necessarily.
First and most importantly, with dividend yield at 2.1%, savings account yield at 2% and headline inflation at 4%, there is no incentive to save. Any long-term cash needs to be parked in an index fund rather than in a bank account.
Second, the Fed is backstopping the equity markets to negate the effect of a decline in real estate wealth on consumers. While consumption elasticity to real estate wealth is higher than stock market wealth (this is a guess), a surging equity market helps.
Third, US markets are not outrageously expensive. Yes there will be earnings downgrades in the later half of this year, so S&P trades at 18x instead of 14x. But 18x is not outrageous - markets have traded here before. And maybe they are actually trading at 18x. Besides, by 2H08, investors will start looking at 2009.
It is not reality but expectations that sets equity prices. In a funny way, these expectations can then actually turnaround to impact reality. If equity prices remain high for a wrong reason but end up benefit consumer spending, it will help the underlying economy, which will then become a justification for higher equity prices.
b) India: Why US is so important for India is because of the amazing correlation between US and Indian stock markets. If US equity markets go up, the likelihood of Indian markets doing the same becomes very high.
There are a lot of concerns with India today. First, growth is expected to slow from 8.5% last year to around 7.5% this year. Second, inflation is high and is now running at 7.5%. Third, there are elections this year. So inflation becomes even more important. Fourth, fiscal deficit is widening each day that oil and fertilizer prices remain high. It has been the turnaround in fiscal deficit that has contributed the maximum to take India's saving rate/GDP from below 30% five years back to 35% today. If fiscal deficit remains persistently wide for a long time (2 years), savings will fall and investment will take a hit.
Does that mean that Indian markets will crash and burn? No. If US markets remain strong and Hong Kong and Brazil move up, India wont remain a terrible laggard. As equity prices go up, they create their own dynamic - where they impact reality as much as reality expects them. In the next post, I will discuss the stocks that are the most leveraged to this dynamic - the brokerage stocks.
Friday, May 02, 2008
Equity markets as the solution..
Just expanding on the previous post here, in the wake of much better than expected employment numbers. There are 3 sources of money to drive consumption:
a) Income: If employment doesnt fall as much as expected, income would be better.
b) Wealth: Most of the wealth is tied in either real estate or equity markets. If real estate prices fall but equity prices go up sufficiently, it would be neutral.
c) Credit: which is where the fear is. But it is abating. And Fed is exchanging all sort of securities for pristine treasury securities. Banks are busy raising equity.
Household real estate in the US totaled $20.6bn at end of 2006. (http://www.stlouisfed.org/news/speeches/2007/10_09_07.html) I guess prices peaked in summer of 2006, so it should be lesser now. Lets assume increase in homes offsets that impact. $9.8 trillion were liabilities. So wealth was $11 billion.
Suppose housing prices decline by 25%. Thats a loss of $5 trillion of wealth, or home equity falls from $11trillion to $6 trillion.
The total stock market cap in US is $25 trillion. http://www.world-exchanges.org/WFE/home.asp?menu=436&document=4822. If this goes up by 20%, the negative impact of household wealth would have been neutralized. Of course, the question of rapidly appreciating asset prices to drive up consumption growth will remain. But, the worst possible outcomes would have been avoided.
This is what the Fed is doing. It is making sure that equity markets don't fall and credit remains available. It has now cut interest rates to 2%, below S&P yield of 2.1%, making sure nobody keeps cash in bank. So the wealth effect is being taken care of.
It is all a cycle - either a virtuous cycle or a vicious cycle. Equity markets go up => consumer doesnt falter much => businesses dont take a massive hit => employment doesnt fall much + Fed eases a lot => house prices stabilize sooner rather than later => credit starts flowing more freely. If US stabilizes => Fed looks at increasing interest rates => dollar becomes stronger => commodites weaken, then it takes care of the inflation problem also.
I think there is now a fair chance that we see a massive rally. US economy is extremely resilient - it took multiple shocks in 2001 to take it into a mild recession. Fed has probably eased more than it should have but it is no hurry to increase rates soon. The emerging market bubble that we were all taking about 7 months ago started but burst in between. I think we are going to see a second coming.
a) Income: If employment doesnt fall as much as expected, income would be better.
b) Wealth: Most of the wealth is tied in either real estate or equity markets. If real estate prices fall but equity prices go up sufficiently, it would be neutral.
c) Credit: which is where the fear is. But it is abating. And Fed is exchanging all sort of securities for pristine treasury securities. Banks are busy raising equity.
Household real estate in the US totaled $20.6bn at end of 2006. (http://www.stlouisfed.org/news/speeches/2007/10_09_07.html) I guess prices peaked in summer of 2006, so it should be lesser now. Lets assume increase in homes offsets that impact. $9.8 trillion were liabilities. So wealth was $11 billion.
Suppose housing prices decline by 25%. Thats a loss of $5 trillion of wealth, or home equity falls from $11trillion to $6 trillion.
The total stock market cap in US is $25 trillion. http://www.world-exchanges.org/WFE/home.asp?menu=436&document=4822. If this goes up by 20%, the negative impact of household wealth would have been neutralized. Of course, the question of rapidly appreciating asset prices to drive up consumption growth will remain. But, the worst possible outcomes would have been avoided.
This is what the Fed is doing. It is making sure that equity markets don't fall and credit remains available. It has now cut interest rates to 2%, below S&P yield of 2.1%, making sure nobody keeps cash in bank. So the wealth effect is being taken care of.
It is all a cycle - either a virtuous cycle or a vicious cycle. Equity markets go up => consumer doesnt falter much => businesses dont take a massive hit => employment doesnt fall much + Fed eases a lot => house prices stabilize sooner rather than later => credit starts flowing more freely. If US stabilizes => Fed looks at increasing interest rates => dollar becomes stronger => commodites weaken, then it takes care of the inflation problem also.
I think there is now a fair chance that we see a massive rally. US economy is extremely resilient - it took multiple shocks in 2001 to take it into a mild recession. Fed has probably eased more than it should have but it is no hurry to increase rates soon. The emerging market bubble that we were all taking about 7 months ago started but burst in between. I think we are going to see a second coming.
Equity markets as the solution to the problem
Bears say that because house prices are declining and savings rate in US is 0, consumer spending will take a hit. That argument is wrong.
For there are two big sources of wealth - homes and stocks. Each is worth about $20trillion. That is where most Americans have put their wealth. So if stocks go up, they take away some of the pain from declining home prices. The wildcard is commodity prices.
Fed has eased a lot since Sep. Whether it is more or less, only time will tell. There is always the possibility now that it has eased more than was necessary and so stocks will rocket from here. I think Dow at 15K, Sensex at 25K before the year ends is now a very distinct possibility.
For there are two big sources of wealth - homes and stocks. Each is worth about $20trillion. That is where most Americans have put their wealth. So if stocks go up, they take away some of the pain from declining home prices. The wildcard is commodity prices.
Fed has eased a lot since Sep. Whether it is more or less, only time will tell. There is always the possibility now that it has eased more than was necessary and so stocks will rocket from here. I think Dow at 15K, Sensex at 25K before the year ends is now a very distinct possibility.
Monday, April 28, 2008
India vs China, Russia and Brazil
Is clubbing India together with China, Russia and Brazil the right thing to do? Can India decouple more or less than these other countries can from a US-Europe slowdown? Many analysts say that because exim trade contributes less to India's GDP than China, India is relatively more shielded. I am not sure that is the case.
I think a very important question when one thinks about growth is - how is the growth financed? Here, I think India is in a much poorer position (this is still a theory, I need to get the hard numbers).
a) Current account deficit - India has a current account deficit. As oil and fertilizer prices go up, this deficit is increasing. BRC run a massive current account surplus which they can use to finance growth, India relies on capital flows - FDI and FII. In the 1990s, east Asia financed its growth through capital flows. Because they didnt have forex reserves, they were hurt badly. India is not in that bad a situation today - forex reserves are high and FDI flow remains strong. Still, it is something to watch out for.
A benefit of having current account surplus is that forex can be used to contain domestic inflation. So China can led yuan appreciate to control inflation because there is a massive current account surplus, India can't.
b) Fiscal deficit - With pay commision award and subsidies on oil and fertilizer, the fiscal position of India can become very bad very soon. If high oil and fertilizer prices for another year, govt will need to cut down on its spending. Whether that will be subsidies or investments is anybody's guess. Most likely, it will be a mix of both.
To do: I need to collect some hard numbers around this.
There is now an inconsistency in the way commodites are priced and the assumption that Chindia can keep growing at 8%+ to support these commodity prices and to also power US out of its slowdown - at least India cant. If Fed is betting on export growth, it should help Chindia tackle inflation by supporting the dollar.
There are two major wildcards now. First, the average price of the US home, and how low it goes. Second, the price of oil, and how high it goes.
Any recession requires multiple shocks - the US economy is extremely resilient. In 2001, there was tech meltdown, Enron-Worldcom-junk bond blowup, and 9-11. This time, we had subprime blowup and the credit crunch. Now, we might be at the onset of an oil shock.
I think a very important question when one thinks about growth is - how is the growth financed? Here, I think India is in a much poorer position (this is still a theory, I need to get the hard numbers).
a) Current account deficit - India has a current account deficit. As oil and fertilizer prices go up, this deficit is increasing. BRC run a massive current account surplus which they can use to finance growth, India relies on capital flows - FDI and FII. In the 1990s, east Asia financed its growth through capital flows. Because they didnt have forex reserves, they were hurt badly. India is not in that bad a situation today - forex reserves are high and FDI flow remains strong. Still, it is something to watch out for.
A benefit of having current account surplus is that forex can be used to contain domestic inflation. So China can led yuan appreciate to control inflation because there is a massive current account surplus, India can't.
b) Fiscal deficit - With pay commision award and subsidies on oil and fertilizer, the fiscal position of India can become very bad very soon. If high oil and fertilizer prices for another year, govt will need to cut down on its spending. Whether that will be subsidies or investments is anybody's guess. Most likely, it will be a mix of both.
To do: I need to collect some hard numbers around this.
There is now an inconsistency in the way commodites are priced and the assumption that Chindia can keep growing at 8%+ to support these commodity prices and to also power US out of its slowdown - at least India cant. If Fed is betting on export growth, it should help Chindia tackle inflation by supporting the dollar.
There are two major wildcards now. First, the average price of the US home, and how low it goes. Second, the price of oil, and how high it goes.
Any recession requires multiple shocks - the US economy is extremely resilient. In 2001, there was tech meltdown, Enron-Worldcom-junk bond blowup, and 9-11. This time, we had subprime blowup and the credit crunch. Now, we might be at the onset of an oil shock.
Sunday, April 27, 2008
SMN
I am still trying to figure this one out. It is very dangerous to stand in front of the momentum train. Nasdaq at 3000 can become Nasdaq at 5000 before it become Nasdaq1500. At the same time, in retrospect it becomes one of the easiest trades to make. What event needs to happen to change the sentiment on commodity/agriculture? Dollar strengthening? Monsoons? Already India is predicting a record wheat production this year.
Philip Morris Int came out with very strong results this qtr. So thats good. My thinking has changed a bit on the stock. Earlier, I was thinking this stock should command a 20x multiple like Coke and other FMCG companies, as its EPS growth is around 10%-12% like Coke. That is incorrect. Volume growth for PMI is close to 0% and there is always the litigation risk. So 16x is probably a good enough multiple for this, which is where it trades. So I bought this stock at fair value - the best I can hope now is EPS growth.
Blue Dart came out with phenomenal numbers. It is now trading at 13x-14x FY08EPS. If this stock falls again to 10x-11x, as I am sure it will, I will pick it up.
What about Crisil? This is the S&P arm in India. Its ratings business is growing at 50% (due to Basel-II norm implementation driven business), but Irevna is flat (as it does I-banking outsourcing work). Both contribute about 45%-45% topline for the company. At its current price, it is trading at 25x FY08. For a 25% EPS grower, isnt that the right multiple to pay? If Irevna comes back, the growth could be even higher.
Philip Morris Int came out with very strong results this qtr. So thats good. My thinking has changed a bit on the stock. Earlier, I was thinking this stock should command a 20x multiple like Coke and other FMCG companies, as its EPS growth is around 10%-12% like Coke. That is incorrect. Volume growth for PMI is close to 0% and there is always the litigation risk. So 16x is probably a good enough multiple for this, which is where it trades. So I bought this stock at fair value - the best I can hope now is EPS growth.
Blue Dart came out with phenomenal numbers. It is now trading at 13x-14x FY08EPS. If this stock falls again to 10x-11x, as I am sure it will, I will pick it up.
What about Crisil? This is the S&P arm in India. Its ratings business is growing at 50% (due to Basel-II norm implementation driven business), but Irevna is flat (as it does I-banking outsourcing work). Both contribute about 45%-45% topline for the company. At its current price, it is trading at 25x FY08. For a 25% EPS grower, isnt that the right multiple to pay? If Irevna comes back, the growth could be even higher.
Eaton Vance's Tax Advantaged Dividend Fund
Couple of people said I was wrong that this fund used leverage. This fund uses a covered call strategy to enhance its dividends. So I went back to check the annual report of this fund.
From Page 2 of the Annual Report of this fund: "As of August 31, 2007, the Fund's $700 million issued and outstanding Auction Preferred Shares (APS) equaled approximately 24% of total assets and maintained a weighted average reset period of 21 days, which is comparable to what it was when the Fund's leverage was originally issued. Use of financial leverage creates an opportunity for increased capital appreciation and income but, at the same time, creates special risks (including the likelihood of greater volatility of net asset value and market price of the common shares). In the event of a rise in long-term interest rates, the value of the Fund's portfolio could decline, which would reduce the asset coverage for its APS."
I also dont find anything on the covered call strategy in the report. Rather, they use a approach called dividend capture strategy - which is basically trading to capture dividends.
From Page 2 of the Annual Report of this fund: "As of August 31, 2007, the Fund's $700 million issued and outstanding Auction Preferred Shares (APS) equaled approximately 24% of total assets and maintained a weighted average reset period of 21 days, which is comparable to what it was when the Fund's leverage was originally issued. Use of financial leverage creates an opportunity for increased capital appreciation and income but, at the same time, creates special risks (including the likelihood of greater volatility of net asset value and market price of the common shares). In the event of a rise in long-term interest rates, the value of the Fund's portfolio could decline, which would reduce the asset coverage for its APS."
