Tuesday, May 27, 2008


Been caught up in work. Huge deadline first week of June. Blogging shall be sporadic in the meantime.

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Thursday, May 22, 2008

Bill Gross on Inflation.

Bill Gross came out with a pretty scathing article today, questioning the low inflation numbers used in the US. He made a clarion call to fellow Americans to get off the couch and shape up – physically, intellectually, and institutionally His arguments made a lot of sense, and I suggest reading the whole article.

Gross was also on CNBC:

His bottomline: Invest in BRICs and countries which are more transparent about their inflation numbers, with authentic real growth and inflation rates.

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Wednesday, May 21, 2008

Short oil because of excessive speculation?

It’s weird how normal $100 plus oil suddenly seems. Oil has gone parabolic, and this chart from Bespoke Investments seems to suggest that things could be getting toppy.

Speculators are not very popular right now. Futures trading in many commodities across the world has been banned. Numerous experts have spoken out that most of crude’s price today is due to "speculation" and a "strong inflow of funds". Indeed, I came across this interesting article where an analyst was commenting on the rampant speculation in the oil space:

Fadel Gheit, an oil analyst at Oppenheimer, said record-breaking prices are a result of pure speculation by hedge funds and commodities traders, not a result of negative market fundamentals, adding that there is no real supply shortage.

"But rumors and speculation have taken over the market," said Gheit. "For example, even if the oil company is shut down, which Russia would not allow, they could maintain their current export volume, because they are limited only by capacity, not by production. And Russia has plenty more oil waiting to be exported."

Before you run off to double your short positions, check the date. The article was published way back on August 2004. The path of least resistance has been consistently up these past few years (even with a 40%+ price correction like we had in 2006). That price action needs to be respected. While oil may very well go down in the event of a global recession, it could also double in between.

Speculators play an important role in price discovery, and just because speculation is rife doesn’t mean that prices are unstable and headed down. Speculators are trend followers, not trend creators. Judging by what the strategists are saying, we may end the year up. (Goldman Sachs is now forecasting a second half price of $141 and a super spike price of $200). Marketwatch has this article with Outstanding Investments predicting $140 oil.

Trying to time the change in a multi-year trend line is risky, especially one that's hitting a new 52 week high seemingly every week.

Full Disclosure: No positions

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Tuesday, May 20, 2008

Interesting Dollar Yen commentary.

Argues that we may actually break the dollar yen downtrend, at least on a short term basis.

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Monday, May 19, 2008

Quotable quotes: the Market direction edition

Which way do you feel like lurching, Mr. Market?

I guess this week can be wrapped up as the 200 day MA week! Everyone was talking about the significance of a breakout above that level on the S&P500 and the Dow.

-We are at a point where the YTD losses are being erased. That could feed in some “extra cash” and keep us going sideways/up for the next few weeks.
-All that emerging markets money which went into commodities could very well rotate into stocks.
-We've had some solid action, with the S&P closing at or near it's intra-day high.
-Can we have a rally if the energy prices go down, dragging the energy and materials sector with them? Can we sustain this rally if the commodity prices/sector continue going up?
-I’m looking out for a Yen breakout and a ten year yield breakout. I think we could be seeing 4% yields on the ten year and a 107 on the Yen before we are through with this rally. (I’ve talked about a reversion to the 200 day MA in my posts earlier). (You can also check out an earlier market direction post)
-I feel the risk-reward situation is for a 5% upside, and a 15% downside.

Well, why listen to me? Let’s catch up on what the strategists are saying on the market direction in this marathon edition:

  • Teun Draaisma : We think the bear market rally is at or near its end. We do not recommend investors to be short yet, and our index target implies 0% downside on a 12-month view. If we were to go 5% higher from here, the risk-reward to short equities would be good.

  • Rick Santelli: It’s a question of realistic expectations. Realistic is that the darkest impact of the credit crisis and the industries in the construction and the housing sector may be behind us. But it's the rate of change.. it’s kind of how much of the path we have going forward. The truth is somewhere in between. Having a bottom is one thing. Having a parade that we are going to the moon is the other end. :)

  • Michael Kahn: The good news is that last week's stock market slide was halted right at the rising March trend line. The better news is that the Russell 2000 has finally broken free from its 2008 trading range. The rally is still on the ugly side with market breadth lagging behind price action and volume still fading.

    Another bit of ugly comes from the NYSE advance-decline line, which has not yet moved above its 2008 range. Market breadth has not confirmed the rally, at least not with any degree of confidence.

    Based on the evidence, we do have a rising trend but one that does not have solid technical underpinnings to sustain it. That means short-term investors can follow along as long as they never take an eye off the long-term chart. It is still a bear market rally.

  • Mark Hulbert : The average equity exposure of the market-beating newsletters over the past 20 years is only seven percentage points greater than for the market-lagging newsletters. In March, the comparable difference was 21 percentage points. This lessening of the bullish plurality is not an outright bearish omen, in my opinion. But it does point to the bullish case not being as strong as it was two months ago.

    To be bearish right now, you have to bet that the market timers who have lagged the market over many years are now, uncharacteristically, going to be more on target with their forecasts than the timers whose market timing calls over the years have added value.

  • Jim Rogers :US stock market is still too high as far as I'm concerned! Some stocks went down a lot, but the overall average is down, what, 6%? I'm surprised the market is not down more! The recession is going to be a lot worse than what we've had in a long time. I may be wrong, won't be the first time I am wrong. But it won't be the first time the stock market is wrong either! Zinc and nickel are down 50%. I've started looking at metals again. India and China are still there! Dollar might rally for the rest of the year!

