Sunday, November 26, 2006

Commodity Prices, what do they Suggest

Well, I am already on record as paying relatively little attention to commodities, but I do pay attention to prices levels of some commodities, particularly gold, because of what it suggests about the purchasing power of the dollar. The news here is not good. The dollar is hitting 20 month lows against the Euro. Worse, the price of gold has quietly crept up to near $640 and it might go higher.

One cornerstone of any successful investing strategy is maintaining (at a minimum) purchasing power in spite of a dollar that loses its value on a regular basis (inflation).

Now I have perhaps taken both sides of this argument in the past, which is to say, I have purchased (and continue to hold) a position in CL becuase of its ability to have strong earnings regardless of the relative strength or weakness of the dollar. At the same time, I have argued that commodity prices should fall with the next US recession, which will, in my opinion, be deep.

Ironically, I see the very rise in commodity prices as a major factor in provoking the recession. The Fed has finally admitted that its monetary policy was far too loose in 2003-2004. As a result prices have begun rising significantly, because there is too much money sloshing around the system, and not enough goods for them to chase.

While this is not bad, what makes this situation a disaster is the resulting credit bubble. Credit bubbles are very, very bad. When there seems like there is little consequence of borrowing (like low interest rates), people borrow more than is prudent. They take advantage of the lower rates possible, by using variable interest rates on their debt. In short, they set themselves up for a credit crunch when money gets tighter (as it inevitably does). The Fed would like to end the credit bubble without bringing economic activity to a standstill. This is an admirable objective, but as price levels are again demonstrating, it is not a probable result.

I felt that the Fed erred in stopping further interest rate rises, which, after a monetary orgy, the likes of which we have not seen in decades, only aggresive policy was likely to really curb the bubble. Instead, the Fed has just slowed down the expansion of credit, rather than rein it in. Therefore, prices are bound to keep rising. But the Fed cannot continue to allow these higher prices. They will be forced not to trim rates, but rather to raise them. In the 1990s, we watched central banks go on competitive devaluations and cut rates. Now, we will watch them go on competitive "protection" positions - each raising in part because it wants to defend the value of its currency. The alternative is to watch commodity prices, in local currency terms, rise to highly inflationary levels.

As banks keep tightening credit, those who borrowed imprudently when money was cheap will begin to have difficulty making payments. You know the story from there. Imagine the impact on housing if the Fed finds itself raising rates to 5.75% or 6% next year! Brutal.

But, with rates headed higher, it still pays to keep savings in short term vehicles. They are already paying higher rates, are protected against principal loss (which will happen if long rates rise to reflect inflation) and offer liquidity for making opportunistic purchases.

Wednesday, November 22, 2006

Sites to See

Just because I haven't posting with regularity doesn't mean I am not trying to keep up with what's going on in the finance blogosphere. I have come across a few new sites you should check out.

It's not a secret that I like stocks that pay dividends and repurchase stock. I like companies where the pie is growing, payouts are growing and my share of the growing pie (and payouts) is growing. One site that can help develop a short list is stockinvestingx. The site lists many features about top 100 dividend payers and repurchasers. Beware, however, that just knowing companies making significant repurchases is not enough, you also need to consider the stock and option issuance that is on the other side of the repurchases. You can always find information on equity and option issuance in a 10-K and shareholder friendly companies also include this in a 10-Q.

The other site is from a real estate bull and sometime commentator on this blog, Larry Nussbaum who writes the Millionaire Now Blog. He also has a book. His site writes on a variety of finance and investing topics.

Harry Dent Forecast

My friend Jason Tilberg has shared a new Harry Dent forecast. Now, I have to admit that I think the man is far too optimistic about a raging bull market between now and 2009. On the other hand, Dent and I agree that there is a big drop coming and we both believe that it relates to coming changes in Boomer spending habits. After years of "living for today" and spending, spending, spending, Boomers are about to get to "imagine no possessions", because that is what their financial condition will provide them in retirement. The problem is, they are going to take the economy with them.

Boomer consumption is a major driver of economic activity. Since few Boomers will be able to maintain that rate of spending in retirement (in part because their spending already exceeds their income), Boomers will dramatically reduce consumption in retirement. Future generations will not spend the same way and lower aggregate demand will result. The problem will get worse as we get deeper into the Boom.

I actually see the downturn in housing leading to reduced activity starting in 2007, with no boom, and a full on bust in full by 2008 from which there will be no recovery for a decade or more. Stalled earnings growth, or even downright lower earnings should end the rally in the markets.

