So what then would be a good hedge against inflation if Gold isn't quite doing the trick?
The second part of Mr Klarman's answer as to that question is real assets.
Let's examine what real assets are: Investopedia defines real assets as "Physical or identifiable assets such as land, equipment, patents, etc."
The only way one can gain ownership of many of these assets is through ownership of REITs or companies that use patents or manufacture equipment.
I submit to you that ownership of companies that own real assets is one way of combating the bit of inflation on your assets. This means not every company is going to benefit from inflation. Only the ones with real assets that can raise prices when inflation comes around.
The problem with most companies is that in an inflationary period, they raise their prices but they also suffer from increased costs. So at best, they can pass on their increased costs to their customers. Or they might not be able to pass on the full cost increase to their customers and it'll start to eat into their profit margin. That would really be bad. There's a good piece by Buffett on this issue.
So you're look for companies that really have pricing power, you'd be looking at monopolies, at companies selling commodities and at real estate related companies. Finally, inflation protected securities or inverse treasury ETFs.
The last two are a bit iffy. Simply 'coz Treasury Inflation Protected Securities (TIPS)'s yield is linked to the CPI index. The CPI index is a poor tracker of inflation because it doesn't have the price of oil in the index. Inverse Treasury ETFs are also difficult because the yields might not exactly match inflation.
So the time is now for us to starting hunting. I've defined the areas so we need to do our digging in those areas.
Thursday, October 1, 2009
Seth Klarman on Gold
My buddy goes to MIT's Sloan Business school to do his MBA. Somehow he is doing a class at Harvard and his professor got Seth Klarman to come in and talk to the class! That's awesome! I managed to ask my buddy to ask Mr Klarman a question.
Simply put:
Does he believe that Gold, even at today's high price, is a good hedge against inflation? If not, what would be a good hedge against inflation?
This is his reply: Mr Klarman said he does think is gold overvalued. He said the best long-run hedge against inflation is real assets.
I agree. I have a lot of difficulty valuing Gold. There's no long term predictable cash flow. There's no business prospects to evaluate. So how can I as an analyst figure out the long term price of gold?
What's the difference between gold and collecting art or wine then? One of the reasons why value investors don't buy art or wine is 'coz they don't have long term predictable streams of cash flow. Hence they can't be considered an investment.
There are 3 main uses of gold - jewelry, manufacturing and financial. The first 2 uses have seen dramatic drops in demand and they normally account for 2/3 of the total gold demand. Currently, what is driving the gold price is mainly financial. Financials can only sustain the gold price for so long. Once markets get back to normal, pp are going to want to go back into other assets, like stocks as their price goes up. That will probably lead to a decrease in the gold price. So the pp who bought it as a retention of real value, just found themselves buying gold at its peak, only to put their capital at risk of permanent loss.
The other thing is I don't quite like buying stuff when everyone else is buying it. Esp if I'm buying the stuff at a multi-year high. Call me a contrarian. But Gold is trading at a multi-year high. I'm not hot on following the crowd. 'coz you never know when the crowd will turn and leave you holding the ball.
Simply put:
Does he believe that Gold, even at today's high price, is a good hedge against inflation? If not, what would be a good hedge against inflation?
This is his reply: Mr Klarman said he does think is gold overvalued. He said the best long-run hedge against inflation is real assets.
I agree. I have a lot of difficulty valuing Gold. There's no long term predictable cash flow. There's no business prospects to evaluate. So how can I as an analyst figure out the long term price of gold?
What's the difference between gold and collecting art or wine then? One of the reasons why value investors don't buy art or wine is 'coz they don't have long term predictable streams of cash flow. Hence they can't be considered an investment.
There are 3 main uses of gold - jewelry, manufacturing and financial. The first 2 uses have seen dramatic drops in demand and they normally account for 2/3 of the total gold demand. Currently, what is driving the gold price is mainly financial. Financials can only sustain the gold price for so long. Once markets get back to normal, pp are going to want to go back into other assets, like stocks as their price goes up. That will probably lead to a decrease in the gold price. So the pp who bought it as a retention of real value, just found themselves buying gold at its peak, only to put their capital at risk of permanent loss.
The other thing is I don't quite like buying stuff when everyone else is buying it. Esp if I'm buying the stuff at a multi-year high. Call me a contrarian. But Gold is trading at a multi-year high. I'm not hot on following the crowd. 'coz you never know when the crowd will turn and leave you holding the ball.