  • Jeffrey Saut: Isn’t it amazing how fear has morphed into greed in a mere seven weeks, for now the cry on the “Street of Dreams” is about the new bull market that has emerged! We, on the other hand, have turned cautious. Our caution centers on the belief that our economic problems are NOT all behind us, the Dow Theory “sell signal” of November 21, 2007, the double-top chart configuration of the SPX at 1560-1570, and the 20-month moving average (MMA) (aka “The Snake”) that has often represented the demarcation line of bull and bear markets.

  • Bill King: For obvious reasons, permabulls, street paper pimps and their stooges in the financial media mitigate the fact that financial firms are raising and must continue to raise enormous amounts of capital and overemphasize purported good news.
    The big sucker rally that we warned almost always follows March (1907, 1929, 1980), and sometimes April (1987) crises as well as soft Q1s in recession years (1990, 1991, 2000, 2001, 2002) is now occurring. And after such sucker rallies, an autumn debacle is a very high probability.

  • David Kotak, Cumberland: We are fully invested worldwide in equities using exchange-traded funds. We will hold these strategies as long as we see the expansion of the Fed’s tools applied for the purpose of restoring the financial system to more normal functionality. When and if we see the Fed reaching a level of cessation of expansion of the tools, we will be proactive in reallocating assets.

    For now this activity is very bullish for equities, and it supports our notion that the US slowdown will be shallower and shorter than it would otherwise have been, had the Fed not become aggressively proactive last December and continued that pro-activity to present.

  • Wilbur Ross : At best we are in a period of stagflation. In the worst case a combination of inflation and a poor economy, largely due to the consumer. Consumer is tapped out and sort of fatigued. I don’t see multiples expanding.

  • George Soros : I think this is a fairly difficult bear market really. I could be wrong, but this is it. I think this is a bear market.

  • Lawrence McMillan: This has been a very strong week, and -- for now -- the danger to the bullish case has passed. $SPX twice tested the trend line, bottoming at 1384 and 1386 last Friday and Monday, respectively. That held, tentatively at first, and more strongly now that $SPX has risen above the 1420 level -- an area that had inhibited advances five separate times this month. Clearly, our observation last week that the trend line was the most important thing about the $SPX charge, was true. In summary, all systems are bullish, and that is evident by the trends in these indicators: the rising bullish trend on the $SPX chart, and the (declining) bullish trends on $VIX and the equity-only put-call ratios.

    Moreover, breadth is overbought, and thus conducive to the bullish case as well. We see no danger to the uptrend until at least two of these reverse direction -- something that doesn't seem too likely at the moment. Equity-only put-call ratios have remained on buy signals since shortly after the March bottom.

  • Anthony Bolton (Fidelity Special Situations) : The recent snap-back in share prices could be short-lived as stock markets face renewed weakness. Equity markets might not hit lows until early next year. The equity market’s slide that began last August might mark the beginning of a prolonged bear market and that the recent rise in equity prices is a “bear market rally”.

  • John Catsimatdis: The dollar is being devalued 30-40% The Dow is still at 12000 something. Yes, it has a lot to rise.

  • Ron Baron: Dow Jones was 11700 on 2000. It’s now 12500. So market has gone up about 1-2% for the past 8-9 years, so yes there is a lot of opportunity in our opinion.

  • John Hussman : With the U.S. stock market still relatively overbought in an unfavorable Market Climate, there is continued risk of substantial and possibly abrupt stock price weakness. As I've noted frequently, I rarely have much of an opinion on near-term direction except when conditions are either overbought in an unfavorable Climate or oversold in a favorable one. We observed some initial weakness late last week, but we remain braced for more significant trouble.
    At the same time, we have to recognize that the rebound through early last week brought market internals not far from the point that would begin to feed purely speculative “trend chasing.”

  • Clark Yingst, chief market strategist at Joseph Gunnar & Co: A lot of the lack of volume is accounted for by the deleveraging of the hedge funds. Requirement of more collateral is a reason for this. Near term Dow resistance level is at 13200. The market is anticipating a better US economy 6-9 months further out. We don’t necessarily agree with that. But we are taking the market action at face value, trying to capitalize on that. We are more inclined to view individual stocks as short term trading vehicles rather than investment vehicles, thinking that if that scenario does not unfold later this year, the market could have a serious retracement.

  • Jeremy Grantham : Sit on the sidelines, unless you're one of those nimble, quick-on-the-button traders who can move money around really fast and leap in and out at the right times. That's a good way to make money if it's your skill set. But for ordinary dudes with a seven-year [time] horizon like us, you've got to pick the long-term fundamental events and stick to them. The toughest thing to do is to stay out of the market, load up on cash and fret about all the money you're not making. But that's probably the best advice. Let the other suckers take all the risk.

  • Alec Young(Standard & Poor's): We are bullish but a little more cautious. We think the market continues to move up through the year. We priced in a weak economy and high oil. We still have enough macroeconomic headwinds eg. analyst revising earnings estimates downwards, that we believe the direction is going to be more two steps up, one step back.

  • Robert Pavlik, of Oaktree Asset Mgmt: I’m very positive on the stock market. I think the market has all the ingredients right now for it to move higher as the year goes on. We are faced right now with a lack of confidence. As we approach the 200 day MA we have an interesting chart pattern developing. It’s an ascending triangle, which is a very positive pattern for going forward. We just need one catalyst to get us over the flat line going up and the market goes up from there.