I also dont find anything on the covered call strategy in the report. Rather, they use a approach called dividend capture strategy - which is basically trading to capture dividends.
Friday, April 25, 2008
Time to short commodities?
Futures are now pricing in just a 25 bps cut next Tuesday and then a stop to the rate cuts by the Fed. That should be bullish for dollar and bearish for commodities (because commodites have been pushed up on the theory of the weak dollar).
I can't understand the supply-demand arguments to justify sharp movements in commodity prices on a daily basis. Suppose oil is in short supply. So why should it be priced only at $115 and not at $1150? I can understand that suddenly there have been port closures in Australia, so coal prices go up. But how come everything goes into short supply at the same time. I suspect the movements in commodities that we have seen in the last few months has a lot to do with the theory that because real interest rates are now -ve in the US, commodities should go up. But they can't go up ad infinitum, right?
Should I go long SMN? It is already up 10% in last few days, but has been absolutely hammered in the last few months. This ETF has shorted stocks of companies through derivatives and is leveraged 2x. Its biggest position is Monsanto, which is a play on agflation. All these companies have seen their stock go vertically up in the last 7 months since the Fed rate cuts started.
I guess what is extremely important for this to succeed in the short run is the nature of the commentary out of Fed next Wednesday. If they as much mention inflation, it will be a good bet. If they do not, it might become a problem - this is again leveraged 2x like SKF, so moves can be magnified. But with now everyone on the theory of agflation, it might be the time to go against it. It might not be a bad bet for the longer term if one has the stomach for it (I don't).
A technical point - how do dividends get adjusted for SMN? If I short a stock that pays dividends, I pay the dividend to the person from whom I borrow the stock to short. In SMN, who pays dividends? Or because of derivatives, that consideration doesn't arise?
I can't understand the supply-demand arguments to justify sharp movements in commodity prices on a daily basis. Suppose oil is in short supply. So why should it be priced only at $115 and not at $1150? I can understand that suddenly there have been port closures in Australia, so coal prices go up. But how come everything goes into short supply at the same time. I suspect the movements in commodities that we have seen in the last few months has a lot to do with the theory that because real interest rates are now -ve in the US, commodities should go up. But they can't go up ad infinitum, right?
Should I go long SMN? It is already up 10% in last few days, but has been absolutely hammered in the last few months. This ETF has shorted stocks of companies through derivatives and is leveraged 2x. Its biggest position is Monsanto, which is a play on agflation. All these companies have seen their stock go vertically up in the last 7 months since the Fed rate cuts started.
I guess what is extremely important for this to succeed in the short run is the nature of the commentary out of Fed next Wednesday. If they as much mention inflation, it will be a good bet. If they do not, it might become a problem - this is again leveraged 2x like SKF, so moves can be magnified. But with now everyone on the theory of agflation, it might be the time to go against it. It might not be a bad bet for the longer term if one has the stomach for it (I don't).
A technical point - how do dividends get adjusted for SMN? If I short a stock that pays dividends, I pay the dividend to the person from whom I borrow the stock to short. In SMN, who pays dividends? Or because of derivatives, that consideration doesn't arise?
Thursday, April 24, 2008
Eaton Vance Tax Advantaged Dividend Income Fund
WSJ is out recommending EVT today as it pays a 7% dividend and trades at discount on NAV because of ARPS issues, but I have my reservations.
This is an equity close-ended fund. None of the big stocks that this fund owns has a 7% yield. So the only way the fund is able to pay out the high cash dividend is through the use of leverage, or auction rate preferred shares. Unless the fund can figure out a way to replicate the low-cost leverage that it has so far used, it will be difficult to sustain the level of dividend payments.
Eaton Vance mentions that is has replaced ARPS with debt for this fund, which will surely have higher cost than ARPS. I wouldn't be surprised if leverage goes down for this fund, which will also reduce its dividend, which is perhaps the only reason to buy this fund.
Capital gains with this fund will be correlated to the stock market. As shown in the literature on the website, this fund has always traded at a discount to its NAV, which can fall if underlying securities fall in price. If that happens, debt holders can force the fund to liquidate - akin to a margin call. Probably debt closed-end funds facing ARPS issues are better than equity closed-end funds.
Friday, April 18, 2008
Valuing Citi
I was thinking about how should one value Citi. Its peak EPS in 2006 was $4.24. I think it will be another 5 years before it returns to that EPS level, because (a) The company has diluted by about 10%, so peak EPS on today's share count is more like $3.80, (b) leverage in SSB is going down for sure - I think its earnings are impaired for at least half a decade (c) there is a recession/slowdown in US. So some impact on banks is bound to happen.
So lets assume Citi hits $4.24 in 2012. At 11x PE, I will value it at $46.80 in 2012. Assuming 12% discount rate (why will I invest in a financial today if I dont double my money in 4 years, so 12% discount rate + 5% dividend = 17% effective return over 4 years = double money), I will value Citi today at $29.74.
Selling SKF
I sold SKF today at a loss of 10% - gave a market order to sell before the market opened. From +10% to -10% in 3 days illustrates the power of leverage. It was a good learning as it reminded me of what I learnt from the Motorola fiasco two years ago.
I think financials are now out of the gate - sentiment is as imporant as reality, the big writedown cycle is most likely over and the regulators are on the case. I have bought KBE at $41 - it is the financials ETF. Plan to hold it for long unless it suddenly jumps to 47 and above.
I also bought Philip Morris International at 16x 08PE and it is now the largest position I have. I like cigarette companies as the free cash flow generation is huge.
Another lesson - buying/selling at open doesnt make sense on a day like this, wait for 30 min for the initial rush to pash through and one can get 1%-2% better for sure.
I think financials are now out of the gate - sentiment is as imporant as reality, the big writedown cycle is most likely over and the regulators are on the case. I have bought KBE at $41 - it is the financials ETF. Plan to hold it for long unless it suddenly jumps to 47 and above.
I also bought Philip Morris International at 16x 08PE and it is now the largest position I have. I like cigarette companies as the free cash flow generation is huge.
Another lesson - buying/selling at open doesnt make sense on a day like this, wait for 30 min for the initial rush to pash through and one can get 1%-2% better for sure.
Thursday, April 17, 2008
Google Earnings
We all know that Merrill and Citi will have lousy quarters when they report in next 48 hrs. The more interesting earnings report will be, however, from Google. comScore data suggests that click growth slowed down dramatically last quarter. Bulls say that Google has tweaked its algo so that the yields have gone up, so there will be no pressure on revenue. But analysts always have lofty expectations from Google, so even a small miss can be penalized heavily.
SKF is still at breakeven, after having been up more than 10% Tuesday when Wachovia announced its capital raise. That was indeed my target. So, why didnt I sell? As I had learnt two years back with Motorola, the more important decision is not buying but selling. Selling when the target price is hit, or selling at a loss, requires great discipline, especially with these speculative positions. There are all the books and experts on the buying decision, but hardly anyone talks about when to sell.
Anyways, ML and Citi report in next 48 hrs. So lets see. I dont think there is much downside left in banks - they have already been pummeled.
I think oil prices are going into dangerous territory, especially for countries like India. Commodities have risen too fast. Ultrashort Materials (SMN) is something to keep a close eye on.
SKF is still at breakeven, after having been up more than 10% Tuesday when Wachovia announced its capital raise. That was indeed my target. So, why didnt I sell? As I had learnt two years back with Motorola, the more important decision is not buying but selling. Selling when the target price is hit, or selling at a loss, requires great discipline, especially with these speculative positions. There are all the books and experts on the buying decision, but hardly anyone talks about when to sell.
Anyways, ML and Citi report in next 48 hrs. So lets see. I dont think there is much downside left in banks - they have already been pummeled.
I think oil prices are going into dangerous territory, especially for countries like India. Commodities have risen too fast. Ultrashort Materials (SMN) is something to keep a close eye on.
Friday, April 11, 2008
Portfolio as of 11 April
In the US,
a) CCS - Comcast's unsecured debt with a 7.5% yield. A better place than my bank account to park money. I am sure Comcast is not going bust. Best thing is that it trades on the exchanges like a stock.
b) PYN - Pimco NY Muni Fund III. I think that (a) municipal markets will stabilize slowly but surely, (b) interest rates would fall more, so funds with high yields will become more attractive and (c) tax rates will rise in the next 3 years - deficits need to be reduced at some point of time - so tax-free muni bonds will become attractive. This trades at a discount to its NAV which has started recovering since Feb when the ARPS crises hit. Hold for long term.
c) SKF - Ultrashort Financials. This is a speculative position. This is a levered play to short financials. Breakeven here - this position was established last week. Citi and ML report next week, so we can see some action here.
d) Am looking at some stocks to buy for the long-term. Philip Morris International seems a good one. It just spun out of Altria. FY08 EPS of $3.10-$3.20 gives it a PE of 15x-16x.
In India,
a) Aban Loyd - leveraged bet on shallow water E&P capex. Lost 10% so far. It is not a 5 year buy kind of stock. As long as oil remains above $80, I think we are safe.
b) Some PSU's - Union Bank, Bank of Baroda. Underwater by 10%. I sold Allahabad Bank last month at a 40% loss to save taxes.
c) Blue Dart - should I add more? This is down by 20% and is a good company.
d) Deccan Chronicle - Down by 20%. It's financials are fraud. But it is newspapers + the only way to play IPL. Wouldnt add more.
e) Sold Tata Power at 20% loss last month to save taxes. This is the only utility stock I will buy if I get it at around Rs 1000. It bought a stake in Bumi resources (Indonesian coal mine) last year, which has been a home run now that coal prices have run up. Plus, conglomerate discount should vanish as it starts monetizing stakes in other Tata group companies to fund its own aggressive capex plans.
I am still 85% uninvested. Cash has been a good bet so far. But now is the time to start buying good quality companies that have become cheap.
a) CCS - Comcast's unsecured debt with a 7.5% yield. A better place than my bank account to park money. I am sure Comcast is not going bust. Best thing is that it trades on the exchanges like a stock.
b) PYN - Pimco NY Muni Fund III. I think that (a) municipal markets will stabilize slowly but surely, (b) interest rates would fall more, so funds with high yields will become more attractive and (c) tax rates will rise in the next 3 years - deficits need to be reduced at some point of time - so tax-free muni bonds will become attractive. This trades at a discount to its NAV which has started recovering since Feb when the ARPS crises hit. Hold for long term.
c) SKF - Ultrashort Financials. This is a speculative position. This is a levered play to short financials. Breakeven here - this position was established last week. Citi and ML report next week, so we can see some action here.
d) Am looking at some stocks to buy for the long-term. Philip Morris International seems a good one. It just spun out of Altria. FY08 EPS of $3.10-$3.20 gives it a PE of 15x-16x.
In India,
a) Aban Loyd - leveraged bet on shallow water E&P capex. Lost 10% so far. It is not a 5 year buy kind of stock. As long as oil remains above $80, I think we are safe.
b) Some PSU's - Union Bank, Bank of Baroda. Underwater by 10%. I sold Allahabad Bank last month at a 40% loss to save taxes.
c) Blue Dart - should I add more? This is down by 20% and is a good company.
d) Deccan Chronicle - Down by 20%. It's financials are fraud. But it is newspapers + the only way to play IPL. Wouldnt add more.
e) Sold Tata Power at 20% loss last month to save taxes. This is the only utility stock I will buy if I get it at around Rs 1000. It bought a stake in Bumi resources (Indonesian coal mine) last year, which has been a home run now that coal prices have run up. Plus, conglomerate discount should vanish as it starts monetizing stakes in other Tata group companies to fund its own aggressive capex plans.
I am still 85% uninvested. Cash has been a good bet so far. But now is the time to start buying good quality companies that have become cheap.
Sunday, April 06, 2008
Same language subtitling helps improve literacy
In today's Times of India, Gurcharan Das has a very fascinating article on a creative method to improve literacy - same language subtitling of Chitrahar and Rangoli on Doordarshan. People often anticipate the next word of a song. If they are able to immediately associate it with the written word, the literacy improves. I immediately turned on Doordarshan to see Rangoli after a gap of maybe 14 years. And yes, it was there. Neat, simple and apparently very effective. Hats off to Dr. Brij Kothari for recognizing such a common sensical approach to improve literacy.
Wednesday, April 02, 2008
It is strange
that Dow Jones is where it was in Dec. Since then, there has been one bad news after another. Still, the major US indices have remained resilient. Why is that? Is the market signalling something? These 400 point moves on Tuesday must really be killing the shorts.
Tuesday, April 01, 2008
Learnings over the last 9 months
The last 9 months have been really incredible. The best way to learn about monetary policy, central banking and stock markets is to be in a financial crisis like today. So here are my key takeaways:
a) Markets can be manipulated - Witness the fall of Bear Sterns and the volatility in Lehman's stock price. Bear Sterns was brought down by feverish rumour mongering. If it can happen in a liquid stock like Bear Sterns, there is also truth to allegations that the 1997-98 East Asian crises was caused/exacerbated by hedge funds. That is not to say there weren't real issues, but the decisive blow could have come through manipulation.
b) 5-year financial models that linearly extrapolate last 3 years of data are useless - In 1997, could anyone have predicted the East Asian crises and then the tech bubble? In 2002, could anyone have predicted a 5-year global bull run? If one cannot predict such defining macro trends, how can one really do a "bottoms up, company specific analysis". Because any such analysis assumes stable macro trends. Except for some defensive companies (FMCG, healthcare etc), almost everything else is impacted by macro trends, most importantly interest rates and currencies. While financial models do help understand a company better (especially if there are one-offs, tax rate changes etc), one should be careful in not getting too bogged down.
c) Speculation is possible: I disagree with those avowed value investors who think speculators are gambling and will lose money in the long run. Sorry. You are wrong. The definitiveness with which you claim that traders are gamblers reminds me of my MBA school's insistence that markets are efficient. They clearly aren't. Otherwise Bear Sterns wouldn't have gone belly up in 24 hrs. Value investing is great, and so is speculation.
d) It pays to be a contraian: Nobody in emerging markets predicted in January that markets are going to crash. But they did. Similarly, if confronted with the fact that UBS had a $19bn write down, a logical person would have said that markets would go down. They didn't. Media commentary tries to justify restrospectively why certain things happened. It is useless. The simplest answer to why markets went up yesterday is - they went up.