But maybe Dent has a point. Much depends on Boomer behavior between now and retirement. While there is no way for most Boomers to save enough to maintain their standard of living in retirment (which means future consumption will decline in any event) but Boomers may try and avoid their fate by making major changes in spending and saving habits. Initial moves to increase savings will lead to higher asset prices, most likely in stocks. It won't be enough to prevent the inevitable, the economy simply cannot support that much consumption by non-workers, but as an investor it might be possible to ride that wave.

I continue to urge caution in investing. Downside risks are large, in spite of bullish predictions and claims that equities are cheap. They are not. Bonds are expensive - but you have to ask yourself, why is that savvy bond market so pessimistic.

Monday, November 20, 2006

What the Phelps Dodge Acquisition Means

So, there is little doubt that I am a bear when it comes to asset prices. Many other commentators agree with me with regards to copper. This is reassuring, since I do not study commodity markets.

People who live this business, however, are suggesting that I am wrong. Had I listened to my friend Jason Tilberg, I could have made some nice dough in Southern Copper. But as I noted above, I don't follow commodity markets, so I ignored it (trying to stay in my zone of comfort). Plus, as noted above, I am an asset price bear, so in my mind, commodities, and companies tied to them, are things to avoid.

However, there is increasing evidence that I have erred. The Freeport acquisition of PD is such evidence. Freeport clearly believes that copper prices will remain high enough, long enough for it to basically pay down the new debt it is issuing to acquire Phelps before prices fall. The transaction is actually accreditive to earnings in the first year. This is rare in an acquisition, since the premium paid is usually too high, and new shares issued for the acquisition, plus other acquisition costs usually put a dent in earnings for at least 12 months, before cost cutting synergies and pricing power take root.

Now, even if copper prices fall, Freeport may have gotten a good deal, since as the largest manufacturer, they should also be the low cost supplier to the market (higher market share leads almost inevitably to lower relative cost), and in an oversupplied market, it is the low cost provider (whic can still reduce prices and make money) that wins.

Even so, this is a bet on higher copper prices going forward, because the increased fixed charges have to be paid by cash coming from operations. If copper can remain at elevated prices for another year or two, however, and Freeport is disciplined at deleveraging, they have the opportunity to reduce those fixed charges by the time prices begin dropping.

Views on the Housing Market

As regular readers know, I am a housing bear. Together with that, I am actually an economic bear. I believe that this housing bubble collapse will lead to wholesale changes in spending patterns, particularly among boomer households, who are as a group woefully unprepared for the retirement that looms for many.

An asset price decline will lead to a negative wealth effect and coupled with actual income declines (most boomers are planning to have only 60-80% of their pre-retirement income in retirement, while they currently spend more than they earn), will lead to a major depression not seen since the 1930s.

In this article from John Mauldin, A. Gary Schilling, a noted Yale professor (and real estate bear) reviews all the reasons why the bear market in real estate is only getting warmed up. He makes frequent mention of how the real estate bubble resembles that of the 1920s. While Schilling does not seem to believe that we are headed to the 1930s he does mention the possibility. It is critical to understand that the depression of the 1930s was NOT caused by the stock market crash. The crash was indicative of (the decline) of other economic activity. The post-crash connection was made by anti-capitalist politicos who played up populist resentment of Northeastern bankers to win elections in 1932, 1934 and 1936. But here I digress.

The depression of the 1930s resulted from an attempt by the Federal Reserve to unmake a massive inflation in caused with easy money in 1926. In that year, the Bank of England wanted to return to the gold standard, and do so at it´s pre-WWI peg. While this action satisfied British egos, it was monumentally stupid. Wartime expenditures had led to a massive increase in pounds stirling in circulation, and gold supply simply had not kept up. So, when the UK returned to its peg, gold started flowing out of the country. The BoE was in danger of dropping the peg when it prevailed on the Fed to cut interest rates to reverse the outflow of gold. The Fed complied, and dropped nominal rates by over 100 basis points, and gold started flowing out of the US and to the UK where it could be put to work at higher rates.