  • Barton Biggs: Sophisticates are bearish and pessimistic. I am bullish and I believe we have seen the worst. Tech is a major place to be. A great trade would be long financials and IBanks, and short Materials and energy sector.

  • Bill Strazzullo, Bell Curve Trading: The response to the sell-off has been extraordinary. Traders are buying because they have a backstop in the Fed. & Govt. The price for this liquidity is a weak dollar. Does the risk-reward make sense, with all the major issues and challenges? We had looked towards the move towards 1450 on April 10th, and this is where we get off the train.

  • Jordan Kotick (Barclays Capital): Markets around the world are breaking to new all-time highs, led by Brazil. Brazil still has a lot of upside.

  • Stephen Pope(Cantor Fitzgerald Europe): I don't think people can actually afford to sell in May and disappear because there's too much money sitting in the wings that needs to find a home

  • (From Quantifiableedge): Dr. Brett Steenbarger tracks the 10-day moving average over the 200-day moving average of the CBOE total put/call ratio. That reading dropped below 0.85 for the first time since October – also not a good time to be long.

  • Liz Ann Sonders: The current bear market for the dollar is the longest since at least 1967.The current period ranks second in terms of declines, down 41% (July 2001 peak to April 2008 trough), behind the 48% decline seen from February 1985 to December 1987. Entering a new bull market for the dollar would bode well for equities, as the average performance of the S&P 500 during dollar bull markets (averaging 1,708 calendar days) is 86% versus only 16% for dollar bear markets.

    I've often noted the perfect inverse correlation historically between core inflation (excluding food and energy) and market valuation. However, historically, sustainably high food and energy prices have eventually filtered into core inflation. If we get a commodity price reprieve, it should lower core inflation expectations—which could lead to equity valuation expansion.

  • VixandMore: Strong bear signal from VIX:VXV ratio lowest level to date on Thursday, previous low was 12/21/07. At the very least, the bulls should consider some downside protection in the current market environment. I suspect the bears are preparing to pounce very soon…

  • Check out that short interest!

  • Michael McCarty(Meridian Equity Partners) (on the low VIX): This measure broke through a trend established in early 2007 and now appears to be headed lower. The move down is real, and that for investors represents a sea shift, much like in sailing from a headwind to a tailwind. The movement in pricing of risk is now beneficial to stock prices.

Drop me a line if you liked this.

Full Disclosure : No positions

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Saturday, May 17, 2008

What I'm reading

  1. RGE Monitor has an excellent review of commodity price histories. Basically argues that this has been a boom in mineral prices, and not really agricultural related. An interesting trade would be going long the currencies of the major mineral exporters

  2. RGE Monitor: US dollar weakness now and afterwards.
    When inflation becomes the main concern instead of recession, interest rate will be raised and regardless of America’s economic performance, the US Dollar will climb back up.

  3. The Future of Dollar "The situation facing the USD is not irreversible. Although macroeconomic indicators are weak and there is much uncertainty, the USA shows more strength and microeconomic dynamism than many countries. It remains one of the most competitive economies in the world and there are no signals that this is about to change. The USD can take back its strength if the US authorities are prepared to implement the needed reforms. Given the position of the current administration, we will have to wait for the next one to sort this out."

  4. Thinkthoughts with a megatrends prediction.

  5. Microsoft trying to break the Google hegemony:

    Today, when a Web surfer is looking for a car, he might type "Chevrolet" into Google and then click on an ad alongside the search results. Google gets all the money for that click, even though other marketing efforts, both online and off, probably helped persuade that person to conduct the search. Ideally, an advertiser would know about all the ads that a potential customer sees before he makes a purchase. "They're trying to say that Google's getting too much credit, and there's probably a lot of truth to that"

  6. Things are not looking pretty in China.

  7. Jeffrey Sachs on how to save the world.

  8. Top 10 tech trends. I noticed that location based services were a notable omission.
  9. Retail moats: Fact or facade?

  10. Analysis of the recent spinoff of Dr. Pepper-Snapple (NYSE:DPS).

  11. RGE Monitor: The willingness of Asian countries to impose export restrictions on food and commodities to secure domestic supplies and proposals to form a rice cartel have been widely criticized. Creating an OPEC-like cartel could exacerbate global food price increases, create price distortions for farmers and deeply impact the poor consumers at home and abroad. While undermining the Doha trade talks, the food crisis also highlights the need to improve agriculture investment and yields as urban population and incomes rise.

  12. The Absolute Return Letter's May edition is titled Food for Thought. Basically argues that the current food price inflation is mainly driven by US ethanol policy and massive investment inflows into the commodity asset class. Also talks about falling agricultural productivity and the impending water shortages.

    Most investors seem to believe that headline inflation will gradually come back to core inflation levels over the next year or so. Few investors seem to
    think the unthinkable — that core inflation will gradually rise to headline levels.

    Even fewer seem to realise that if oil prices and agricultural prices continue to run amok, the Asian miracle story, upon which so many investors have pinned their hopes for the next few years, may, in fact, turn into a nightmare. The reason is simple enough. Asian countries are large importers of both oil and food staples. Very large!

    My food for thought: What's the impact of commodity inflation on Asian currencies and growth estimates? Indian rupee has declined over 10% in a two week period on the back of food price inflation. What about the current growth rate estimates? The BRICs are a 14 trillion economy on a Purchasing Power Parity basis, but only one-third that on a nominal comparision. I just fear that the PPP-based estimates might be overstating the case.

    Because of where the BRICs are on the utility curve and the inefficiencies in the system, a 5% rise in commodity prices has a much serious impact on the regional economies than in the developed world. I'll also point out to the fact that Indian elections are due next year, and money supply growth is running at a 30%+ rate; definitely not promising indicators on the shape of things to come.