I guess what Warren Buffet says is true. Markets are efficient, but not all the times. And we are living in such a time.
a) Markets can be manipulated - Witness the fall of Bear Sterns and the volatility in Lehman's stock price. Bear Sterns was brought down by feverish rumour mongering. If it can happen in a liquid stock like Bear Sterns, there is also truth to allegations that the 1997-98 East Asian crises was caused/exacerbated by hedge funds. That is not to say there weren't real issues, but the decisive blow could have come through manipulation.
b) 5-year financial models that linearly extrapolate last 3 years of data are useless - In 1997, could anyone have predicted the East Asian crises and then the tech bubble? In 2002, could anyone have predicted a 5-year global bull run? If one cannot predict such defining macro trends, how can one really do a "bottoms up, company specific analysis". Because any such analysis assumes stable macro trends. Except for some defensive companies (FMCG, healthcare etc), almost everything else is impacted by macro trends, most importantly interest rates and currencies. While financial models do help understand a company better (especially if there are one-offs, tax rate changes etc), one should be careful in not getting too bogged down.
c) Speculation is possible: I disagree with those avowed value investors who think speculators are gambling and will lose money in the long run. Sorry. You are wrong. The definitiveness with which you claim that traders are gamblers reminds me of my MBA school's insistence that markets are efficient. They clearly aren't. Otherwise Bear Sterns wouldn't have gone belly up in 24 hrs. Value investing is great, and so is speculation.
d) It pays to be a contraian: Nobody in emerging markets predicted in January that markets are going to crash. But they did. Similarly, if confronted with the fact that UBS had a $19bn write down, a logical person would have said that markets would go down. They didn't. Media commentary tries to justify restrospectively why certain things happened. It is useless. The simplest answer to why markets went up yesterday is - they went up.
I guess what Warren Buffet says is true. Markets are efficient, but not all the times. And we are living in such a time.
Marathon
So after years of procrastinating, I have decided to finally prepare for a marathon this year. I have yet to figure out which one. The longest I have ever run is 28 km last year in New York (now I live in Mumbai). Then, I had run from my house on 58th street and 9th Avenue to George Washington Bridge on 181st street and Riverside Avenue along the Hudson. I have tried running beyond 28km but have failed as my knees start wobbling around the 24-25 km mark.
Of the 4 aims I list above, only two are work-in-progress - stock markets and learning French. So I will discard the other two and focus on marathon this year. I think I will maintain a diary so as to really make sure that I practice.
29/03 - 5 km at the gym
01/04 - 6 km around Five Gardens
Of the 4 aims I list above, only two are work-in-progress - stock markets and learning French. So I will discard the other two and focus on marathon this year. I think I will maintain a diary so as to really make sure that I practice.
29/03 - 5 km at the gym
01/04 - 6 km around Five Gardens
Some Interesting Facts from UBS Writedown
1. Shares are up 8%. I think all market prognosticators are scratching their heads. Just tells how impossible it is to trade this market. Time has come to start taking longer term views - that is, if one is possible (see point 2).
2. "The Mandatory Convertible Notes issued in March 2008 are subject to anti-dilution provisions, which will result in downward adjustments of the applicable conversion price to reflect the theoretical value of the Subscription Rights." - I guess it is almost impossible to figure out what the share count of the various banks will be once all this fund raising is over. How does one then calculate the normalized EPS (and the target price) for any bank? Or, should one simply try to time and enter at the dilution price which is the minimum price of all the dilutions. That way, one has benefited from the dilutions that happened at the higher price. But then, how does one figure out that minimum dilution price?
3. While positions in subprime and Alt-A declined, auction rate certificates increased. We all know about the turmoil in ARPS market. Didn't realize that brokers will take them on their balance sheet. But this shouldn't be a major cause of concern, as any writedowns should be low (compared to subprime). "Over 1Q , UBS's exposure to US residential sub-prime mortgage related positions declined to approximately USD 15 billion from USD 27.6 billion on 31 December, and the exposure to Alt-A positions was reduced from USD 26.6 billion to approximately USD 16 billion. Auction rate certificate positions increased from USD 5.9 billion on 31 December to approximately USD 11 billion."
2. "The Mandatory Convertible Notes issued in March 2008 are subject to anti-dilution provisions, which will result in downward adjustments of the applicable conversion price to reflect the theoretical value of the Subscription Rights." - I guess it is almost impossible to figure out what the share count of the various banks will be once all this fund raising is over. How does one then calculate the normalized EPS (and the target price) for any bank? Or, should one simply try to time and enter at the dilution price which is the minimum price of all the dilutions. That way, one has benefited from the dilutions that happened at the higher price. But then, how does one figure out that minimum dilution price?
3. While positions in subprime and Alt-A declined, auction rate certificates increased. We all know about the turmoil in ARPS market. Didn't realize that brokers will take them on their balance sheet. But this shouldn't be a major cause of concern, as any writedowns should be low (compared to subprime). "Over 1Q , UBS's exposure to US residential sub-prime mortgage related positions declined to approximately USD 15 billion from USD 27.6 billion on 31 December, and the exposure to Alt-A positions was reduced from USD 26.6 billion to approximately USD 16 billion. Auction rate certificate positions increased from USD 5.9 billion on 31 December to approximately USD 11 billion."
Wednesday, March 26, 2008
Asset Prices as the Driver of Business Cycles
Leo Tolostoy said "Happy families are all alike; every unhappy family is unhappy in its own way". Applied to financial markets, this would read as "all boom times are alike, but recessions are unique in their own way." It is at times like today which determine who is really a good investor and who is not.
Coming to recessions, the most often cited logic for business cycles is inventory mismatch. Greenspan viewed the 2000-01 bust as caused by excess inventory in tech sector, and will no doubt view today's bust as caused by housing inventory. But shouldn't one move one step back to what caused this inventory. That will be rampant speculation in asset prices - in tech in 2000 and in housing in 2007.
Conventional inventory buildups in the supply chain have become more manageable with the advent of technology and spread of supply chain management solutions. So, as the volatility of inventory has reduced, the big factor impacting business cycles might no longer be inventory, but something else.
Are asset prices the real driver of the business cycle now? In other words, do stock market and real estate market drive underlying economic growth, rather than the other way around? If that is the case, then the mandate of the Fed to promote substainable growth (i.e. reduce volatility of the business cycle) should force it to target asset prices. But they do not. They say thay if we were to target asset prices, then we would get an economic contraction, which is what we are trying to avoid in the first place.
I have enormous respect for Greenspan, despite him being regarded as the chief culprit behind the housing mess. He is right when he says that there has been a housing boom worldwide and not just in the US. So what exactly is the theory which made him reluctant to target asset prices?
Is it that bubbles are actually good? They are the best form of socialism. Somebody overinvests, and somebody else benefits. India benefitted from reduced telecom costs following the tech burst. If house prices fall a lot, many people who couldn't afford them earlier during pre-housing bubble times could afford them once the credit markets stabilize, as their incomes would have risen this decade.
Tuesday, March 18, 2008
The Lehman miss
I missed Lehman yesterday, when the stock went down to 20. As they say, "Be greedy when others are fearful, and be fearful when others are greedy". Considering that (a) Fed effectively extended credit lines to brokerages on Sunday, and (b) Lehman was set to produce its balance sheet in 24 hrs, the chances of a liquidity crisis at Lehman were <50%. What was clear was that if Lehman survived 24 hrs, one will get 100% return. And if not, lose 100%. So the expected return/risk was in favor of speculating in Lehman.
A bet against Lehman yesterday was a bet against the Fed. And a bet against the Fed never wins. This was a miss that I will perhaps rue for my life. While financials are bad and probably stink over the next year, there will be trades like this all over in the next few months. I need to make sure I act on them and not be carried away in all the bearishness.
But then, an important question emerges. Suppose I had really bought Leh yesterday and really made 100%. I would have made money. But would it have given me an overconfidence in my timing abilities and made me more speculative which would ultimately lead to more losses in the long term? I need to be careful what I wish for.
The trade of the next few years is financials. Get them right, and one will have multibaggers.
A bet against Lehman yesterday was a bet against the Fed. And a bet against the Fed never wins. This was a miss that I will perhaps rue for my life. While financials are bad and probably stink over the next year, there will be trades like this all over in the next few months. I need to make sure I act on them and not be carried away in all the bearishness.
But then, an important question emerges. Suppose I had really bought Leh yesterday and really made 100%. I would have made money. But would it have given me an overconfidence in my timing abilities and made me more speculative which would ultimately lead to more losses in the long term? I need to be careful what I wish for.
The trade of the next few years is financials. Get them right, and one will have multibaggers.
Monday, March 03, 2008
Buffet's crazy put options
Buffet has collected a $4.5 bn premium by selling 15-20 year put options on four stock indices (including S&P), stuck at the current level of market. Who are these geniuses who are so bearish on the market over a 15 year time-span that they paid a $4.5bn premium? Simply inflation would push up the level of markets - so the probablity of this event is low. But if the probability of this event is low, Buffet must have written this on a staggering huge notional amount - something like a trillion dollars. Is it Fidelity or Vanguard or one of these giant asset management firms who have bought these options - cant think of anyone else who has a trillion dollars to protect? Or am I reading this incorrectly? Why hasnt anyone else picked this up?
The Idearc Fiasco
Well well. Idearc fell to $3.57 on Friday (it is right now slightly above $5 as Barron's published a story on levered equities on the weekend). I had purchased this stock around $28 when it spun out off Verizon and sold it at $35 in August when the credit crunch started. Levered equities are dangerous when credit markets freeze. I also sold AMT at that time.
Is IAR worth a second look? RHD lowered its guidance on Thursday - surprisingly the $100 mn reduction in revenue guidance is almost falling straight to EBITDA and FCF line, indicating a high fixed cost structure for the business.
Negatives are - Economy is slowing, so ad revenues will take a hit + small businesses on whom yellow pages rely will default more in a slow economy leading to higher bad debt expense + Google etc are eating yellow pages lunch + IAR's and RHD's acquisition of domain names for multi-hundred million dollars is not confidence inspiring + IAR's CEO left barely 1 week into his job last week.
Positives are - the company has EBITDA/Interest Expense ratio of nearly 2x, so there is a lot of cushion + Debt/EBITDA ration is nearly 7x which is high, but not 9x of RHD + dividend yield of 23% is mouth-watering - dividend payout is 60% of FCF today. Problem is - if EBITDA declines rapidly, the Debt/EBITDA ratio can suddenly look much worse. Its bonds are trading at a 15% yield, indicating high level of concerns in the debt markets.
Is IAR worth a second look? RHD lowered its guidance on Thursday - surprisingly the $100 mn reduction in revenue guidance is almost falling straight to EBITDA and FCF line, indicating a high fixed cost structure for the business.
Negatives are - Economy is slowing, so ad revenues will take a hit + small businesses on whom yellow pages rely will default more in a slow economy leading to higher bad debt expense + Google etc are eating yellow pages lunch + IAR's and RHD's acquisition of domain names for multi-hundred million dollars is not confidence inspiring + IAR's CEO left barely 1 week into his job last week.
Positives are - the company has EBITDA/Interest Expense ratio of nearly 2x, so there is a lot of cushion + Debt/EBITDA ration is nearly 7x which is high, but not 9x of RHD + dividend yield of 23% is mouth-watering - dividend payout is 60% of FCF today. Problem is - if EBITDA declines rapidly, the Debt/EBITDA ratio can suddenly look much worse. Its bonds are trading at a 15% yield, indicating high level of concerns in the debt markets.
Tuesday, February 19, 2008
Are munibond funds attractive?
Some munibond funds are right now yielding 5%-6% tax free. A 5% tax-free yield translates to 7% pre-tax yield (assuming 30% tax rate). Look at some Blackrock funds (MQY). Why is this the case?
Normally municipal bonds are the safest bonds around. Their default rates have been amongst the lowest. With Fed fund rate at 3%, muni funds should not be offering 5%.
It is not that suddenly muni bonds have started defaulting which has resulted in this spread widening. Rather some interesting events have happened in the muni market:
(a) Threat of monoline downgrades - If MBI or Ambac lose their AAA rating, muni bonds insured by them might also lose their AAA rating, if the rating of the issuer is below AAA.
(b) If (a) happens, some muni funds will dump the downgraded securities, per their guidelines on holding non AAA securities. If the funds are forced to dump in an illiquid market, the prices realized might be lower than used in calculating NAVs.
(c) Failure of Auction-rate preferreds auctions: Muni funds have historically used leverage to juice up their dividends to common shareholders. The mechanism they used to lever up is called auction rate preferred shares (ARPS), which has failed in the last 2 weeks. It is essentially like an SIV - use short term funding to buy long term assets and profit from the spread. The risk is that one needs continuous access to short-term funding to rollforward the debt as it comes due. I guess ARPS investors have gone on strike much like SIV investors, because they fear that the collateral backing the securities has lower value (or will have a lower value if monolines get downgraded and the muni fund is forced to sell the downgraded bonds in an illiquid market). More can be read on the Blackrock site - http://www1.blackrock.com/eIndex.aspx?eid=43598&cmty=ind&ln=36494&lo=4
Is there a parallel between SIV fiasco and the unfolding ARPS fiasco? Muni bonds are much safer than subprime mortgages. Besides ARPS are overcollaterized - a muni fund needs to back ARPS by 200% of collateral. I dont know about SIV's - but I dont think they were as collaterized. Still, investor confidence has been shaken in ARPS, and confidence is the currency of the realm. If investors dont return to the ARPS market, muni funds might be forced to redeem their ARPS by selling some assets (deleveraging) in today's illiquid market. That will hurt common shareholders.