This drop in rates, however, led to speculative borrowing in the US. It also led to a temporary increase in the price of farm products (which had enjoyed war-influenced high prices since 1915: the war had destroyed significant acreage in Europe, and the Continent was forced to import food, leading to high prices). All of this came to a head at the same time. By 1928, Continental acreage was coming back under tillage, increasing supply, while subsequent increases in interest rates (used to reduce speculative purchases of coastal real estate) meant that farm loans, and their interest payments now exceeded the revenue that family farms could generate. While this may seem laughable today, it was significant in a country where half the population still lived on farms. Banks failed all over the place, but most severely in the Midwest and West, where banking laws forced the Bank of Podunk to take deposits and make loans in Podunk. With such concentration of portfolios, substantially all of the assets of the bank (loans to the farmers of Podunk, secured with mortgages against the farms of Podunk) were devalued together. Once the banks failed, even farmers who weren't in default found themselves with their savings wiped out (remember, there was no deposit insurance).

But, I hear the reader say, we have much more sophisticated risk modelling today: banks have better risk management, they are no longer limited to lending in the neighborhood, through securitization, they can lay off significant risks (and purchase risks from other markets), the Federal Reserve has 80 more years of education under its belt, and we have deposit insurance.

All of these things are true, but what we need to recognize is that we have also transferred risk to individuals on a scale we have not had since before the Bad Deal. While this is not a bad thing (it enables those individuals to profit from the risk premia they have assumed, for instance), many of those risk-takers do not understand the risks they are taking. This means that they may not be insisting on the premiums they require. While there may be deposit insurance on savings, there is no such insurance on the equity and mutual fund portfolios that comprise the vast majority of the financial assets of Americans. The Federal Reserve seems just as willing today to make poor economic decisions in the interest of politics, namely the Greenspan inflation, which I have discussed often. Finally, let us not forget that Japan had all the same advantages when it entered its 15 year "lost decade". Asset prices still have nor recovered to pre-collapse levels. And the US lacks the significant exports and current account surplus that Japan has used to bolster economic activity.

This real estate collapse will be unlike any we have seen. I think Schilling´s projections of a 25% drop in prices is quite realistic. Only a major inflation can prevent it.

I continue to recommend defensive positions. An interesting suggestion of Schilling (who believes interest rates are headed lower as part of the deflation) is to purchase long zero coupon bonds. Prices of such bonds are going to skyrocket if rates decline to 3% as he believes.

I am looking to investigate this option seriously.

Sunday, November 19, 2006

Personal Update

Regular readers of this blog will note that postings have become somewhat anemic lately. I have to apologize, because my commitment to investing and to this blog have not diminished, but available time has been hard to come by.

I am making some major changes in my life. I am leaving my nice job here in New Jersey working on strategic management in aftersales to increase my international exposure and earn an MBA at the University of St Gallen, one of the top-5 MBA programs in Europe. The school´s website is here. With this degree (and 12 months in Switzerland, which is going to be awesome in itself), I will look to join the ranks of the strategy consultants, hopefully with BCG. We shall see.

Actually, returning to school will probably help the quality of this blog. I will benefit from academic exposure and the time to think about ideas that school offers. The problem has been that I have been in the process of launching some new programs at work before I leave, and simultaneously moving to another country.

I will endeavor to post more in the next few weeks, before I head to Europe on the 6th of December, and thence to Thailand. Once that happens, on the 9th of December, there will likely be few posts until I get settled in Switzerland in the new year.


Nathan Mayer Rothschild, the oldest of the five Rothschild brothers who established the venerable commercial bank in the late eighteenth and early nineteenth centuries, is said to have remarked, "I never buy at the bottom and I always sell too soon." This sentiment is echoed by the American financier (I believe it was JP Morgan), who, when presented with an investment offering 100% returns, remarked, "Well, you can have the first 30% and the last 30% and I will just take the nice safe 40% in the middle." In other words, he wasn´t interested in buying before he was certain that the return would be positive.

I have recently read that the essence of investing is not managing returns, it´s managing risk. First you want to be reasonably sure of a positive return (capital preservation), only then do you want to consider the potential magnitude of the returns. Too many people look at the magnitude of returns first, and only then consider the probability of achieving these returns. This is why the lottery is so popular - it offers a huge return, for essentially nothing. Of course, most purchasers are simply incapable of appreciating the remoteness of the probability that their return will be positive. So they lose 100% every week, occasionally winning a minor pot of $5 or $10 to desensitize them to the dififculty of the odds they face.

This post isn´t about the lottery, however, it´s about TRLG. I mentioned in a prior post that I had left the temple of True Religion. Actually, I left a few weeks too early. I sold at $22.60 on a day when the high price for the day was §22.80. A few weeks later, the stock actually made new all-time highs in the $24.65 range. I lost out on an extra $800 by "selling too soon". But as my calculations from my DCF model suggested, the stock was near its highs at $22.60, and the probability of further gains were remote. Earnings would have to rise even faster than the 50% I projected for this year (35% for next), or operating margins would have to increase. While the first event was possible, I held out no expectations of the latter.