Full Disclosure: No positions

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Wednesday, May 14, 2008

Memory vendors investment thesis: timely call.

Here’s an interesting video which shows the advantages of a Solid State Drive over a Hard Disk.

The article I had written earlier about the impending upturn in the memory sector turned out to be quite timely (Here’s the Seeking Alpha version).

  • Citigroup upgraded Sandisk on Tuesday. SanDisk Corporation (NASDAQ:SNDK) is Citi's mid-cap top pick on contract pricing and EPS revision catalysts.
  • Trade radar posted a summary on the industry coverage. It talked about the Citigroup upgrade, reports by the DRAM Exchange, the Korea Times, and the Internetnews.com.
  • Applied Materials, Inc. (NASDAQ:AMAT) on their conference call talked about a sharp slowdown in DRAM and NAND flash spending. (A sure sign of price stabilization.) The memory vendors, Micron Technology, Inc. (NYSE:MU), SanDisk Corporation (NASDAQ:SNDK) and Qimonda AG (NYSE:QI) rallied on the news.
  • [EDIT]: There was a Sandisk upgrade from Needham as well.

One consequence of any stabilization in memory pricing would be a minor erosion in the margins of companies like Hewlett-Packard Company (NYSE:HPQ) and Apple Inc. (NASDAQ:AAPL). These guys have been helped thus far by a favorable commodity pricing environment, which might be tough to repeat going forward.

While this rally may turn out to be short lived, and we may very well retest the January -March bottom, the consensus is slowly but surely turning around to the fact that the worst in the memory sector is probably behind us.

Full Disclosure: No positions.

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Tuesday, May 13, 2008

Quotable quotes : The Warren Buffett edition.

I got held up in posting the quotable quotes for the week. Well, we had the investing Woodstock in Omaha Nebraska. When Warren speaks, you don't need to hear what anyone else is saying! Make a note, remember it, and file it away for posterity.

These are quotes by both Buffett and Munger from the Berkshire shareh0lder meeting and the Wesco shareholder meeting. While this event was heavily covered, I still wanted to put together what I think are truly 'words of wisdom' or interesting observations.

  • (Book reco) I'll read the Intelligent Investor, chapters 8 and 20 I recommend
  • (On hiring managers)I would look for a person with a passion for the job, doing more than their share, good communicators.
  • The two most important things one can learn are: 1. How to value a business and 2. How to overcome influence from market fluctuations. (On what you should learn from Business School)
  • Go to work for organization you admire or an individual you admire. Which also means most MBAs I meet would be self employed.
  • I went to work for Ben Graham. I never asked my salary.
  • You’ll do better if you have a passion for something in which you have an aptitude. If Warren had gone into ballet, no one would have heard of him.
  • I avoided all classes that had public speaking, I got physically ill if I had to speak. I signed up for Dale Carnegie course. Gave them check for $100, then I went home and stopped payment on check. I was in Omaha, took $100 cash to Wally Kean, I took that Carnegie course, and then I went to University of Omaha to start teaching – knowing I had to get in front of people. Ability to communicate in writing and speaking – it is under taught – and enormously important. If you can communicate well, you have an enormous advantage. Force yourself into situations where you have to develop those abilities. At Dale Carnegie – they made us stand on tables. I may have gone too far. You are doing something very worthwhile if you are helping introverted people get outside of themselves.
  • It’s the nature of things that most small businesses will never be big businesses. It is the nature of things that most big businesses fall into mediocrity or worse. Most players have to die.
  • (Advice to 12 year old) I’d read a daily newspaper. You want to learn about the world around you. Bill Gates quit at letter P in World Book Encyclopedia. Just sop it up, and find what is most interesting to you. The more you learn, the more you want to learn. It is fun.
  • I wouldn’t be in currencies with a small amount of money.
  • I think it is stupid to use up hydrocarbons of the world so quickly. Stupid when there are few and limited alternatives. What should we have done? We should have brought all the oil over from Middle East and put it in our ground. Are we doing it now? No. Government policy is behind in rationality. If we have prosperous civilization, we must use the sun.
  • Accounting people really failed us. Accounting standards ought to be dealt with like engineering standards.
  • The great problem of mankind is that the genie is out of the bottle on nuclear weapons.
  • We live in a dangerous world. Getting more dangerous as we go along. In Cuba Missile Crisis it was probably a 50/50 odds, we were lucky. It won’t go away. You would hope we have an administration which will try to figure out how to minimize the risk. It should be paramount to eliminate deaths on a large scale.
  • When I get classes in universities I ask them to buy one classmate to own for rest of life. They pick the person who not with highest IQ, but who are most effective, the ones you want to be around. These people are easy to work with, generous, on time, not claiming credit, helping others. There are things that turn other people on, and turning other people off. Those are good habits to develop.
  • Your children will live in a better country than you, even if a few idiots run it in the meantime.
  • I think you have to start with the idea that a lot of the current troubles are richly deserved.
  • We may not save very much because we don’t need to. We are a very rich country, and we may not need to save as much as other countries trying to reach their potential.
  • If we had banned the phrase, “this is a financial innovation which will diversify risk", we would have been far better off.
  • Most important job you have is to be the teacher to your children. You are the big great thing to them, you don’t get the rewind button, you don’t get to do it twice, teach by what you do not what you say. By the time they get formal school they would have learned more from you than school.
  • If you look at effective individual – why do people want to be around them? You should copy those qualities… I would look for what I admire and emulated, and try not to let things distasteful be copied.
  • Capitalism without failure is like Christianity without hell.
  • Inflation is bad for civilization but great for capitalists.