The key then - is to figure out the conditions unders which ARPS holders can force the funds to redeem their securities. If the funds can postpone the redemption indefinitely, they can wait for 1-2-10 years that it takes market to return back to normal and then redeem at fundamentally justified prices. In this case, common shareholders like me benefit. If, on the other hand, the funds are forced to redeem after - say x days - then if the ARPS credit crunch continues beyond those x days, I as common shareholder might lose.
Or, one just needs to believe that whatever happens, regulators will ensure that the municipal business of the bond insurers continues to get the AAA rating. Spitzer said on Thursday that bond insurers have 3-5 days to figure out a private market solution. That makes the deadline today. If the threat of mass downgrades on muni bond goes away, I think ARPS market will snap back to normal over time. And that will make muni funds attractive. I am willing to take that bet.
Tuesday, February 05, 2008
Average Price of US Home
What I thought in September here seems to be becoming a reality. People with no equity in their homes are walking away (Marketbeat). Average Home price in the US is the single most important variable that will determine the direction of US economy from here. Deflation is dangerous - whether in consumer prices or asset prices.
Thursday, January 31, 2008
A new massacre is about to begin
S&P has downgraded a whole host of mortgage backed securities and CDOs. I have the sinking feeling that we are about to see the replay of the events in Nov and January, both of which were preceded by downgrades by S&P. Plus it seems like MBIA might be downgraded anyday. This time, asset price declines will hit fundamentals, because it will hit sentiment really hard. Normally, earnings determine stock prices. But now, stock prices will determine earnings. Lets see.
Friday, January 25, 2008
Bill Ackman's Letter to Rating Agencies regarding Bond Insurers
Shorting a stock requires much more skill than going long. Due to inflation, the natural tendency of prices is to go up than down. I have become a big fan of Ackman. Whether he is proven right or wrong ultimately is secondary. The way he has conducted his short campaign against the bond insurers is admirable.
----------------------
January 18, 2008
Mr. Raymond McDaniel Mr. Stephen Joynt
Executive Chairman and CEO CEO and President
Moody’s Corp. Fitch Ratings
99 Church St. One State Street Plaza
New York, NY 10007 New York, NY 10004
Mr. Deven Sharma
President
Standard & Poor’s
55 Water Street
New York, NY 10041
Re: Bond Insurer Ratings
Ladies and Gentlemen:
As a Nationally Recognized Statistical Rating Organization, Moody’s, S&P, and Fitch
have been granted a level of authority that capital market participants and Federal and
State regulators have historically relied upon in evaluating the safety and soundness of
corporations, regulated financial institutions, and structured finance securities. To state
the obvious, because of your critical role in the capital markets, it is essential that the
ratings you publish are the result of comprehensive and accurate analysis.
As you well know, we have privately, in meetings and correspondence with you, and
publicly in various presentations that we have made, called into question your ratings of
the bond insurance industry, in particular, the ratings for MBIA Insurance Corp. and
Ambac Assurance Corp. and their holding companies.
Each of you, according to your recent public statements, is in various stages of updating
your ratings of the bond insurers. Unfortunately, however, your previous ratings
assessments have erred materially in their omission of certain critical analysis and the
inclusion of outright errors in your work. As you conduct your most recent revisions of
your analysis on the bond insurers, it is vital that you conduct a thorough assessment of
all aspects of the bond insurers’ business lines, their reinsurers, and investment portfolios
so that the rating decisions that you ultimately publish can be relied upon by capital
markets participants.
Below we highlight a number of factors that you have failed to consider in your prior
assessments of the bond insurers’ capital adequacy:
1) Impact of Losses Should be Measured on a Pre-tax Basis
We believe that each of you overstates the bond insurers capital cushion due to tax
benefits you include in calculating the impact of RMBS and CDO losses. For instance, in
S&P’s recent press release update published yesterday, MBIA’s losses on RMBS and
CDOs are expressed as “after-tax” losses. In order, therefore, to determine the actual
cash losses implied by S&P’s after-tax estimate, one must gross up the reported $3.18
billion of after-tax losses. Assuming a tax rate of 38%, it appears that S&P is estimating
MBIA’s actual cash losses at $5.13 billion, nearly $2 billion more than the losses
adjusted for tax benefits.
Insurance claims must be paid in cash. A bond insurer is only able to obtain tax benefits
if the insurer is a going concern and is able to generate sufficient taxable income in the
current or future years to offset the losses from paid insurance claims. Your analysis
makes the aggressive assumption that the bond insurers will remain going concerns and
will therefore be able to continue to write new premiums and generate income in the
future.
Based on recent industry developments – including Berkshire Hathaway’s entrance into
the business – it appears unlikely that MBIA, Ambac and many of the other bond insurers
will be able to continue as going concerns. In a runoff scenario, we do not believe that
the bond insurers will generate sufficient taxable income to offset the net operating losses
generated by paid losses. While U.S. corporations can receive tax refunds by carrying
back tax losses up to two calendar years, the amounts that could be refunded from
carrying back losses are de minimis relative to claims payable. Even in the event the
bond insurers generate taxable income in future years, it may be many years before these
tax benefits can be realized, if ever, particularly in the event of corporate ownership
changes caused by capital raising or stockholder turnover.
Net operating loss carryforwards are not cash and are not available to pay claims and
should therefore not be deducted from losses in calculating bond insurer capital
adequacy. By using after-tax loss estimates rather than pre-tax losses – the amount that
will need to be paid in cash – you are understating the actual losses payable by more than
60%.
Your updated rating assessments should be adjusted to exclude tax benefits in your
calculation of capital adequacy
2
2) Covenant Violations and Loss of Access to Liquidity Facilities
As a result of recent losses, both MBIA and Ambac have triggered covenant violations on
their liquidity facilities. As a result, Ambac has lost access to $400 million of funding
and MBIA to $500 million of capital. The impact of the loss of these facilities is material
to the liquidity profile of the holding companies and their insurance subsidiaries and must
be considered in your credit assessment.
3) Loss Estimates Must Incorporate Reinsured Exposures
Your ratings of the bond insurers are based on the bond insurers’ net credit exposures.
That is, you reduce their credit exposure by those exposures that have been reinsured.
This is best understood by example.
As of September 30, 2007, MBIA has re-insured approximately $80 billion of par value
of its exposures. More than $42 billion of this reinsurance was purchased from Channel
Re, a Bermuda- based reinsurer whose only customer is MBIA. The two most senior
officers of Channel Re are former executives of MBIA. MBIA owns 17% of the
company and has two representatives on Channel Re’s board of directors.
On recent conference calls, Moody’s and S&P have stated that they have not yet updated
their ratings of the monoline reinsurers including Channel Re. Earlier this week, on
January 16th, Partner Re and Renaissance Re, the majority equity owners of Channel Re,
wrote off the entire value of their investments in Channel Re due to losses it has recently
incurred that substantially exceed Channel Re’s capital, an impairment that Channel Re’s
two majority owners have concluded is “other than temporary.”
Despite the fact that Channel Re has negative book equity and $42 billion of MBIA’s
credit exposure – $21.5 billion of which is CDOs of ABS or CLO/CBOs – Moody’s and
S&P continue to rate the company Triple A with a stable outlook. Fitch does not rate
Channel Re and apparently relies on S&P’s and Moody’s stale Triple A ratings in its
analysis of MBIA’s capital adequacy.
Captive reinsurers whose ratings are not regularly updated offer the potential for abuse.
We believe that MBIA reinsured on a quota share basis 25% of its 2007 CDO
transactions with Channel Re. As a result of Moody’s and S&P not updating its ratings
of Channel Re, these exposures do not appear on MBIA’s list of exposures and have not
been included in your calculation of MBIA’s capital adequacy.
MBIA’s second largest reinsurer is Ram Re which has reinsured $11 billion of par as of
September 30, 2007. While the rating agencies have not updated their credit ratings of
Ram Re, the market appears to have already done so. The publicly traded stock of Ram
Holdings Ltd., the parent company of Ram Re, has declined 92% in the last year. The
company currently trades as a penny stock with a market value of $32 million.
3
We believe that Ram Re is substantially undercapitalized and therefore, like Channel Re,
is unlikely to be able to meet its obligations to MBIA.
We also note that MBIA reinsures Ambac, and Ambac reinsures MBIA. You must also
consider the iterative impact of downgrades of one on the other with respect to both
reinsurance and their respective guarantees of each other’s investment portfolio assets
which we discuss further below.
In your updated assessment, it is critical that you update your ratings of the bond
insurers’ reinsurers and reconsolidate and calculate the losses on these exposures that
have been reinsured with reinsurers that are inadequately capitalized.
4) Investment Portfolios are Riskier Than They Appear
As you are well aware, the investment portfolios of the bond insurers include a
substantial amount, often a majority, of bonds that are guaranteed by either the bond
insurer itself or by other bond insurers. The bond insurers include these guarantees in
calculating the weighted average ratings of their investment portfolios. We note that a
minimum average Double A rating is a key rating agency criterion for the insurers’ Triple
A rating.
A guaranty to oneself is of course worthless and therefore you should exclude the bond
insurers’ guaranty of its own investment obligations and use the underlying ratings of
these instruments in determining the portfolios’ credit quality.
You should also carefully calculate the impact of a downgrade of the bonds held by one
bond insurer that are guaranteed by other insurers in your calculation of capital adequacy.
In light of the general distress in the industry, we believe that the rating agencies should
evaluate the bond insurers’ investment portfolios as considered on an underlying rating
basis.
5) Commercial Mortgage Backed Securities (CMBS)
To date, you have limited your analysis to RMBS securities and other structured finance
securities with exposure to RMBS (CDOs). This limited review of exposures ignores the
fact that the same lending practices and flawed incentive schemes that fueled the
subprime lending bubble have been very much at work in CMBS and corporate finance.
On January 17, 2008, Fitch commented that it believed that CMBS delinquencies are
“likely to double, and perhaps even triple, by the end of 2008.” As of September 30,
2007, MBIA had insured $43 billion net par of CMBS securities, the vast majority of
which was underwritten in the past two years. Failing to consider the potential for losses
in this portfolio in your calculation of capital adequacy is simply negligent.
4
6) Claims-Paying Resources Definition Overstates Capital Available to Pay Claims
The rating agencies have adopted the bond insurance industry’s definition of capital in
the form of “Claims Paying Resources” or “CPR.” We believe there are significant flaws
with the calculation of CPR used by the industry and the rating agencies.
First, bond insurers include the present value of future premiums discounted at extremely
low discount rates ~5% in their calculation of claims paying resources. Substantially all
of these premiums are from structured finance guarantees. We believe that the bond
insurers and the rating agencies do not adequately consider the facts that: (1) when
structured finance obligations default, accelerate, or otherwise prepay ahead of schedule
these premiums disappear, (2) purchasers of secondary market guarantees are likely to
terminate their periodic premium payments because of the deteriorating credit quality of
the bond insurers, (3) the reserves for losses on these exposures (for example 12% of
premium for MBIA) have proven to be inadequate and therefore overstate the net
premium income, and (4) there is no provision for overhead, remediation, legal or other
costs required for the bond insurers to run their business going forward. There is also no
mechanism whereby the bond insurers can borrow against these potential future
premiums to be used to pay claims in the present day.
There is no other financial institution in the world which takes the present value of
interest spread income on loans in its portfolio and adds it to its capital. For all of the
above reasons, we believe that the present value of future premiums should not be
included in CPR.
CPR includes the bond insurers’ so-called depression lines of credit. As you well know,
depression lines of credit can only be drawn to pay claims on municipal obligations and
only after a substantial deductible. In that the losses are occurring primarily on structured
finance obligations, these lines of credit should not be included in CPR
The Capital Base included in CPR is also likely to be overstated because the investment
assets of the bond insurers consist primarily of bond insurer guaranteed obligations that
are valued inclusive of the guarantee, when they should be valued on an unwrapped basis.
The high degree of balance sheet leverage for certain bond insurers means that small
changes in the values of these portfolios have a large impact on the bond insurers’ capital
base.
You should adjust your estimate of CPR for each insurer to reflect the above factors in
order to accurately establish the capital available to pay claims.
5
7) MBIA’s $1 Billion Surplus Note Issuance
Last Friday, MBIA priced an offering of surplus notes at par with a 14% yield. Within
one week the notes traded down to the mid-70s and have a yield to call of more than
20%. Previous to their pricing, the notes were rated by Moody’s and S&P at Double A.
The MBIA surplus note issuance is perhaps the clearest example of the failure of the
rating agencies to accurately assess the creditworthiness of a bond insurer. MBIA is still
rated Triple A by all three raters. The notes received a Double A rating because of their
subordination to the other obligations of MBIA Insurance Corporation. That said, how
can a billion dollars of Double A rated obligations sell in a cash transaction between
sophisticated parties at a 14% yield, and then trade to yield of 20% or more — a rate
consistent with a Triple C or near-to-default obligation?
Bank of America 5 ¾% bonds due 2017, obligations of a financial institution that is also
rated Double A, closed today at 5.55% yield, a more than 15 percentage point lower rate
than the MBIA surplus notes. This is prima facie evidence that your ratings of MBIA are
overstated.
Billions of MBIA’s CDO Exposure Require Payment on Default
You have stated that bond insurers have no accelerating CDO guarantees and that all of
their contracts are structured as “pay-as-you-go.” I quote S&P from a paragraph entitled,
“Time is On Their Side,” in their December 19, 2007 report: “Detailed Results of
Subprime Stress Test of Financial Guarantors.”
“As for swap exposure, except for ACA there are no collateral posting
requirements and swaps are written in pay-as-you-go format.”
On January 9, 2008, MBIA filed a copy of a powerpoint presentation which was used in
the Surplus Notes offering road show. On page 8, MBIA states that $8.1 billion of its
Multi-sector CDOs require payment with “Credit events as they occur.”
The liquidity demands of accelerating CDO exposure create extreme liquidity risk and
must be considered in the context of the bond insurer ratings. We encourage you to
examine all of the bond insurers CDS/CDO exposure to determine the amount of
exposure that is not pay-as-you-go, but rather accelerates, and consider the liquidity
demands of such exposures in your rating assessments.