I work for a manufacturer. Like all companies with independent distribution, we regularly consider whether we wouldn´t be better off if we could capture more downstream revenue. Since pricing is usually based on cost-plus margining, capturing retail sales would significantly increase revenue, without actually capturing market share (we would benefit from selling at the retail price, which , for spare parts, is usually 65-100% greater than the wholesale price). The problem is that in order to do this, we would also have to absorb retail inventory, which would significantly increase working capital. We would also have to pay the expenses at retail that the distributors bear, personnel, rent and overhead. Worse, as a manufacturer, we would only really have one product line, whereas most distributors can amortize expenses over a wider product assortment available to them (since they can sell products from many manufacturers). This is essentially the difference between a specialty retailer and a department store. The department store also finds it easier to attract new customers, since it can easily cross-sell shoppers in the store for other promotions or products.

In fact, what we have begun to see from True Religion is that sales outside of the US are flagging, or at least, not increasing. Sales in the US are increasing, but primarily due to growth in the retail segment (i.e. the company is capturing that downstream revenue). However, this means that revenue is increasing faster than product volume, which raises serious questions about the acceptance of the brand on a broader scope. Worse, they are seeing increasing overhead, which management insists is required for future product introductions, but managing a retail chain is difficult. The company has brought in experience for this. The current management team has demonstrated success with retail, but what we are seeing is collapsing operating margins. For a company whose primary value is in future earnings, lower operating margins have to terrify investors.

In fact, while I was in Mexico on a business trip (I was in the buffett line at lunch actually), two other attendees started talking about the collapse of the stock price of TRLG, which has since declined to the mid $15 range. At this price, you might very well be able to round-trip the stock back up to $20, if management can find the new revenues to justify the ramp-up in expenses. But for the first time, management has failed to deliver the goods and so their ability to win converts on the street will come much harder.

At this point, I am sitting on lots and lots of cash. Buffett notes that this is no fun, and I concur, but at the same time, its better to sit on cash than watch your positions collapse. I am still looking for another investment that I find as attractive as TRLG. Right now, the only investment I consider worthwhile is BAC. I am even beginning to doubt the CL. Since I purchased in October 0f 2004, I have watched the stock price rise 50%, from $44 to $66, at the same time, I have earned nice dividends, which have been hiked twice, from 24 cents to 32 cents a share (for a 33%) increase over the same period. My shareholdings have increased by nearly four percent, giving me a total return of over 56% for the period (If you are wondering why my return isn´t 54%, the sum of the two, the reason is that the shares purchased from dividend reinvestment have also benefitted from rising prices, so my total return exceeds the price increase plus dividend payments).

Generally speaking, your return should reflect the dividend yield plus the rate of increase of dividends. (I have another post explaining why this is so, but essentially, with dividend paying stocks, prices tend to increase at the same rate as dividend increases). With CL price increases have outstripped dividend increases, so the dividend yield has fallen. This suggests lower returns going forward. Indeed, to return to the dividend rate of Oct 2004, when I purchased, dividends would have to increase about 17% or 5 cents per share, from here with no increase in the stock price. This would then offer a return of about 2.6% (the dividend yield at 37 cents per share, per quarter). Such a dividend increase is actually quite probable. The company tends to maintain a dividend payout ratio of around 50% of earnings, with much of the remaining money going to repurchase stock, both preferred and common. In the latest quarter the company earned $0.73 per share. With forward earnings expected to run about $0.80 per share per quarter the company could raise to 38-39 cents per share per quarter. Organic growth, plus benefits from the company´s restructuring make these very reasonable projections. But even with this strong dividend increase rate, the stock should have only moderate price appreciation. Of course, as I have suggested many times, I own the stock because it offers a reasonable return with a high degree of safety, but even stocks like KO can take big dives (granted, at its all-time high Coke was trading at a ridiculous 45 times earnings).

The real kicker with CL is that it trades at 27 times earnings, but that is before the stock is fully diluted. There are 39 million options on the stock. While repurchases are easily oustripping option issuance, redemptions and forfeits are reducing the overall stock of ourstanding options, but with all options exercised, the stock trades at over 30 times earnings. There have to be better options. Unfortunately I haven´t had the time to find them.