Note: These are Charlie Munger quotes from Wesco’s shareholder meeting.

  • People are used to laying money aside and investing in standard fashion, and becoming quite comfortable. It is easy to forget that this isn’t guaranteed.
  • The reason my generation did so well was kind of a fluke, and won’t necessarily continue. There will be lots of chicanery in future. Many claim alpha – but really they are just taking an earthquake risk.
  • Envy effects corporate compensation. People want to be paid like movie stars rather than archbishops.
  • (On Berkshiree) There is a lot to be said that people in power make money with shareholders, not off them.
  • We do not need the smartest people in science and math in computer driven strategies. This is not a plus for the wider civilization.
  • We normally avoid [discussing the general investment climate] like the plague. Most assets are priced to a level where it is hard to get excited. It is hard to get 4% yield on a nice apartment, and it doesn’t include replacing the carpets. Bonds of strong corporations are 4% yield. Corporate equities are paying 2% pa, growing 4% per year. Such a world isn’t the one that made all of you able to come to the meeting. Last generation has been in hog heaven – some bumps, but it had easiest time getting ahead. In the eighteen years that preceded hog heaven, the purchasing power of Yale’s endowment went down 60%. They were getting real investment return of 0%, negative. It is not at all impossible that brilliant investors like Yale get bad results in the future.
  • The only duty of corporate executive is to widen the moat.
  • (On CDS) There is no reason in America to have vast bets on $100m bond issue to which no one is party. It creates needless complexity and very perverse incentives. They say “it’s a free market”. The correct adjective is insane.
  • (On war on terror) Terror is a hell of a problem. People are vastly overconfident in the solution. They are probably making an error.
  • I would avoid funds that have 100% turnover per year. It is a ridiculous way for an ordinary index fund to behave.
  • Berkshire would have been a mess if it had ever stopped learning. Only reason we’ve been able to keep a shred of decency in our record is that we have been hell bent to keep learning.
  • We tend not to sell operating businesses. That is a lifestyle choice.

Full Disclosure: No positions.

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Sunday, May 11, 2008

Shorting share buybacks: great comments.

Boy, taking the opposite side of a well accepted notion does upset quite a few people!

The shorting share buybacks blog entry attracted a fair amount of comments on Seeking Alpha. In case you missed out, the Seeking Alpha article can be found by clicking here.

I shall be posting a summary and addendum of my thoughts on the subject early next week.

Thanks for the excellent exchange.

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Friday, May 9, 2008

Contrarian pick: Buy flash memory vendors because of elasticity.

The investment thesis in flash memory vendors consists of the following:

  • Memory prices are in the dumps.
  • The creation of newer markets due to price erosion.
  • Increased demand due to higher memory capacities and new markets, more than offsetting any price per bit declines.
  • Memory vendors currently trade at rock bottom valuations.
  • Most existing players are looking to divest or merge. The survivors should be great investment candidates.
  • The trend towards mobility and computing convergence will drive growth towards newer markets and higher capacities.

Moore's law has been a constant guiding light over the last 30 to 40 years in the semiconductor industry. Gordon Moore made this observation thirty years ago, and it has held true ever since. This basically predicts the shrinking of transistors, thus doubling performance every 18 months, with reduced costs and area. The reduced cost and added functionality facilitates their use in a wider array of markets and applications.

As the average selling price (ASP) continues to plummet, elasticity dictates that newer markets and applications would be discovered, which would simulate sales growth. Andy Kessler discovered the same phenomena with EPROMs in the 1980s. Really, nothing has changed in terms of demand supply curves. Elasticity is the guiding investment principle in this sector.

Right now, as memory prices collapse and vendors bleed red, people are scared from investing in companies like Micron Technology, Inc. (NYSE:MU) and SanDisk Corporation(NASDAQ:SNDK). A slump in demand, coupled with an oversupply, has forced vendors to sell memory chips below cost. Many have predicted an impending shakeout with the smaller players either exiting or being bought out. Most chip companies like Intel Corporation(NASDAQ:INTC), Advanced Micro Devices, Inc. (NYSE:AMD), Infineon Technologies AG (NYSE:IFX) and STMicroelectronics N.V. (NYSE:STM) have spun off or merged their 'undesirable' memory divisions, or are in the process of doing so. The memory sector has been left for dead, which is exactly the best time to get in from a contrarian perspective. A similar shakeout took place in the mid 1980s, when Intel exited the DRAM sector. That turned out to be a good time to invest.

The number one use of flash right now is in Apple Inc.’s(NASDAQ:AAPL) iPods. Just contemplating the possible markets where memories could be widely used gets me excited.

  • Think of the growth in feature rich cell phone markets. Multiply that growth with the increasing memory capacities for each of those cell phones. You get the picture.
  • The introduction of the high memory capacity iPhones by Apple Inc.’s(NASDAQ:AAPL) should drive other phone providers to beef up the memory capacity in their phones, thus accelerating the trend towards higher capacity phones.
  • While everyone is anticipating a faster 3G rollout because of the iPhone, fewer analysts are anticipating the growth in memory usage. Broadband and wireless just gets wider coverage than the commoditized memory sector.
  • In 2007, 271 million PCs (laptops+desktops) were sold. In contrast, a mind boggling 1.15 billion cell phones were sold last year (and growing fast). As these become more feature rich and pack in higher capacity chips, the memory vendors who survive the current shakeout are in for a bonanza.
  • Solid state drives in laptops are on the cusp of mass adoption. Five years from now, most of us would be toting around flash enabled SSD drives. Flash memories would be faster, less noisy, more power efficient and increasingly a preferred usage choice for even high capacity drives.