Thursday, September 24, 2009
Acorn International Inc. (NASDAQ: ATV)
Well, Acorn International Inc (ATV) is another mainland chinese orphan stock. My main worry with these Mainland Chinese stocks is simple - Fraud. Is the cash really there? I've heard loads of horror stories about the Chinese and their companies. I just read David Einhorn's Fooling Some People All the Time. Which of course, doesn't engender much goodwill and warm feelings towards management and corporate governance. And I have personally found odd ball accounting practices with one mainland Chinese company (The9 Limited, NCTY). So my approach towards evaluating these stocks is one of skepticism and lots of research.
Acorn is a multi-platform marketing company in China. Basically, they are the equivalent of the Home Shopping Network in China. They sell everything from cell phones to slimming products through their various sales channels. These channels include TV, call centers and distributions to retail outlets.
The reason I'm interested in this company is simple. It's sitting on nearly $167MM worth of cash for a market cap of $117.15MM and notes payable of $3.3MM. Basically, it's selling for less than the cash on its books. Efficient market says that this should not be the case, but hey... don't look at me. It's there.
I'm looking through their income statements right now. For some odd reason SG&A is up quite a bit. Up 31% for the first 6 months of 2009 as compared to first 6 months of 2008. The reason given by the Company is: a 1 time charge of $1.6M for the Liaoning TV lawsuit and increases in salaries and benefits. Somehow I'm skeptical, why are salaries increasing at this point in time? The company lost money in 2008, 1Q 09 and 2Q 09. Why are salaries rising? Compare this to the behavior of the ACTS management who took a 20% cut to their salaries. Totally different approach to running a company.
Finally, the market in China for TV sales and other direct marketing techniques is very volatile. In the sense that the government has the ability and has intervened in the past to ban the sale of certain products. This has material impact on the revenues of the company. The gov banned the company from selling its branded neck massage product. This had a negative impact on the company's revenues.
All in all, ATV is starting to turn the company around but I'm not a big fan of the way the company is being run. Although it might be a viable investment from the stand point of the market cap being less than the cash position of the company, I am not comfortable with the industry or the management. I'm going to pass on this investment.
Acorn is a multi-platform marketing company in China. Basically, they are the equivalent of the Home Shopping Network in China. They sell everything from cell phones to slimming products through their various sales channels. These channels include TV, call centers and distributions to retail outlets.
The reason I'm interested in this company is simple. It's sitting on nearly $167MM worth of cash for a market cap of $117.15MM and notes payable of $3.3MM. Basically, it's selling for less than the cash on its books. Efficient market says that this should not be the case, but hey... don't look at me. It's there.
I'm looking through their income statements right now. For some odd reason SG&A is up quite a bit. Up 31% for the first 6 months of 2009 as compared to first 6 months of 2008. The reason given by the Company is: a 1 time charge of $1.6M for the Liaoning TV lawsuit and increases in salaries and benefits. Somehow I'm skeptical, why are salaries increasing at this point in time? The company lost money in 2008, 1Q 09 and 2Q 09. Why are salaries rising? Compare this to the behavior of the ACTS management who took a 20% cut to their salaries. Totally different approach to running a company.
Finally, the market in China for TV sales and other direct marketing techniques is very volatile. In the sense that the government has the ability and has intervened in the past to ban the sale of certain products. This has material impact on the revenues of the company. The gov banned the company from selling its branded neck massage product. This had a negative impact on the company's revenues.
All in all, ATV is starting to turn the company around but I'm not a big fan of the way the company is being run. Although it might be a viable investment from the stand point of the market cap being less than the cash position of the company, I am not comfortable with the industry or the management. I'm going to pass on this investment.
Actions Semiconductor Co Ltd (NASDAQ: ACTS)
I know I haven't been posting a lot. I've been doing a whole bunch of digging out there in the market place. I just liquidated half my portfolio to cash. 'coz I wasn't comfortable with current market levels. A lot of the big name stocks are floating around at 2006/07 valuations. Yes, the economy is improving. But does it really justify such lofty valuations? I don't think so.
Anyway, I decided that if the market isn't going to correct. I'm looking into plays that are less market dependent - Special Situations. Odd ball plays.