9) Holding Company Liquidity Risk
In light of recent events, we believe it is likely that most bond insurers will be prevented
from upstreaming dividends to their holding companies as a result of regulatory
intervention, as regulators work to preserve capital for policyholders.
6
Most bond insurer holding companies have limited cash, have lost or will lose access to
liquidity facilities, and have substantial cash needs for interest payments, operating
expenses, and dividends (for so long as they continue to be paid). In addition, bond
insurers with substantial investment management or swap operations have additional
liquidity needs in the event of a downgrade.
We believe that both MBIA and Ambac have substantial collateral posting obligations in
the event of a holding company downgrade. For example, MBIA has $45 billion of
derivative obligations at the holding company that relate to currency, interest-rate, and
credit default swaps that the holding company has entered into. The combination of
volatility in each of these markets and the increased collateral demands required in
holding company downgrade scenarios will put a severe strain on holding company
liquidity.
The bond insurers’ muni-GIC business is also a large potential liquidity strain as
municipalities withdraw funds from these GIC programs, assets must be liquidated,
and/or collateral must be posted. Various MTM programs also create liquidity risk as
assets may have to be sold to meet redeeming bondholders. The liquidity risks of these
programs and the underlying assets should be carefully examined.
ACA’s immolation is but one example of what happens to a once-investment grade bond
insurer which, if downgraded, is required to post collateral.
In addition, as a result of shareholder, bondholder, and/or surplus noteholder litigation,
we expect holding company legal expenses and eventual litigation claims to rise
substantially. Because the holding companies typically provide indemnities for
employees and directors, we would expect that directors would be loathe to allow
liquidity to leave the holding company estate, depriving directors and employees of the
resources to protect themselves from claims. In these circumstances, we would expect
companies to seek bankruptcy as a means to protect the allocation of value among
various stakeholders.
10) MBIA - Warburg Pincus Transaction
You have assumed in your analysis that the Warburg Pincus deal and follow-on rights
offering are certainties even though neither transaction has closed. While Warburg has
made affirmative statements about the transaction, both publicly as well as privately, to
surplus note buyers and the media, we believe there continues to be transaction closure
risk for both the initial stock purchase and future rights offering, with the rights offering
having greater uncertainty.
You have also assumed that 100% of the $1 billion Warburg deal will be downstreamed
to the insurance subsidiaries and this, too, is not a certainty. You should receive
7
assurances from MBIA and require it to contribute the full billion dollars to its insurance
subsidiaries before you include the funds in calculating insurance company capital.
With the collapse in MBIA’s stock price and today’s downgrade of Ambac, we believe it
will be difficult for MBIA to execute the rights offering, particularly before the March
31st, 2008 drop dead date. With the stock at $8.55 per share and the market aware that
the $500 million in rights offering proceeds is insufficient to adequately capitalize the
company, it will be difficult to set a market-clearing price. Assuming for a moment the
price is set at $5.00 per share, the company would have to issue 100 million shares and
may sell control to Warburg at a discount in the event shareholders elect not to
participate. We believe a shareholder vote and approved registration statement will likely
be required in such a circumstance, delaying the ability to consummate the transaction
beyond the March 31st Warburg backstop drop dead date.
11) Future Business Prospects and Franchise Value Have Been Irreparably
Destroyed
Following the dramatic decline in share prices, widening of credit protection spreads,
dismal performance of the high yield surplus note issuance, and recognition of multibillion
dollar losses in a supposed “no-loss” business, the ability of bond insurers to
market their “AAA” seal of approval has been permanently undermined. As uncertainty
has grown, municipalities have raised capital without insurance and found that they can
borrow at attractive rates as compared to historical insured bond issuances.
The entrance of Berkshire Hathaway is a devastating competitive reality that will capture
the lion’s share of an already shrinking market for municipal bond insurance. While
some commentators have suggested that this might create a pricing umbrella that will
benefit the existing bond insurers, this is demonstrably false. Because Berkshire
Hathaway already possesses a real Triple A rating, the bonds that are wrapped with its
guarantee will trade with a tighter spread when compared to a bond insured by a
traditional bond insurer, even one without legacy structured finance exposure.
Consequently, Berkshire will be able to charge higher premiums than the other monolines
by taking a higher percentage of the spread (perhaps as much as 80% or more) that is
saved through the use of insurance, and still provide the issuer with an overall lower cost
of borrowing that if they bought insurance from a traditional monoline. As such, we
believe that Berkshire Hathaway will likely quickly reach an 80%-90% market share of
municipal bond insurance.
12) Going Concern Opinion
In light of all of the above and other current developments, we believe it will be difficult
for MBIA, Ambac, and certain other bond insurers to obtain going concern opinions from
their auditors. You should consider the likelihood of the insurers’ obtaining clean
opinions and the implications if they do not in your rating assessments.
8
Lastly I encourage you to ask yourself the following question while looking at your
image in the mirror:
Does a company deserve your highest Triple A rating whose stock price has
declined 90%, has cut its dividend, is scrambling to raise capital, completed a
partial financing at 14% interest (now trading at a 20% yield one week later), has
incurred losses massively in excess of its promised zero-loss expectations wiping
out more than half of book value, with Berkshire Hathaway as a new competitor,
having lost access to its only liquidity facility, and having concealed material
information from the marketplace?
Can this possibly make sense?
Please call me if you have any questions about the above. As usual, I will make myself
available at your convenience.
Sincerely,
William A. Ackman
----------------------
January 18, 2008
Mr. Raymond McDaniel Mr. Stephen Joynt
Executive Chairman and CEO CEO and President
Moody’s Corp. Fitch Ratings
99 Church St. One State Street Plaza
New York, NY 10007 New York, NY 10004
Mr. Deven Sharma
President
Standard & Poor’s
55 Water Street
New York, NY 10041
Re: Bond Insurer Ratings
Ladies and Gentlemen:
As a Nationally Recognized Statistical Rating Organization, Moody’s, S&P, and Fitch
have been granted a level of authority that capital market participants and Federal and
State regulators have historically relied upon in evaluating the safety and soundness of
corporations, regulated financial institutions, and structured finance securities. To state
the obvious, because of your critical role in the capital markets, it is essential that the
ratings you publish are the result of comprehensive and accurate analysis.
As you well know, we have privately, in meetings and correspondence with you, and
publicly in various presentations that we have made, called into question your ratings of
the bond insurance industry, in particular, the ratings for MBIA Insurance Corp. and
Ambac Assurance Corp. and their holding companies.
Each of you, according to your recent public statements, is in various stages of updating
your ratings of the bond insurers. Unfortunately, however, your previous ratings
assessments have erred materially in their omission of certain critical analysis and the
inclusion of outright errors in your work. As you conduct your most recent revisions of
your analysis on the bond insurers, it is vital that you conduct a thorough assessment of
all aspects of the bond insurers’ business lines, their reinsurers, and investment portfolios
so that the rating decisions that you ultimately publish can be relied upon by capital
markets participants.
Below we highlight a number of factors that you have failed to consider in your prior
assessments of the bond insurers’ capital adequacy:
1) Impact of Losses Should be Measured on a Pre-tax Basis
We believe that each of you overstates the bond insurers capital cushion due to tax
benefits you include in calculating the impact of RMBS and CDO losses. For instance, in
S&P’s recent press release update published yesterday, MBIA’s losses on RMBS and
CDOs are expressed as “after-tax” losses. In order, therefore, to determine the actual
cash losses implied by S&P’s after-tax estimate, one must gross up the reported $3.18
billion of after-tax losses. Assuming a tax rate of 38%, it appears that S&P is estimating
MBIA’s actual cash losses at $5.13 billion, nearly $2 billion more than the losses
adjusted for tax benefits.
Insurance claims must be paid in cash. A bond insurer is only able to obtain tax benefits
if the insurer is a going concern and is able to generate sufficient taxable income in the
current or future years to offset the losses from paid insurance claims. Your analysis
makes the aggressive assumption that the bond insurers will remain going concerns and
will therefore be able to continue to write new premiums and generate income in the
future.
Based on recent industry developments – including Berkshire Hathaway’s entrance into
the business – it appears unlikely that MBIA, Ambac and many of the other bond insurers
will be able to continue as going concerns. In a runoff scenario, we do not believe that
the bond insurers will generate sufficient taxable income to offset the net operating losses
generated by paid losses. While U.S. corporations can receive tax refunds by carrying
back tax losses up to two calendar years, the amounts that could be refunded from
carrying back losses are de minimis relative to claims payable. Even in the event the
bond insurers generate taxable income in future years, it may be many years before these
tax benefits can be realized, if ever, particularly in the event of corporate ownership
changes caused by capital raising or stockholder turnover.
Net operating loss carryforwards are not cash and are not available to pay claims and
should therefore not be deducted from losses in calculating bond insurer capital
adequacy. By using after-tax loss estimates rather than pre-tax losses – the amount that
will need to be paid in cash – you are understating the actual losses payable by more than
60%.
Your updated rating assessments should be adjusted to exclude tax benefits in your
calculation of capital adequacy
2
2) Covenant Violations and Loss of Access to Liquidity Facilities
As a result of recent losses, both MBIA and Ambac have triggered covenant violations on
their liquidity facilities. As a result, Ambac has lost access to $400 million of funding
and MBIA to $500 million of capital. The impact of the loss of these facilities is material
to the liquidity profile of the holding companies and their insurance subsidiaries and must
be considered in your credit assessment.
3) Loss Estimates Must Incorporate Reinsured Exposures
Your ratings of the bond insurers are based on the bond insurers’ net credit exposures.
That is, you reduce their credit exposure by those exposures that have been reinsured.
This is best understood by example.
As of September 30, 2007, MBIA has re-insured approximately $80 billion of par value
of its exposures. More than $42 billion of this reinsurance was purchased from Channel
Re, a Bermuda- based reinsurer whose only customer is MBIA. The two most senior
officers of Channel Re are former executives of MBIA. MBIA owns 17% of the
company and has two representatives on Channel Re’s board of directors.
On recent conference calls, Moody’s and S&P have stated that they have not yet updated
their ratings of the monoline reinsurers including Channel Re. Earlier this week, on
January 16th, Partner Re and Renaissance Re, the majority equity owners of Channel Re,
wrote off the entire value of their investments in Channel Re due to losses it has recently
incurred that substantially exceed Channel Re’s capital, an impairment that Channel Re’s
two majority owners have concluded is “other than temporary.”
Despite the fact that Channel Re has negative book equity and $42 billion of MBIA’s
credit exposure – $21.5 billion of which is CDOs of ABS or CLO/CBOs – Moody’s and
S&P continue to rate the company Triple A with a stable outlook. Fitch does not rate
Channel Re and apparently relies on S&P’s and Moody’s stale Triple A ratings in its
analysis of MBIA’s capital adequacy.
Captive reinsurers whose ratings are not regularly updated offer the potential for abuse.
We believe that MBIA reinsured on a quota share basis 25% of its 2007 CDO
transactions with Channel Re. As a result of Moody’s and S&P not updating its ratings
of Channel Re, these exposures do not appear on MBIA’s list of exposures and have not
been included in your calculation of MBIA’s capital adequacy.
MBIA’s second largest reinsurer is Ram Re which has reinsured $11 billion of par as of
September 30, 2007. While the rating agencies have not updated their credit ratings of
Ram Re, the market appears to have already done so. The publicly traded stock of Ram
Holdings Ltd., the parent company of Ram Re, has declined 92% in the last year. The
company currently trades as a penny stock with a market value of $32 million.
3
We believe that Ram Re is substantially undercapitalized and therefore, like Channel Re,
is unlikely to be able to meet its obligations to MBIA.
We also note that MBIA reinsures Ambac, and Ambac reinsures MBIA. You must also
consider the iterative impact of downgrades of one on the other with respect to both
reinsurance and their respective guarantees of each other’s investment portfolio assets
which we discuss further below.
In your updated assessment, it is critical that you update your ratings of the bond
insurers’ reinsurers and reconsolidate and calculate the losses on these exposures that
have been reinsured with reinsurers that are inadequately capitalized.
4) Investment Portfolios are Riskier Than They Appear
As you are well aware, the investment portfolios of the bond insurers include a
substantial amount, often a majority, of bonds that are guaranteed by either the bond
insurer itself or by other bond insurers. The bond insurers include these guarantees in
calculating the weighted average ratings of their investment portfolios. We note that a
minimum average Double A rating is a key rating agency criterion for the insurers’ Triple
A rating.
A guaranty to oneself is of course worthless and therefore you should exclude the bond
insurers’ guaranty of its own investment obligations and use the underlying ratings of
these instruments in determining the portfolios’ credit quality.
You should also carefully calculate the impact of a downgrade of the bonds held by one
bond insurer that are guaranteed by other insurers in your calculation of capital adequacy.
In light of the general distress in the industry, we believe that the rating agencies should
evaluate the bond insurers’ investment portfolios as considered on an underlying rating
basis.
5) Commercial Mortgage Backed Securities (CMBS)
To date, you have limited your analysis to RMBS securities and other structured finance
securities with exposure to RMBS (CDOs). This limited review of exposures ignores the
fact that the same lending practices and flawed incentive schemes that fueled the
subprime lending bubble have been very much at work in CMBS and corporate finance.
On January 17, 2008, Fitch commented that it believed that CMBS delinquencies are
“likely to double, and perhaps even triple, by the end of 2008.” As of September 30,
2007, MBIA had insured $43 billion net par of CMBS securities, the vast majority of
which was underwritten in the past two years. Failing to consider the potential for losses
in this portfolio in your calculation of capital adequacy is simply negligent.
4
6) Claims-Paying Resources Definition Overstates Capital Available to Pay Claims
The rating agencies have adopted the bond insurance industry’s definition of capital in
the form of “Claims Paying Resources” or “CPR.” We believe there are significant flaws
with the calculation of CPR used by the industry and the rating agencies.