Check out the graph below. While I agree with the growth projections, I’d just like to add that it probably underestimates the cannibalization of MP3 player growth rates due to integrated phones with music capabilities (like iPhones), and underestimates the erosion in USB Drives due to online storage and cloud computing applications.

Here would be the top three names to play the memory sector:

  • Sandisk(SNDK): A strong patent portfolio in flash, good management, a visionary CEO in the form of Eli Harari, and an innovative marketing and design strategy makes this a buy. Should come out very strongly through the current downturn.
  • Micron(MU): One of the strongest patent powerhouses in the world. It’s resilience to past downturns and current scale makes it a buy.
  • Samsung: A low cost structure due to geographical location and scale gives it a serious competitive advantage. Should survive any shakeout and continue to do well in an economic upturn. This is not a pure memory sector play, as it has several product lines.
  • Bonus: iShares MSCI South Korea Index Fund (NYSE:EWY) would be a diversified way to gain exposure to Samsung (14% of the ETF). Moreover, valuations for Korea are attractive, as suggested by Warren Buffett recently.

Caveat: There is a potential threat from newer memory technologies (FeRAM, MRAM, phase change RAM), but their commercial deployment and proven success is still many years away.

In short:

  • We are truly on the cusp of a phenomenal growth cycle in memory chip usage.
  • The best part is that people absolutely hate the sector right now.
  • This makes it a classic contrarian pick.
  • The current carnage would scare away incumbent semiconductor players toying with the idea of an entry.
  • Demand-supply elasticity tells us that the memory sector should scale beautifully over the next few years.

To conclude, buying the discounted memory chip vendors close to the bottom of the economic cycle sounds like an excellent investment proposition.

What say you?

Stocks mentioned: MU, EWY, SNDK, AAPL, INTC, AMD, IFX, STM

Full Disclosure: No positions.

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Thursday, May 8, 2008

Why you should short companies doing a share buyback.

Am I the only guy who believes that stock buybacks are a waste of shareholder money and a management diversion?

Theoretically, if the earnings yield (inverse of P/E) is higher than the after tax interest rate, buybacks add to the EPS number. Buybacks are dilutive otherwise. (This provides no information on the value of the company.)

Here’s why I don’t like buying companies doing stock buybacks, and would rather short some of them:

  • Some of the announced buybacks never happen.
  • P/E multiple compression. A dividend or a buyback is a cash flow to the investor right now, versus a possible higher return later on through future profitable growth. According to the classic Gordon growth model, a company’s price earnings multiple is proportional to the retention ratio. Well, a buyback is another way to return cash to the shareholders (or a lower retention ratio). Lower rates of reinvestment suggest lower future growth rates, and hence a lower multiple.
  • Implicit recognition that the avenues for internal growth through reinvestments are not that high as returning cash to shareholders through buying back ‘undervalued’ stock. Let’s say you have a debt-free company with a 20 P/E doing a buyback. Does this imply that the company cannot find enough investable projects with returns in excess of 5%? Would you want to invest in that kind of a company? The company might be signaling a lack of investment opportunities above the cost of capital.
  • Buybacks are effectively a leverage on the EPS numbers. In good times, profitable growth leads to aggressive buybacks, further magnifying EPS numbers. During a downturn, a negative growth with reduced buyback would amplify the EPS compression. Cyclical companies with huge buybacks are the best short candidates for this.
  • If the management thinks that the stock is undervalued, why isn’t a value investor or activist hedge-fund buying your stock? Palm(PALM) and Motorola(MOT) are two companies which had huge buybacks when the stock price was a lot higher. Even the activist funds have lost money on their initial investments so far.
  • A lot of tech company buybacks are to offset equity dilution due to stock options, and the net buyback is minimal. (BIG short). I’ve seen companies with 5-10% annual stock dilution. (Let’s not even get into the whole option expensing debate!) . Yahoo(YHOO) and Nvidia(NVDA) are examples of companies with a sizable equity dilution.
  • Buybacks to combat short sellers is a questionable tactic with dubious merits. This gets into the whole ego turf. Good short candidate. (Example: Overstock(OSTK))
  • Buybacks followed by heavy insider selling are a big red flag.
  • Possible internal management conflict to boost EPS numbers for executive compensation, instead of long term shareholder growth. (This paper suggests that the combination of a share buyback, insider selling, and a high ratio of incentive compensation is a high risk event.)
  • Cost cutting and restructuring: Increasing cash flows through temporary cost cutting measures don’t really add to the firm's innovativeness. Using that cash to buy back shares instead of reinvesting is a good short candidate, since the uptick in cash flow is temporary.
  • If you pay more than your book value, you reduce your book value effectively.
  • As investors, you care for the “intrinsic valuation” of the company. This doesn’t change with a buyback. By pandering to short term speculators, management risks alienating value investors.

Hey if buybacks are such a great thing, how come Berkshire doesn’t have one? That’s because it chooses to reinvest earnings in profitable enterprises, thus increasing intrinsic value, and consequently the share price. Gaming and managing quarterly earning numbers through buybacks is not a good long term investment thesis. It doesn’t matter if the stock is trading at half the intrinsic worth. The company should essentially ignore what the market thinks in the short term.