Actions Semiconductor Co Ltd is one such play. It currently trades for less than the cash value on its books. It has $235MM in cash. The market cap is $195.5MM. ACTS lost $2.3MM in the first 6 months of 2009, specifically $777k in 2Q09. I think they are slowly righting their ship. Losses aside, the company is still sitting on a large cash pile. I believe that this is a good opportunity to take advantage of this.
This is not a company that I'd invest in long term. The company manufactures chips for MP3 players, which are seeing heavy competition from mobile phones as alternative music listening devices. Most importantly, the company is seeing margin contractions that is common to the industry. In 2Q 2009, ACTS reported a gross margin of 27.7%. Their prospectus reports that in 2004 to 2005, their gross margins were above 40%. So we can see that they are getting squeezed here.
The one thing that really impressed me about these guys is that all the senior management VP level and above, department heads took a 20% pay cut. That reduced their SG&A significantly. Very impressive that the senior management bit the bullet. On top of that, the company increased R&D expenditure by hiring more staff and increasing their research budget. Now that's the proper way to run a business!
All in all, this is still a good company to invest for the short term reset of the price or for a one time special dividend.
Disclosure: Currently, I do not own ACTS stock. I may invest in the company in the future.
Anyway, I decided that if the market isn't going to correct. I'm looking into plays that are less market dependent - Special Situations. Odd ball plays.
Actions Semiconductor Co Ltd is one such play. It currently trades for less than the cash value on its books. It has $235MM in cash. The market cap is $195.5MM. ACTS lost $2.3MM in the first 6 months of 2009, specifically $777k in 2Q09. I think they are slowly righting their ship. Losses aside, the company is still sitting on a large cash pile. I believe that this is a good opportunity to take advantage of this.
This is not a company that I'd invest in long term. The company manufactures chips for MP3 players, which are seeing heavy competition from mobile phones as alternative music listening devices. Most importantly, the company is seeing margin contractions that is common to the industry. In 2Q 2009, ACTS reported a gross margin of 27.7%. Their prospectus reports that in 2004 to 2005, their gross margins were above 40%. So we can see that they are getting squeezed here.
The one thing that really impressed me about these guys is that all the senior management VP level and above, department heads took a 20% pay cut. That reduced their SG&A significantly. Very impressive that the senior management bit the bullet. On top of that, the company increased R&D expenditure by hiring more staff and increasing their research budget. Now that's the proper way to run a business!
All in all, this is still a good company to invest for the short term reset of the price or for a one time special dividend.
Disclosure: Currently, I do not own ACTS stock. I may invest in the company in the future.
Sunday, September 20, 2009
Overbought Market
Hi
Been following our recent rally. It looks and feels great to see my portfolio worth a lot more every time I look at it. Makes me want to look at it a lot more.
However, if you look at the PE ratio of the S&P 500, it's way over valued. 20+ times operating earnings. The historical average is 16. The full article can on the S&P PE valuation can be found here.
I've been keeping close watch on corporate insider sales over the last few months. Corp insider sales have outstripped buys by a lot. Insiders are selling in large amount way larger than insiders are buying. I don't have the figures as to how many times the insiders are selling over buying. But just read the insider trades page on Barrons and you'll see what I mean. It's been this way for a while.
These two key facts lead me to believe we are in an overbought market. It's simply too good to be true. It can't go on forever. I've started to move into cash.
Been following our recent rally. It looks and feels great to see my portfolio worth a lot more every time I look at it. Makes me want to look at it a lot more.
However, if you look at the PE ratio of the S&P 500, it's way over valued. 20+ times operating earnings. The historical average is 16. The full article can on the S&P PE valuation can be found here.
I've been keeping close watch on corporate insider sales over the last few months. Corp insider sales have outstripped buys by a lot. Insiders are selling in large amount way larger than insiders are buying. I don't have the figures as to how many times the insiders are selling over buying. But just read the insider trades page on Barrons and you'll see what I mean. It's been this way for a while.
These two key facts lead me to believe we are in an overbought market. It's simply too good to be true. It can't go on forever. I've started to move into cash.
Wednesday, September 9, 2009
Greif Inc (NYSE: GEF)
The word discipline and acquisitions rarely go together in this day and age.