First, bond insurers include the present value of future premiums discounted at extremely
low discount rates ~5% in their calculation of claims paying resources. Substantially all
of these premiums are from structured finance guarantees. We believe that the bond
insurers and the rating agencies do not adequately consider the facts that: (1) when
structured finance obligations default, accelerate, or otherwise prepay ahead of schedule
these premiums disappear, (2) purchasers of secondary market guarantees are likely to
terminate their periodic premium payments because of the deteriorating credit quality of
the bond insurers, (3) the reserves for losses on these exposures (for example 12% of
premium for MBIA) have proven to be inadequate and therefore overstate the net
premium income, and (4) there is no provision for overhead, remediation, legal or other
costs required for the bond insurers to run their business going forward. There is also no
mechanism whereby the bond insurers can borrow against these potential future
premiums to be used to pay claims in the present day.
There is no other financial institution in the world which takes the present value of
interest spread income on loans in its portfolio and adds it to its capital. For all of the
above reasons, we believe that the present value of future premiums should not be
included in CPR.
CPR includes the bond insurers’ so-called depression lines of credit. As you well know,
depression lines of credit can only be drawn to pay claims on municipal obligations and
only after a substantial deductible. In that the losses are occurring primarily on structured
finance obligations, these lines of credit should not be included in CPR
The Capital Base included in CPR is also likely to be overstated because the investment
assets of the bond insurers consist primarily of bond insurer guaranteed obligations that
are valued inclusive of the guarantee, when they should be valued on an unwrapped basis.
The high degree of balance sheet leverage for certain bond insurers means that small
changes in the values of these portfolios have a large impact on the bond insurers’ capital
base.
You should adjust your estimate of CPR for each insurer to reflect the above factors in
order to accurately establish the capital available to pay claims.
5
7) MBIA’s $1 Billion Surplus Note Issuance
Last Friday, MBIA priced an offering of surplus notes at par with a 14% yield. Within
one week the notes traded down to the mid-70s and have a yield to call of more than
20%. Previous to their pricing, the notes were rated by Moody’s and S&P at Double A.
The MBIA surplus note issuance is perhaps the clearest example of the failure of the
rating agencies to accurately assess the creditworthiness of a bond insurer. MBIA is still
rated Triple A by all three raters. The notes received a Double A rating because of their
subordination to the other obligations of MBIA Insurance Corporation. That said, how
can a billion dollars of Double A rated obligations sell in a cash transaction between
sophisticated parties at a 14% yield, and then trade to yield of 20% or more — a rate
consistent with a Triple C or near-to-default obligation?
Bank of America 5 ¾% bonds due 2017, obligations of a financial institution that is also
rated Double A, closed today at 5.55% yield, a more than 15 percentage point lower rate
than the MBIA surplus notes. This is prima facie evidence that your ratings of MBIA are
overstated.
Billions of MBIA’s CDO Exposure Require Payment on Default
You have stated that bond insurers have no accelerating CDO guarantees and that all of
their contracts are structured as “pay-as-you-go.” I quote S&P from a paragraph entitled,
“Time is On Their Side,” in their December 19, 2007 report: “Detailed Results of
Subprime Stress Test of Financial Guarantors.”
“As for swap exposure, except for ACA there are no collateral posting
requirements and swaps are written in pay-as-you-go format.”
On January 9, 2008, MBIA filed a copy of a powerpoint presentation which was used in
the Surplus Notes offering road show. On page 8, MBIA states that $8.1 billion of its
Multi-sector CDOs require payment with “Credit events as they occur.”
The liquidity demands of accelerating CDO exposure create extreme liquidity risk and
must be considered in the context of the bond insurer ratings. We encourage you to
examine all of the bond insurers CDS/CDO exposure to determine the amount of
exposure that is not pay-as-you-go, but rather accelerates, and consider the liquidity
demands of such exposures in your rating assessments.
9) Holding Company Liquidity Risk
In light of recent events, we believe it is likely that most bond insurers will be prevented
from upstreaming dividends to their holding companies as a result of regulatory
intervention, as regulators work to preserve capital for policyholders.
6
Most bond insurer holding companies have limited cash, have lost or will lose access to
liquidity facilities, and have substantial cash needs for interest payments, operating
expenses, and dividends (for so long as they continue to be paid). In addition, bond
insurers with substantial investment management or swap operations have additional
liquidity needs in the event of a downgrade.
We believe that both MBIA and Ambac have substantial collateral posting obligations in
the event of a holding company downgrade. For example, MBIA has $45 billion of
derivative obligations at the holding company that relate to currency, interest-rate, and
credit default swaps that the holding company has entered into. The combination of
volatility in each of these markets and the increased collateral demands required in
holding company downgrade scenarios will put a severe strain on holding company
liquidity.
The bond insurers’ muni-GIC business is also a large potential liquidity strain as
municipalities withdraw funds from these GIC programs, assets must be liquidated,
and/or collateral must be posted. Various MTM programs also create liquidity risk as
assets may have to be sold to meet redeeming bondholders. The liquidity risks of these
programs and the underlying assets should be carefully examined.
ACA’s immolation is but one example of what happens to a once-investment grade bond
insurer which, if downgraded, is required to post collateral.
In addition, as a result of shareholder, bondholder, and/or surplus noteholder litigation,
we expect holding company legal expenses and eventual litigation claims to rise
substantially. Because the holding companies typically provide indemnities for
employees and directors, we would expect that directors would be loathe to allow
liquidity to leave the holding company estate, depriving directors and employees of the
resources to protect themselves from claims. In these circumstances, we would expect
companies to seek bankruptcy as a means to protect the allocation of value among
various stakeholders.
10) MBIA - Warburg Pincus Transaction
You have assumed in your analysis that the Warburg Pincus deal and follow-on rights
offering are certainties even though neither transaction has closed. While Warburg has
made affirmative statements about the transaction, both publicly as well as privately, to
surplus note buyers and the media, we believe there continues to be transaction closure
risk for both the initial stock purchase and future rights offering, with the rights offering
having greater uncertainty.
You have also assumed that 100% of the $1 billion Warburg deal will be downstreamed
to the insurance subsidiaries and this, too, is not a certainty. You should receive
7
assurances from MBIA and require it to contribute the full billion dollars to its insurance
subsidiaries before you include the funds in calculating insurance company capital.
With the collapse in MBIA’s stock price and today’s downgrade of Ambac, we believe it
will be difficult for MBIA to execute the rights offering, particularly before the March
31st, 2008 drop dead date. With the stock at $8.55 per share and the market aware that
the $500 million in rights offering proceeds is insufficient to adequately capitalize the
company, it will be difficult to set a market-clearing price. Assuming for a moment the
price is set at $5.00 per share, the company would have to issue 100 million shares and
may sell control to Warburg at a discount in the event shareholders elect not to
participate. We believe a shareholder vote and approved registration statement will likely
be required in such a circumstance, delaying the ability to consummate the transaction
beyond the March 31st Warburg backstop drop dead date.
11) Future Business Prospects and Franchise Value Have Been Irreparably
Destroyed
Following the dramatic decline in share prices, widening of credit protection spreads,
dismal performance of the high yield surplus note issuance, and recognition of multibillion
dollar losses in a supposed “no-loss” business, the ability of bond insurers to
market their “AAA” seal of approval has been permanently undermined. As uncertainty
has grown, municipalities have raised capital without insurance and found that they can
borrow at attractive rates as compared to historical insured bond issuances.
The entrance of Berkshire Hathaway is a devastating competitive reality that will capture
the lion’s share of an already shrinking market for municipal bond insurance. While
some commentators have suggested that this might create a pricing umbrella that will
benefit the existing bond insurers, this is demonstrably false. Because Berkshire
Hathaway already possesses a real Triple A rating, the bonds that are wrapped with its
guarantee will trade with a tighter spread when compared to a bond insured by a
traditional bond insurer, even one without legacy structured finance exposure.
Consequently, Berkshire will be able to charge higher premiums than the other monolines
by taking a higher percentage of the spread (perhaps as much as 80% or more) that is
saved through the use of insurance, and still provide the issuer with an overall lower cost
of borrowing that if they bought insurance from a traditional monoline. As such, we
believe that Berkshire Hathaway will likely quickly reach an 80%-90% market share of
municipal bond insurance.
12) Going Concern Opinion
In light of all of the above and other current developments, we believe it will be difficult
for MBIA, Ambac, and certain other bond insurers to obtain going concern opinions from
their auditors. You should consider the likelihood of the insurers’ obtaining clean
opinions and the implications if they do not in your rating assessments.
8
Lastly I encourage you to ask yourself the following question while looking at your
image in the mirror:
Does a company deserve your highest Triple A rating whose stock price has
declined 90%, has cut its dividend, is scrambling to raise capital, completed a
partial financing at 14% interest (now trading at a 20% yield one week later), has
incurred losses massively in excess of its promised zero-loss expectations wiping
out more than half of book value, with Berkshire Hathaway as a new competitor,
having lost access to its only liquidity facility, and having concealed material
information from the marketplace?
Can this possibly make sense?
Please call me if you have any questions about the above. As usual, I will make myself
available at your convenience.
Sincerely,
William A. Ackman
Wednesday, January 23, 2008
Reasons for the Fed Action
I think most commentrators have it wrong here. Does anyone really believe that Fed will act to snuff out a 500 point decline in the DOW? Dow has declined by that before, without nary a Fed action. Yesterday was different.
1. If Fed hadn't cut yesterday and let markets sink, I think it would have become impossible for MBIA and Ambac to raise new financing. You can't raise financing when stock prices are at 0. And I think it was these 2 companies, more than anything else, that made Fed cut as much as they did. There is just a chance that MBIA and Ambac might now survive. MBIA is either a 10x or a 0 from here.
2. At some level of interest rates, credit markets will work again. There is nothing like free money that motivates people.
3. Monetary policy was behind the curve and now it has finally caught up.
4. Why let markets have a 500 point bad day when anyway the cut was coming next week?
1. If Fed hadn't cut yesterday and let markets sink, I think it would have become impossible for MBIA and Ambac to raise new financing. You can't raise financing when stock prices are at 0. And I think it was these 2 companies, more than anything else, that made Fed cut as much as they did. There is just a chance that MBIA and Ambac might now survive. MBIA is either a 10x or a 0 from here.
2. At some level of interest rates, credit markets will work again. There is nothing like free money that motivates people.
3. Monetary policy was behind the curve and now it has finally caught up.
4. Why let markets have a 500 point bad day when anyway the cut was coming next week?
A Lap of Victory is in Order
I nailed the Fed rate cut, right down to the minute. Markets cannot go down in a straight line without the regulators intervening. So there was a massacre, as I thought earlier this month (http://gaurav1.blogspot.com/2008/01/wholescale-massacre-is-about-to-begin.html) , and there is a rebound. I know all this timing etc is more luck than anything else. But let me be happy and gloat for a day.
Funnily, some people think Fed rates are useless. That it is somehow morally wrong. That it shows Fed panicked - so there is trouble. That, we are now entering Armageddon etc. I dont think they have really thought this through.
The biggest variable in the world right now is the value of a US home. As I mentioned here,(http://gaurav1.blogspot.com/2007/09/when-price-itself-becomes-biggest.html), the Fed and the US govt will need to ultimately stem in to prevent housing price declines. Otherwise, even prime borrowers with little equity in their homes will walk away. This is also what Wachovia mentioned in its conf call yesterday - "people are chosing to hand in their keys".
With yesterday's action, Fed has moved decisively in that direction. As housing prices stabilize, a lot of pessimism surrounding housing, structured finance and US economy will disappear. There might be some more pain left and some financial institutions might still go bankrupt in the US. There will be slow growth/mild recession. But some securities that are pricing in Armageddon scenarios might give 7x returns from here, especially MBIA.
In economies as dependent on asset price inflation as the US and the UK, asset price deflation is dangerous. So both US and UK will reduce interest rates. Low interest rates lower discount rates and push up asset prices.
Fed should now stop its bull of "we can't predict bubbles till they have burst." If you can't, dont get in the way of market forces when they burst.
Funnily, some people think Fed rates are useless. That it is somehow morally wrong. That it shows Fed panicked - so there is trouble. That, we are now entering Armageddon etc. I dont think they have really thought this through.
The biggest variable in the world right now is the value of a US home. As I mentioned here,(http://gaurav1.blogspot.com/2007/09/when-price-itself-becomes-biggest.html), the Fed and the US govt will need to ultimately stem in to prevent housing price declines. Otherwise, even prime borrowers with little equity in their homes will walk away. This is also what Wachovia mentioned in its conf call yesterday - "people are chosing to hand in their keys".
With yesterday's action, Fed has moved decisively in that direction. As housing prices stabilize, a lot of pessimism surrounding housing, structured finance and US economy will disappear. There might be some more pain left and some financial institutions might still go bankrupt in the US. There will be slow growth/mild recession. But some securities that are pricing in Armageddon scenarios might give 7x returns from here, especially MBIA.
In economies as dependent on asset price inflation as the US and the UK, asset price deflation is dangerous. So both US and UK will reduce interest rates. Low interest rates lower discount rates and push up asset prices.
Fed should now stop its bull of "we can't predict bubbles till they have burst." If you can't, dont get in the way of market forces when they burst.
Tuesday, January 15, 2008
The step function - Non-linearities in recession
I think people who are predicting the impact of recession on firms by linearly extrapolating past trends are wrong. This is because of the step function and its preponderance in life. Here is what Greenspan says in today's WSJ:
"The symptoms are clearly there. Recessions don't happen smoothly. They are usually signaled by a discontinuity in the market place, and the data of recent weeks could very well be characterized in that manner," he said.
"The symptoms are clearly there. Recessions don't happen smoothly. They are usually signaled by a discontinuity in the market place, and the data of recent weeks could very well be characterized in that manner," he said.
Why is trouble brewing?
Buried in Citi's 4Q earnings release which has $18bn of writedowns is this nugget:
"In addition, the company is continuing to reduce its Consumer-based holdings of mortgage-backed securities, and other assets held in its Securities and Banking business. Overall, in the fourth quarter, the company reduced its GAAP assets by approximately $176 billion, representing approximately 7.4% of its balance sheet."
Citi is deleveraging. Banks are the biggest creators of liquidity. As banks reduce their balance sheets, liquidity goes down. People who are saying that liquidity will be created because Fed is cutting rates do not realize who creates liquidity. It is not the Fed - it is the banks.