If the company is returning all that operating cash flow to the shareholders, aren’t you better off just buying a conglomerate like Berkshire(BRK) or Luecadia(LUK) which reinvests that cash in profitable enterprises for you? They effectively take away any reinvestment risk.

The implicit assumption in a buyback is that the company feels that the stock is undervalued. The belief is that insiders know something that Mr. Market doesn’t. Often times, this is not based on a strong order book, or an increasing sales profile. More often, an overly optimistic and rosy outlook leads to the buyback. Given the folly of forecasting beyond a few quarters, that’s questionable.

Sometimes, the announcement is made after an earnings shortfall, or if the company has some future negative outcome which the market is possibly 'discounting'. For example, even right now, the average analyst estimates for the last two quarters of 2008 are too high. From a bottom-up analysis, companies feel that even though there is a general economic downturn, they won’t be affected. Some of them have buybacks in place.( This 2005 article from the McKinsey Quarterly provides some further food for thought)

I’m not saying that buybacks are bad per se. There are genuine occasions when Mr. Market throws a temper and gives us a steep discount with a nice margin of safety. Just that there are situations where shorting companies doing buybacks might actually be a profitable strategy. Using the guidelines above can help us in reaching this decision.

Ticker symbols discussed: BRK, LUK, OSTK, YHOO, MOT, PALM, NVDA.

Full Disclosure: Long LUK since 2005.

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Wednesday, May 7, 2008

Paul Wilmott on the Black Scholes option pricing model.

Paul Wilmott had an interesting post last week about his tryst with the Black Scholes option pricing model. On how his opinion of the model has changed with time and experience.

I had gone from a naïve belief in Black-Scholes with all its simplifying assumptions at the start of my quant career, via some very sophisticated modelling, full circle back to basic Black-Scholes. But by making that journey I learned a lot about the robustness of Black-Scholes, when it works and when it doesn’t, and have learned to appreciate the model despite its flaws. This is a journey that to me seems, in retrospect, an obvious one to take. However, most people I know working as quants rarely get even half way along. (As discussed elsewhere, I believe this to be because most people rather like being blinded by science.) "

"My research now continues to be aimed at questioning commonly held beliefs, about the nature of ‘value,’ about how to use stochastic calculus to make money rather than in a no-arbitrage world, about the validity of calibration (it’s not valid!), and how people price risk (inconsistently is how!). All the time I strive to keep things understandable and meaningful, in the maths sweet spot that I’ve mentioned before. "

The many improvements on Black-Scholes are rarely improvements, the best that can be said for many of them is that they are just better at hiding their faults. Black Scholes also has its faults, but at least you can see them. It’s simply that more complexity is not the same as better, and the majority of models that people use in preference to Black-Scholes are not the great leaps forward that they claim, more often than not they are giant leaps backward.

Wilmott has posted some good stuff on this topic, and I suggest you check out his blog.

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Monday, May 5, 2008

Quotable Quotes: The World this week.

This is a weekly update on what I've been reading and watching. To encapsulate, you had asset class predictions from GMO and BCA's perspectives on Brazil. Three strategists recommended selling this rally. Peter Bernstein reflected on the similarities to the Great Depression, and Bill Gross talked about a fat-tail possibility. The Indian finance minister's comments qualified him for the "bizarre quote of the week".

I haven't had a chance to read the transcript of the annual Berkshire conference. I did manage to catch this quote from a Marketwatch article, which discussed Berkshire's acquisition of a portfolio of subprime mortgages with frozen interest rate resets.

Buffett: "We're not in the business of resetting mortgages higher". That's quintessential Buffett for you. Candid, honest and fair. Long term profitable ventures are sustainable in nature, and you cannot sustain predatory lending which dupes gullible borrowers beyond a point. Berkshire's enterprises have a very human face to them (Sudan and PetroChina controversy notwithstanding), something that corporations would do well to keep in mind. With this fitting prelude, let's dig in.

Jeremy Grantham came out with GMO's seven year forecast on various asset class returns. I thought this chart was good food for thought:

BCA Research is clearly positive on Brazil's prospects:

P Chidambaram (Indian Finance minister) (Bizarre quote of the week) :

"If rightly or wrongly people perceive that commodities- futures trading is contributing to a speculation-driven rise in prices, then in a democracy you will have to heed that voice."

Comment: I seriously worry that we could have a black swan event in food and commodity prices, further exacerbated by political expediency. There are elections in India next year, and the political posturing has begun. Deficit is high, inflation is out of control, futures trading on food staples has been banned, fuel subsidies are distorting fuel usage, exporters are demanding tax incentives, sops or government intervention in keeping the rupee pegged to the dollar. The list goes on . The news from China isn't getting any better. Increasing emerging markets trade protectionism could undo the WTO trade benefits, further throwing a spanner in the Doha round of negotiations.

Check out this Don Coxe interview for his take on the current situation..

Former fed official Vincent Reinhart :

"The central bank's rescue of Bear Stearns was the worst policy decision in a generation.
The panicked decision jumped over other possibilities and may prove as damaging as Fed policy errors that caused the "great contraction'' of the 1930s and the "great inflation'' of the 1970s.
The Fed's actions eliminated forever the possibility that the Federal Reserve could serve as an `honest broker'. The central bank also "tilted the political playing field toward direct mortgage relief. "

Desmond Lachman, Chief Economist of the American Enterprise Institute:

"Further interest rate cuts and a second stimulus package are required. Unorthodox measures are needed to stabilize the housing market. "

-Household wealth reduced by $2 trillion till date.
-Real prices 20% above equilibrium.
-Excess inventory of 1 million.
-Case-Shiller Indices predicting further declines.
-Sub-prime lending dried up.
-Record foreclosures.
-Commercial property burst
-Goldman Sachs estimates 1.2 trillion in losses
-Interest rate spreads have widened, neutralizing Fed's interest rate cuts.
-Fiscal stimulus neutralized by high oil prices.
-CDS market a hidden non-bond sector danger.