Greif Inc (NYSE: GEF) is thus an oddity or a rarity rather. It has managed to be disciplined in its acquisitions. This is rare among companies. None of that one time big acquisition stuff. That doesn't work - many integration issues. GEF does its acquisitions small and frequently. It has a system called the Greif Business System to integrate and streamline all businesses that is acquires.
During financial year 2008, the Company completed acquisitions of four industrial packaging companies and one paper packaging company and made a contingent purchase price payment related to an acquisition from October 2005 for an aggregate purchase price of $90.3 million. During 2007, the Company completed seven acquisitions of industrial packaging companies for an aggregate purchase price of $346.4 million. These industrial packaging and paper packaging acquisitions are expected to complement the Company’s existing product lines that together will provide growth opportunities and scale.
The company has a policy of acquiring companies at a PE of 5 to 7 times earnings. It generally sticks to companies from 30M to 300M. It's current market cap is around $2.4B. It acquires companies to increase its product footprint in a given region.
Currently, trading at 26 times earnings, it is by no means cheap. I'm hoping for the market to turn, perhaps creating a buying opportunity.
Greif Inc (NYSE: GEF) is thus an oddity or a rarity rather. It has managed to be disciplined in its acquisitions. This is rare among companies. None of that one time big acquisition stuff. That doesn't work - many integration issues. GEF does its acquisitions small and frequently. It has a system called the Greif Business System to integrate and streamline all businesses that is acquires.
During financial year 2008, the Company completed acquisitions of four industrial packaging companies and one paper packaging company and made a contingent purchase price payment related to an acquisition from October 2005 for an aggregate purchase price of $90.3 million. During 2007, the Company completed seven acquisitions of industrial packaging companies for an aggregate purchase price of $346.4 million. These industrial packaging and paper packaging acquisitions are expected to complement the Company’s existing product lines that together will provide growth opportunities and scale.
The company has a policy of acquiring companies at a PE of 5 to 7 times earnings. It generally sticks to companies from 30M to 300M. It's current market cap is around $2.4B. It acquires companies to increase its product footprint in a given region.
Currently, trading at 26 times earnings, it is by no means cheap. I'm hoping for the market to turn, perhaps creating a buying opportunity.
Monday, September 7, 2009
The Art of Short Selling Chapter 2
Chapter 2 surveys the various hedge fund managers and what they look for in a short position.
Julian Robertson of Tiger Funds
Hallmarks:
1. Prodigious research
2. Bottoms-up Analytical methodology
3. A long-term time horizon
Robertson feels that short selling based on high valuation/ price alone is a bad idea. There must be a fundamental change in the outlook of the company or a major misconception by the stock-buying public.
Alex Porter of Porter, Felleman
Hallmarks:
Short positions reduce the risk to the portfolio of a long term market decline. The trick is to be short the stocks where financial accounting/ analysis shows that something is seriously wrong with the company.
1. Company based analysis
2. Management does not own much stock
3. Management is not realistic and forthcoming about their business
4. The company itself is over-leveraged or has a fatal balance-sheet issues.
Joe DiMenna of Zweig Funds
Hallmarks
Total short exposure is dictated by:
1. The number of attractive short-sale candidates their research uncovers
2. Net exposure to the market that their macro indicators suggests
5 types of short candidates
1. Frauds
2. Earnings disappointments
3. Hyped stocks where there are major holes in Wall Street's consensus expectations
4. Industry themes where macro-forces are negative
5. Deteriorating balance sheets
He generally won't short stocks with strong relative strength and earnings momentum solely on the basis of overvaluation.
Feshbachs
Hallmarks
They look for stocks with the following characteristics:
1. Stock prices overvalued by at least two times Feshbach-perceived valuation
2. A fundamental problem at the company
3. A weak financial condition
4. Weak or crooked management
The Feshbachs' hallmark is intense work and informational overkill. They start with fundamental analysis and add on information from a wide variety of sources. They don't short a stock unless they think it's going to drop in price by 50%. The reason is short selling is too risky for marginal plays.
The most difficult part of short selling is timing. They don't have an answer as to what is the optimal point to short a stock. They believe that one has to be certain of an important factor that other people do not see. Furthermore, the factor must affect the way the company is ultimately valued. One then has to see those mechanics begin to impact the income statement and the balance sheet, visualizing how the change evolves through the health of the company. Talking to competitors and suppliers reveals the climate and how long it might continue and gives insights into possible triggers. He cautions that the first position is not necessarily the biggest because stocks go up and you want to be able to average up.