The asset backed commercial paper market has shrunk from $1.2trillion in August to $800 billion now. That deleveraging plus Citi's deleveraging = $576billion of liquidity that has vanished. Ane here in India, investors are getting excited about $20 billion of FII flows.
"In addition, the company is continuing to reduce its Consumer-based holdings of mortgage-backed securities, and other assets held in its Securities and Banking business. Overall, in the fourth quarter, the company reduced its GAAP assets by approximately $176 billion, representing approximately 7.4% of its balance sheet."
Citi is deleveraging. Banks are the biggest creators of liquidity. As banks reduce their balance sheets, liquidity goes down. People who are saying that liquidity will be created because Fed is cutting rates do not realize who creates liquidity. It is not the Fed - it is the banks.
The asset backed commercial paper market has shrunk from $1.2trillion in August to $800 billion now. That deleveraging plus Citi's deleveraging = $576billion of liquidity that has vanished. Ane here in India, investors are getting excited about $20 billion of FII flows.
Friday, January 11, 2008
The difference between Sep 2007 and Jan 2008, and the case for PSU banks
Yesterday, Bernanke hinted at aggressive policy action.
Bill Gross - the bond king at Pimco - argues for 3% Fed rate. His argument is that real Fed rates touch 1% in a slowdown/recession. Core US inflation is 2%, which gives a Fed rate of 3%.
This seems likely now. Fed is at 4.25% today. 50bps is likely on Jan 30. June interest rate futures are pricing in a 3.2% Fed rate.
Despite aggressive Fed cuts now, US will go through a slowdown/recession. If it hits exporters like China and causes their stock markets to correct, will it have rub off effects on our own markets? Or like in Sep 2007, if Fed eases by 50bps, the India momentum trade will take another leg up.
There is a difference between now and Sep. In Sep, it was a financial crisis. Now, it is turning into an economic one.
In Sep 1998, Fed cut during a financial crisis - LTCM. In late 1999, Fed cut in a technological crisis - Y2K. Both times markets went up.
In Jan 2001, Fed cut, and still markets crashed. Because that time, it was an economic slowdown.
The case for PSU Banks
Two scenarios are possible from here:
a) A new momentum grips the Indian markets. Banks are going to be one of the beneficiaries, this includes PSU banks.
b) If economic slowdown worries hit emerging markets like China, India wont be immune. But then, RBI will cut rates - after all this is an election year. This will cushion the interest rate sensitive sectors - real estate, banking. Real estate and pvt sector banks stocks are a bubble, so they might still deflate. But PSU banks are relatively cheap.
So, I think PSU banks are the safest way to play momentum.
Bill Gross - the bond king at Pimco - argues for 3% Fed rate. His argument is that real Fed rates touch 1% in a slowdown/recession. Core US inflation is 2%, which gives a Fed rate of 3%.
This seems likely now. Fed is at 4.25% today. 50bps is likely on Jan 30. June interest rate futures are pricing in a 3.2% Fed rate.
Despite aggressive Fed cuts now, US will go through a slowdown/recession. If it hits exporters like China and causes their stock markets to correct, will it have rub off effects on our own markets? Or like in Sep 2007, if Fed eases by 50bps, the India momentum trade will take another leg up.
There is a difference between now and Sep. In Sep, it was a financial crisis. Now, it is turning into an economic one.
In Sep 1998, Fed cut during a financial crisis - LTCM. In late 1999, Fed cut in a technological crisis - Y2K. Both times markets went up.
In Jan 2001, Fed cut, and still markets crashed. Because that time, it was an economic slowdown.
The case for PSU Banks
Two scenarios are possible from here:
a) A new momentum grips the Indian markets. Banks are going to be one of the beneficiaries, this includes PSU banks.
b) If economic slowdown worries hit emerging markets like China, India wont be immune. But then, RBI will cut rates - after all this is an election year. This will cushion the interest rate sensitive sectors - real estate, banking. Real estate and pvt sector banks stocks are a bubble, so they might still deflate. But PSU banks are relatively cheap.
So, I think PSU banks are the safest way to play momentum.
Thursday, January 10, 2008
A wholescale massacre is about to begin
Post the weak job reports on Friday, I am firmly in the US recession camp.
Last year was subprime. This year it will be CDS. Corporate bankruptcies are bound to surge as US goes into even a mild recession. The counterparties to the CDS - insurers and banks - are going to take massive hits. Bill Gross estimates $250bn.
Financials have become very tempting now. My advice to myself - stay away.
As Fed keeps cutting rates, my money will get a lesser and lesser return in the US. Should I invest in CCS - Comcast BBB debt giving a 7.5% yield? Or will there be a better time?
I bet there will be some major bankruptcy this year. Citi and ML can raise capital, but their smaller brethren will find it difficult. That should cause spreads to widen. CCS is currently at 22. If it falls to 16, it is a no brainer - I will buy a 10% yield on Comcast any day.
Last year was subprime. This year it will be CDS. Corporate bankruptcies are bound to surge as US goes into even a mild recession. The counterparties to the CDS - insurers and banks - are going to take massive hits. Bill Gross estimates $250bn.
Financials have become very tempting now. My advice to myself - stay away.
As Fed keeps cutting rates, my money will get a lesser and lesser return in the US. Should I invest in CCS - Comcast BBB debt giving a 7.5% yield? Or will there be a better time?
I bet there will be some major bankruptcy this year. Citi and ML can raise capital, but their smaller brethren will find it difficult. That should cause spreads to widen. CCS is currently at 22. If it falls to 16, it is a no brainer - I will buy a 10% yield on Comcast any day.
Tuesday, January 01, 2008
The Year 2007
For a year which had a remarkable number of blowups in the all important financial complex, for a year in which credit markets have remained frozen for half the year, one would have thought being in cash was a good strategy. WRONG. Everything is up. Nasdaq is up 10%, Dow 7%, S&P 5%, Hong Kong 39%, India by a similar amount, and what not. A smart person should have seen the policy responses from the Fed and ECB to the unfolding crises and taken appropriate positions. At least I made money in VWO.
How will the markets turn in 2008. It is a difficult guess. I think we have entered a phase in which "the sequence in which events unfold determines what events actually unfold." If the unemployment report in early Sep had come out with a -4K job gain (subsequently revised up), Fed might not have cut 50 bps, and the world would have been a different place.
One needs to be on the lookout for 2 things this year:
a) Will inflationary pressures cause the Fed to increase rates later this year?
b) Does China growth slow down post Olympics?
I am thinking of buying some Russia ETF. It is a play on oil.
How will the markets turn in 2008. It is a difficult guess. I think we have entered a phase in which "the sequence in which events unfold determines what events actually unfold." If the unemployment report in early Sep had come out with a -4K job gain (subsequently revised up), Fed might not have cut 50 bps, and the world would have been a different place.
One needs to be on the lookout for 2 things this year:
a) Will inflationary pressures cause the Fed to increase rates later this year?
b) Does China growth slow down post Olympics?
I am thinking of buying some Russia ETF. It is a play on oil.
Monday, December 17, 2007
The Importance of the Step Function
Stocks on Radar - GIC Housing Finance
The most important thing in life is freedom - particularly intellectual freedom. And in my quest for intellectual freedom, I think I have discovered some unusual things. Perhaps the most important of these is the step function.
I think human beings have an innate attraction for the linear function. So, we try to reduce everything to linearilites. Force =mass * acceleration, Price =EPS*P/E multiple etc. Over centuries, we have also become more comfortable with the cubic order equations. Where, however, we fail is the step function.
What I have observed, and this might be wrong, is that while systems often change state linearly, at some crucial times, systems jump from one state to another. This is most readily observed in stock markets. Markets might not adjust to something (say subprime) for months, and then in 2 days, there would be crash-and-burn and the system moves to another state. Weather systems also seem to follow a similar pattern - that is why climate scientists are worried that we might jump to a state of no-return in our fight against global warming.
Why is this important? Because, in stock markets, the point of maximum profits is the point of the step change. Simply extrapolating last 3 years revenue growth, margins and ROEs into the future is wrong and dangerous. And we might be more close to a step change in the global economic, political and social outlook than we have been in the last few years.
My personal life has definitely moved in step functions. Nothing will happen for years, and then suddenly, something will happen which will take into another state for the next few years.
The most important thing in life is freedom - particularly intellectual freedom. And in my quest for intellectual freedom, I think I have discovered some unusual things. Perhaps the most important of these is the step function.
I think human beings have an innate attraction for the linear function. So, we try to reduce everything to linearilites. Force =mass * acceleration, Price =EPS*P/E multiple etc. Over centuries, we have also become more comfortable with the cubic order equations. Where, however, we fail is the step function.
What I have observed, and this might be wrong, is that while systems often change state linearly, at some crucial times, systems jump from one state to another. This is most readily observed in stock markets. Markets might not adjust to something (say subprime) for months, and then in 2 days, there would be crash-and-burn and the system moves to another state. Weather systems also seem to follow a similar pattern - that is why climate scientists are worried that we might jump to a state of no-return in our fight against global warming.
Why is this important? Because, in stock markets, the point of maximum profits is the point of the step change. Simply extrapolating last 3 years revenue growth, margins and ROEs into the future is wrong and dangerous. And we might be more close to a step change in the global economic, political and social outlook than we have been in the last few years.
My personal life has definitely moved in step functions. Nothing will happen for years, and then suddenly, something will happen which will take into another state for the next few years.
Tuesday, November 27, 2007
Citi's 11% convertible bond placement with Abu Dhabi
I was wondering what forced Citi to place this $7.5 billion bond at such a high yield. After-all, Citi can raise high-yield debt at less than 9%. And this bond has a convertible option, so the yield should have been lesser.
Then I read this statement in Citi's press release - "The payment rate reflects market terms based on the conversion premium as well as Citi's current dividend yield." Citi's current dividend yield is 7%. So the yield on bond is 4%. Is this the correct way to think about it? Maybe yes. After-all, why will anyone buy a mandatorily converible bond if the bond yield is less than the current dividend yield. The investor would be better off simply buying the stock in the open market.
For Citi, this is better than selling stock at current depressed price of $30 (conversion price is $31.83 to $37.24). But it would have been better if they had stuck this deal when the stock was at $40 a month ago, when the full extent of their SIV troubles was already known. At that time they could have saved 2%-3% in interest cost, besides striking a higher conversion price.
Then I read this statement in Citi's press release - "The payment rate reflects market terms based on the conversion premium as well as Citi's current dividend yield." Citi's current dividend yield is 7%. So the yield on bond is 4%. Is this the correct way to think about it? Maybe yes. After-all, why will anyone buy a mandatorily converible bond if the bond yield is less than the current dividend yield. The investor would be better off simply buying the stock in the open market.
For Citi, this is better than selling stock at current depressed price of $30 (conversion price is $31.83 to $37.24). But it would have been better if they had stuck this deal when the stock was at $40 a month ago, when the full extent of their SIV troubles was already known. At that time they could have saved 2%-3% in interest cost, besides striking a higher conversion price.
Thursday, November 22, 2007
Trip to Bhopal
I went to Bhopal last weekend to visit my sister. It is a really nice city, with some good tourist attractions. I would recommend anyone to go there for a weekend. As wikitravel doesn't do justice to Bhopal, I thought I will write a brief review here.
Places to see:
a) Bhimbetka - A World Heritage site in Bhopal !! I wasn't aware of this. It has some of the oldest cave paintings in India and in the world. So this is where one finds the earliest signs of human life in India. On some of the stone walls, there are a 10000 year old, a 5000 year old and a 2000 year old drawings, all side by side. The place is called Bhimbetka because according to legend, the Pandavas stayed here while in exile. There is a rock high above where Bhim is supposed to have sat (so Bhim + beth, i.e. sit in Hindi). Ask for Mr Rai as the guide - he is an old chap but his voice really rings out loud. http://en.wikipedia.org/wiki/Rock_Shelters_of_Bhimbetka
b) Bhojeshwar Temple in Bhojpur has the largest Shivling in India. Incidentally, Bhopal is named after Raja Bhoj (of Gangu teli fame).
c) Lakes - Many lakes in the city. Bada Taal is really huge. One can do kayaking/boating in "Bada taal", and then go to Cafe Coffee Day on the hill to drink coffee while having a nice view of the lake.
My sister took me to a couple of really good restaurants. I forget the name. Sorry!!
Places to see:
a) Bhimbetka - A World Heritage site in Bhopal !! I wasn't aware of this. It has some of the oldest cave paintings in India and in the world. So this is where one finds the earliest signs of human life in India. On some of the stone walls, there are a 10000 year old, a 5000 year old and a 2000 year old drawings, all side by side. The place is called Bhimbetka because according to legend, the Pandavas stayed here while in exile. There is a rock high above where Bhim is supposed to have sat (so Bhim + beth, i.e. sit in Hindi). Ask for Mr Rai as the guide - he is an old chap but his voice really rings out loud. http://en.wikipedia.org/wiki/Rock_Shelters_of_Bhimbetka
b) Bhojeshwar Temple in Bhojpur has the largest Shivling in India. Incidentally, Bhopal is named after Raja Bhoj (of Gangu teli fame).
c) Lakes - Many lakes in the city. Bada Taal is really huge. One can do kayaking/boating in "Bada taal", and then go to Cafe Coffee Day on the hill to drink coffee while having a nice view of the lake.
My sister took me to a couple of really good restaurants. I forget the name. Sorry!!
Tuesday, November 13, 2007
Stocks on radar
CNBC ran a 5 min clip on holding stocks trading at huge discount to assets. With the current run up in stock prices, one can argue that the stocks that these holding stocks own are expensive, rather than the holding companies being cheap. Still, it will be useful to have these on radar. TCI Finance, which owns Gati, could be interesting.
Mcdowell Holdings
Nagreeka Capital
TCI Finance
BNK Capital
Mcdowell Holdings
Nagreeka Capital
TCI Finance
BNK Capital
Selling EWH and VBC Ferro Alloys
I sold the two speculative stocks that I had in my portfolio last week. EWH - the Hong Kong Index - was sold a mere 2 days after it was first purchased. I sold it at a loss of about 4% (at $23.10). As it was a speculative position and I was investing in an unknown, my stop loss was very low. I am happy that I got out soon as EWH has kept dropping - today it is at $21.14.