Peter Bernstein:

"I'm a child of the Depression, and I am thinking about what the early years were like after World War II. It took a very long time to get the memory of the Depression out of business decisions, and certainly banking decisions. I think this is going to be the same.

The people who think we will have turned in 2009 are wrong. There has to be a respite along the way. Nothing goes in one direction forever. But it will take longer than people think."

Adam Myers, market strategist at Credit Suisse:

“Money markets are reflecting a level of caution which is not reflected in credit or equity markets. The difference between the two is that … a money market trader has a much better idea of solvency of their trading counter parties than does an asset fund manager. Given money market traders’ proximity to balance sheets, they get clear information from buying and selling of money between each other. The view of the equity and credit market is far too sanguine.”

"The real economic effect of this credit crunch is only beginning to be felt. We are going to see a much more substantial impact than is reflected in equity and credit markets."

Morgan Stanley analyst Betsy Graseck: Sell bank shares

“We think it is a mistake to chase this rally,” she writes. “The risk is much greater that credit deterioration will accelerate and banks will raise more dilutive equity and cut dividends than expected.”consumer net worth is likely to decline 11% over the next two years due to the housing decline, and loan losses will continue to rise. This will drive weakness in commercial asset classes, “as corporates who sell to consumers suffer from slower top-line growth.”“we think we are only in the 3rd inning of the credit cycle and expect this credit cycle will be worse than 1990-91.”

Jeffrey Saut:

"We turned bullish at the January 2007 “lows,” cautious at the subsequent February “highs,” and aggressively bullish on the March downside re-test of those January “lows” believing the re-test would be successful; and, that the ensuing rally would carry the averages above the February highs, eventually scooting into the 1400s basis the S&P 500 . From there, if the envisioned pattern continues to play, we should see a decline. To reiterate, that decline should be measured by “if” the U.S. economy spills into a recession; and that then, the extent of the decline should be measured by if the recession is short-and-shallow or long-and-deep.

To take advantage of the aforementioned potential stock market pattern, we have recommended numerous trading and investment positions. Speaking to the trading positions, we have continued to move stop-loss points “higher” as the rally has progressed; and would look to sell many of these positions into any “blue heat” upside type of hour toward SPX 1440. "

Bill Gross Investment Outlook:

"Lower Fed Funds? They would, in PIMCO’s opinion, likely do more damage than good from this point forward.

Mohamed El-Erian has been counseling to at least consider a fat-tail possibility that could stop us in our tracks on the list of our strategic battle plan. (Note: I pondered on the possible consequences of this possibility in this post)

Mohamed suggests the possibility, not the probability, that recent euphoric moves in equity prices and credit market spreads might be premature. The market’s justification may rest on the two-barreled conclusion that, 1) the delevering of the financial system is reaching a natural culmination as prices stop going down and banks and investment banks recapitalize their balance sheets, and 2) that numerous and previously unthinkable policy responses have restored enough liquidity to relubricate our finance-based economy. Recession, and its vicious-cycle effect on employment and consumer spending, remains a threat and this recession, although currently mild and as of yet not even officially validated, may not be your garden-variety, father’s Oldsmobile-type of downturn.

Because the U.S. and selected other economies are now substantially asset-based and dependent on stable and upward tilting prices, a deflation of an economy’s primary financial asset can be ruinous. Its deflationary thrust must be countered, wrote Minsky, or else the battle might be lost. If so, the real economy as Mohamed El-Erian suggests, might become so shell-shocked that financial markets once again turn down instead of up. "

Full Disclosure: No positions in any securities mentioned.

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Friday, May 2, 2008

Three reasons to buy consumer staples right now!

Mr Market has been in a good mood these days. The recent upward movement in stock prices has led to a return of investor’s risk appetites. While we may very well trend higher, it may be a wise idea to consider a shot of consumer staples in your portfolio.

Here’s why:

  • The arguments for and against a recession are purely academic. The simple fact is that we are looking at below trend GDP growth for at least the next 2 years, and possibly a decline in GDP per capita. Right now, large caps with consistent cash flows are trading at historically cheap valuations. As the investing boat tosses and turns, investors will begin to pay up for companies generating stable consistent cash flows that are impervious to a slowdown. Advantage: consumer staples.

  • While energy prices are really high right now, quite a few strategists have called this a commodity bubble, with fundamentals justifying lower prices (You can check out my posts here and here discussing this further). When the bubble deflates and energy prices come down to reflect the new realities of slower global growth (based on IMF predictions), the money flowing out of energy issues could very well flow into the consumer sector. (I’m not recommending exposure to the consumer discretionary sector, because some of them will take a hit in a slowdown.)

  • Emerging markets strength. A lot of the growth in these names is through emerging markets. Consumer staples are a good way to play the ‘decoupling’ argument. You are not affected by a developed world slowdown, and stand to benefit from any growth in the developing world.

Best ways to play this? For a quick and dirty diversified way, you can buy the Consumer Staples Select Sect. SPDR ETF (AMEX:XLP). For active stock investors, Unilever plc (NYSE:UL), PepsiCo, Inc.(NYSE:PEP) and The Procter & Gamble Company (NYSE:PG) would be my picks.

Full Disclosure: no positions in any securities mentioned.

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