Most importantly, you need to remain analytical when other people panic.
McBear
Hallmarks
1. Short ideas based on extensive credit work
2. Gathers important information by visiting companies. Feels Wall Street analysts are a poor conduit for company insights because they screen out relevant facts.
3. He feels that being a good listener asking thoughtful questions can learn critical facts about business trends.
4. The market is inefficient because there is always a bias to buy. Therein lies the opportunity for short sellers to make money.
Jim Chanos
Hallmarks
1. Chanos' specialty is solving complex financial puzzles.
2. Typically shorts large-cap financial companies with a high probability of bankruptcy.
3. Average holding period is 9 months.
4. No problems with buy-ins because of his use of large-cap stocks.
5. Does not visit companies and he uses Wall Street as a corporate emissary or interpreter.
6. Unique is his use of return on invested capital as a key financial indicator. The formula is: EBIT divided by average total capital (defined as total liabilities plus equity minus current liabilities plus short-term debt. In other words, the return on all interest-bearing liabilities plus equity plus deferred taxes and short-term debt.)
7. Financial companies are lucrative shorts because of the potential for rampant earnings manipulation.
My thoughts and Summary
In summary, I believe that on the short side, shorting requires more extensive and in-depth research. The refrain that one should not short a stock just based on valuation is heard over and over again. There must be major problems both on the operations side and on the financial side (over-leverage etc) of the company. Poor management is another requisite.
Julian Robertson of Tiger Funds
Hallmarks:
1. Prodigious research
2. Bottoms-up Analytical methodology
3. A long-term time horizon
Robertson feels that short selling based on high valuation/ price alone is a bad idea. There must be a fundamental change in the outlook of the company or a major misconception by the stock-buying public.
Alex Porter of Porter, Felleman
Hallmarks:
Short positions reduce the risk to the portfolio of a long term market decline. The trick is to be short the stocks where financial accounting/ analysis shows that something is seriously wrong with the company.
1. Company based analysis
2. Management does not own much stock
3. Management is not realistic and forthcoming about their business
4. The company itself is over-leveraged or has a fatal balance-sheet issues.
Joe DiMenna of Zweig Funds
Hallmarks
Total short exposure is dictated by:
1. The number of attractive short-sale candidates their research uncovers
2. Net exposure to the market that their macro indicators suggests
5 types of short candidates
1. Frauds
2. Earnings disappointments
3. Hyped stocks where there are major holes in Wall Street's consensus expectations
4. Industry themes where macro-forces are negative
5. Deteriorating balance sheets
He generally won't short stocks with strong relative strength and earnings momentum solely on the basis of overvaluation.
Feshbachs
Hallmarks
They look for stocks with the following characteristics:
1. Stock prices overvalued by at least two times Feshbach-perceived valuation
2. A fundamental problem at the company
3. A weak financial condition
4. Weak or crooked management
The Feshbachs' hallmark is intense work and informational overkill. They start with fundamental analysis and add on information from a wide variety of sources. They don't short a stock unless they think it's going to drop in price by 50%. The reason is short selling is too risky for marginal plays.
The most difficult part of short selling is timing. They don't have an answer as to what is the optimal point to short a stock. They believe that one has to be certain of an important factor that other people do not see. Furthermore, the factor must affect the way the company is ultimately valued. One then has to see those mechanics begin to impact the income statement and the balance sheet, visualizing how the change evolves through the health of the company. Talking to competitors and suppliers reveals the climate and how long it might continue and gives insights into possible triggers. He cautions that the first position is not necessarily the biggest because stocks go up and you want to be able to average up.
Most importantly, you need to remain analytical when other people panic.
McBear
Hallmarks
1. Short ideas based on extensive credit work
2. Gathers important information by visiting companies. Feels Wall Street analysts are a poor conduit for company insights because they screen out relevant facts.
3. He feels that being a good listener asking thoughtful questions can learn critical facts about business trends.
4. The market is inefficient because there is always a bias to buy. Therein lies the opportunity for short sellers to make money.