Net net, with the gains in VWO last month and the loss in EWH this month, I made roughly 7% in a month and a half on 25K. Speculation can be rewarding.
I also sold VBC Ferro Alloys in India at Rs 365. I had purchased it at Rs 351. I can see why this stock should do well in the current power craze in Indian stock markets as the company owns 10%-15% odd in Konaseema Gas Power plant. At Rs 365, VBC Ferro is trading close to book value when power stocks in India are trading at 3x-4x book. Still I sold, as I think the noose is tighetining around speculators. US is going to flirt with a recession in 6 months if not earlier.
I own 3 stocks in my PA now:
a) Blue Dart - trading at 15x Dec08 P/E and growing at 30% yoy. Almost a monopoly in overnight courier business. While competition is hotting up with Gati starting services soon, the stock is cheap. Plus DHL (Blue Dart's majority owner) came out with its open offer last year at 550. Stock is now at 565. I plan to keep this forever.
b) Deccan Chronicle - While corporate governance is questionable, I love newspaper stocks. At 15x March08 P/E, it is cheaper than US newspaper companies. I plan to keep this forever.
c) Omaxe - Some money should be invested on speculation - this is my speculative stock these days.
Net net, with the gains in VWO last month and the loss in EWH this month, I made roughly 7% in a month and a half on 25K. Speculation can be rewarding.
I also sold VBC Ferro Alloys in India at Rs 365. I had purchased it at Rs 351. I can see why this stock should do well in the current power craze in Indian stock markets as the company owns 10%-15% odd in Konaseema Gas Power plant. At Rs 365, VBC Ferro is trading close to book value when power stocks in India are trading at 3x-4x book. Still I sold, as I think the noose is tighetining around speculators. US is going to flirt with a recession in 6 months if not earlier.
I own 3 stocks in my PA now:
a) Blue Dart - trading at 15x Dec08 P/E and growing at 30% yoy. Almost a monopoly in overnight courier business. While competition is hotting up with Gati starting services soon, the stock is cheap. Plus DHL (Blue Dart's majority owner) came out with its open offer last year at 550. Stock is now at 565. I plan to keep this forever.
b) Deccan Chronicle - While corporate governance is questionable, I love newspaper stocks. At 15x March08 P/E, it is cheaper than US newspaper companies. I plan to keep this forever.
c) Omaxe - Some money should be invested on speculation - this is my speculative stock these days.
Monday, October 29, 2007
The Party Continues - Buying EWH
Selling VWO last week looks like a wrong idea now. It is now at 116, while I sold it at 109.45. So, I have become even more speculative now. I have bought EWH - the Hong Kong Index ETF. It is up 55% in 2 months, and I am buying it at its lifetime high. So I now join the army of China lovers.
Why buy EWH? Few reasons:
Why buy EWH? Few reasons:
- High likelihood that Fed cuts on Wednesday.
- Since Hong Kong Dollar is pegged to US dollar, Hong Kong will follow US monetary policy. i.e. rates in Hong Kong will go down, whether HK authorities want or not.
- Chinese Olympics next year - rally in China should continue till that time.
- If China allows its citizens to invest in HK, HK will boom as it has been for the last 2 months.
Wednesday, October 17, 2007
The Party is Over - for the time being
If India crashes today - post the SEBI proposal to reign in P-Notes - I think markets worldwide take a hit. Why? Because it is the BRICs which are supposed to save the world from US housing disaster. Anyways it is becoming difficult for the DOW and S&P500 to break into new highs. Credit concerns still exist - witness the creation of the master fund by Citi. IFN was down 8% in NYSE. Lets see if Sensex tanks by 1000+ points.
I sold VWO yesterday at 109.45 - 30 min before SEBI came out with the notification. Call it luck. I bought it at 100.50. 9% profit in a month is not bad - is it? Thats the party.
YHOO bet low expectations yesterday, Intel had a blowout quarter, while IBM was in line.. Will this offset the impact of Sensex's crash on the DOW.
This Friday is the 20th anniversary of Black October.
I sold VWO yesterday at 109.45 - 30 min before SEBI came out with the notification. Call it luck. I bought it at 100.50. 9% profit in a month is not bad - is it? Thats the party.
YHOO bet low expectations yesterday, Intel had a blowout quarter, while IBM was in line.. Will this offset the impact of Sensex's crash on the DOW.
This Friday is the 20th anniversary of Black October.
Tuesday, October 16, 2007
Is the party getting over?
It is becoming difficult for DOW to get to new highs. Plus Ericsson warned majorly today. Yahoo is reporting today, and if previous quarters are any guide it will be a mess. Tech has been outperformer in the last month (see Nasdaq). If tech takes a hit today, then we have a problem. Then oil is also touching $88.
Note that when I mention in the previous post that oil is going to $60, it is pure speculation. I am not an oil analyst and have no clue on inventories of oil etc. Speculating is a useful art that I am trying to learn.
Tata Power went up by 20% today. Look at the difference between the valuation of Reliance Energy and Tata Power now. One can argue that Tata Power can also set up a subsidiary like Reliance Energy is doing with Reliance Power and get the same crazy valuation. I am speculating on Tata Power tomorrow.
This is getting crazy by the day. $5 billion companies gain 20% on no news.
Note that when I mention in the previous post that oil is going to $60, it is pure speculation. I am not an oil analyst and have no clue on inventories of oil etc. Speculating is a useful art that I am trying to learn.
Tata Power went up by 20% today. Look at the difference between the valuation of Reliance Energy and Tata Power now. One can argue that Tata Power can also set up a subsidiary like Reliance Energy is doing with Reliance Power and get the same crazy valuation. I am speculating on Tata Power tomorrow.
This is getting crazy by the day. $5 billion companies gain 20% on no news.
Wednesday, October 10, 2007
Sensex at 18000
I mentioned here a month ago that Sensex will cross 18000.(http://gaurav1.blogspot.com/2007/09/definition-of-inflation-and-deflation.html),
I had predicted here 2 months ago that oil is crossing 85 this time.(http://gaurav1.blogspot.com/2007/08/august-blues.html)
Oil is now falling to $60 by January. Why? Seasonality. Last year it fell to $50 in early January. Lets see if the pattern repeats itself.
I had predicted here 2 months ago that oil is crossing 85 this time.(http://gaurav1.blogspot.com/2007/08/august-blues.html)
Oil is now falling to $60 by January. Why? Seasonality. Last year it fell to $50 in early January. Lets see if the pattern repeats itself.
Philosophy of Investing
What exactly is my philosophy of investing?
Almost everyone who is a professional investor has a philosophy. Some swear by technical analysis, while many swear by fundamental analysis. Some are growth investors, others are value investors, and still others are momentum investors. What is intriguing is that the different classes of investors often do not see eye to eye. Technical analysts think fundamental analysts are bullshitting while fundamental analysts think technical analysis is a joke. Value investors think growth and momentum investors are gamblers. Growth investors argue value investors are Buffets wannabes who often get stuck in value traps.
Where am I?
I think something is true about all the approaches. However, at a particular point of time, one philosphy is more true than others. My philosophy is to figure out which philosophy is the truest of all at any point of time with respect to any particular security or the entire market.
My target is to have a 20% return each year with minimal risk. I do not define risk in terms of volatility of the portfolio. Rather, I define risk as the ratio of the number of days when I have negative returns versus number of days I have positive returns, weighted by the daily returns.
I dont care whether that 20% return comes from fundamental investing, momentum investing, technical charting, or what not. What I care is the following.
A) Will the security give me 20% annualized return.
B) Under which philosophy am I investing in the security.
C) If I am wrong, I should NOT switch to any other philosophy to justify my purchase.
How did I come up with 20% benchmark. Well, Buffet has compounded the book value of Berkshire Hathway at 21% over the last 40 years. If I do 20%, it is great.
Almost everyone who is a professional investor has a philosophy. Some swear by technical analysis, while many swear by fundamental analysis. Some are growth investors, others are value investors, and still others are momentum investors. What is intriguing is that the different classes of investors often do not see eye to eye. Technical analysts think fundamental analysts are bullshitting while fundamental analysts think technical analysis is a joke. Value investors think growth and momentum investors are gamblers. Growth investors argue value investors are Buffets wannabes who often get stuck in value traps.
Where am I?
I think something is true about all the approaches. However, at a particular point of time, one philosphy is more true than others. My philosophy is to figure out which philosophy is the truest of all at any point of time with respect to any particular security or the entire market.
My target is to have a 20% return each year with minimal risk. I do not define risk in terms of volatility of the portfolio. Rather, I define risk as the ratio of the number of days when I have negative returns versus number of days I have positive returns, weighted by the daily returns.
I dont care whether that 20% return comes from fundamental investing, momentum investing, technical charting, or what not. What I care is the following.
A) Will the security give me 20% annualized return.
B) Under which philosophy am I investing in the security.
C) If I am wrong, I should NOT switch to any other philosophy to justify my purchase.
How did I come up with 20% benchmark. Well, Buffet has compounded the book value of Berkshire Hathway at 21% over the last 40 years. If I do 20%, it is great.
Friday, September 28, 2007
When Price itself becomes the Biggest Variable
Normally, in economics, we try to argue for a particular price for an object based on supply-demand. But that is true only under normal cicumstances. In some situations though, price itself is the variable that impacts future prices. This is what people are doing when they are looking at charts and doing "momentum" investing.
And this is what might now happen in US housing. If home prices fall by 9% (at least the prices of new homes for sale has fallen by that in the report released yesterday, exisiting home sale price declines are much lower), why would anyone who has little equity in the home pay the full mortgage, whether employed or not? This would increase foreclosures, bring more houses on the market, further depress housing prices and accentuate the downward movement. I am sure Fed will be forced to intervene even more heavily than it already has (though I dont know when they will intervene). Though what they can do to move the 10yr bond (which determines mortgage rates) is open to speculation. Remember Fed controls the 3 month rate. The 10 yr rate is determined in the market, and with dollar depreciating on rate cuts, whether foreign investors will continue to invest in 10yr treasury bonds as Fed cuts more is an open question.
For stocks, momentum is often the best play. Look at Reliance in the last 2 months here in India. As Mr Steve Edney of Citadel had told me all those years ago, there are just two factors determing stock prices - earnings revisions and price momentum. But momentum cuts both ways, just like leverage.
So whats my portfolio now. 100% equities. I bought VWO heavily the day Fed cut rates by 50bp, which was 10 days ago. There is momentum in emerging markets. Dollar is weakening and commodities are going up which will benefit emerging markets. Plus 4th qtr is upon us - the best qtr for stock indices. The only risk is that next month is October - the deadliest month for markets (Oct 1929, Oct 1987, Oct 1998). It might be deadly this time if Fed doesnt cut. In India I bought ICICI, and it is already up 10%. Long live Momentum.
And this is what might now happen in US housing. If home prices fall by 9% (at least the prices of new homes for sale has fallen by that in the report released yesterday, exisiting home sale price declines are much lower), why would anyone who has little equity in the home pay the full mortgage, whether employed or not? This would increase foreclosures, bring more houses on the market, further depress housing prices and accentuate the downward movement. I am sure Fed will be forced to intervene even more heavily than it already has (though I dont know when they will intervene). Though what they can do to move the 10yr bond (which determines mortgage rates) is open to speculation. Remember Fed controls the 3 month rate. The 10 yr rate is determined in the market, and with dollar depreciating on rate cuts, whether foreign investors will continue to invest in 10yr treasury bonds as Fed cuts more is an open question.
For stocks, momentum is often the best play. Look at Reliance in the last 2 months here in India. As Mr Steve Edney of Citadel had told me all those years ago, there are just two factors determing stock prices - earnings revisions and price momentum. But momentum cuts both ways, just like leverage.
So whats my portfolio now. 100% equities. I bought VWO heavily the day Fed cut rates by 50bp, which was 10 days ago. There is momentum in emerging markets. Dollar is weakening and commodities are going up which will benefit emerging markets. Plus 4th qtr is upon us - the best qtr for stock indices. The only risk is that next month is October - the deadliest month for markets (Oct 1929, Oct 1987, Oct 1998). It might be deadly this time if Fed doesnt cut. In India I bought ICICI, and it is already up 10%. Long live Momentum.
Wednesday, September 19, 2007
The Asymmetric Definitions of Inflation and Deflation
How can someone be short the markets when the central bank's definition of inflation excludes asset price inflation (as well as oil and food), but the definition of deflation includes asset price deflation? The Fed is concerned with a credit crunch impacting growth. A credit crunch will happen whenever asset prices decline. So the Fed is concerned with asset price declines. So they will always cut when asset prices fall. At the same time they won't do anything if asset prices rise, because it doesn't get included in calculation of core CPI. So one should always be long.
I was wrong. The bottom happened on August 16 - the day Fed cut the discount rate. I mentioned to Akshat that day that Indian markets are going to 18000, but never acted. Plus the tape kept telling and I kept ignoring. Lesson learnt - never bet against the Fed. Fed moves the markets.
I was wrong. The bottom happened on August 16 - the day Fed cut the discount rate. I mentioned to Akshat that day that Indian markets are going to 18000, but never acted. Plus the tape kept telling and I kept ignoring. Lesson learnt - never bet against the Fed. Fed moves the markets.
Monday, September 17, 2007
The Fed Meets Tomorrow
And it will be something to see.
Japan is not raising interest rates anytime soon, contrary to what I thought 3 weeks ago. Their Prime Minister Mr. Abe has resigned and 2Q GDP growth came out -ve. So the yen carry trade is not unwinding anytime soon.
I need to figure out where to invest in Indian markets.
Japan is not raising interest rates anytime soon, contrary to what I thought 3 weeks ago. Their Prime Minister Mr. Abe has resigned and 2Q GDP growth came out -ve. So the yen carry trade is not unwinding anytime soon.
I need to figure out where to invest in Indian markets.
Subscribe to:
Posts (Atom)