Jim Chanos
Hallmarks
1. Chanos' specialty is solving complex financial puzzles.
2. Typically shorts large-cap financial companies with a high probability of bankruptcy.
3. Average holding period is 9 months.
4. No problems with buy-ins because of his use of large-cap stocks.
5. Does not visit companies and he uses Wall Street as a corporate emissary or interpreter.
6. Unique is his use of return on invested capital as a key financial indicator. The formula is: EBIT divided by average total capital (defined as total liabilities plus equity minus current liabilities plus short-term debt. In other words, the return on all interest-bearing liabilities plus equity plus deferred taxes and short-term debt.)
7. Financial companies are lucrative shorts because of the potential for rampant earnings manipulation.
My thoughts and Summary
In summary, I believe that on the short side, shorting requires more extensive and in-depth research. The refrain that one should not short a stock just based on valuation is heard over and over again. There must be major problems both on the operations side and on the financial side (over-leverage etc) of the company. Poor management is another requisite.
Market Rally
Hi Sorry for the long delay in posts. I was on a 2 week vacation in Aug.
It's been a week since I've come back from vacation and I've been looking. Hunting for good companies to buy at cheap prices. But to no avail. I can't seem to find companies that satisfy that criteria. It's kinda frustrating.
There are quite a few companies trading at really low price to book ratios like Seahawk Drilling Inc. (NASDAQ: HAWK). But after a lot of research, I find that there is a reason they are trading that way. The industries they are in face serious challenges and their assets might not be that valuable. Seahawk has a price to book of 0.5. But 10 out of 20 of their jack up oil rigs do not fit the depth specifications required by their largest client, PEMEX. And the average age of their rigs is 28 years old.
Sorry to sound so pessimistic but I really feel that this rally is starting to over price stocks for their current economic fundamentals.
I've been reading that quite a few hedge fund managers are rather pessimistic at this as well. For example Paul Tudor Jones.
As for now, I'm going to keep looking but maybe not buy anything yet.
It's been a week since I've come back from vacation and I've been looking. Hunting for good companies to buy at cheap prices. But to no avail. I can't seem to find companies that satisfy that criteria. It's kinda frustrating.
There are quite a few companies trading at really low price to book ratios like Seahawk Drilling Inc. (NASDAQ: HAWK). But after a lot of research, I find that there is a reason they are trading that way. The industries they are in face serious challenges and their assets might not be that valuable. Seahawk has a price to book of 0.5. But 10 out of 20 of their jack up oil rigs do not fit the depth specifications required by their largest client, PEMEX. And the average age of their rigs is 28 years old.
Sorry to sound so pessimistic but I really feel that this rally is starting to over price stocks for their current economic fundamentals.
I've been reading that quite a few hedge fund managers are rather pessimistic at this as well. For example Paul Tudor Jones.
As for now, I'm going to keep looking but maybe not buy anything yet.
Thursday, August 13, 2009
Pair Trade: Retail Ventures Inc and DSW Inc
Hi, I was over at a value investing blog - Barel Kasan and saw that he posted this pair trade. I dug more into it. I thought it'd be an interesting opportunity for us to analyze an arbitrage play.
Investment Thesis
As of May 2, 2009, Retail Ventures (RVI) owns Class B Common Shares of DSW representing approximately 62.9% of DSW’s outstanding common shares and approximately 93.1% of the combined voting power of such shares. DSW currently trades at $12.91 with a market cap of 565.64M (as of market close Aug 10). Therefore RVI's stake should be worth 355.79M.
RVI is currently trading at $3.38 (as of market close Aug 10). RVI's market cap is $165.39M. RVI's book value as of May 2nd, 2009 was $363.1M. The thesis is that there is an arbitrage opportunity since RVI should not trade below its DSW stake. The difference is quite significant and the thinking is that we could take advantage of it.
RVI is basically a holding company. It doesn't have any operating segments. Its main asset is the 62.9% of DSW common shares that it owns, the $103.3M in cash, $10.3M in restricted cash and $81.4M in short-term investments.
RVI does have $128.1M in long-term obligations and $100.4M in Other non-current liabilities. The $128.1M consists entirely of Premium Income Exchangeable Securities (PIES). PIES are a structured product. The total principal amount of PIES is $143.75M. The PIES bear a coupon at an annual rate of 6.625% of the principal amount and mature on Sept 15th, 2011. Except to the extent RVI exercises its cash settlement option, the PIES are mandatorily exchangeable on the maturity date, into Class A common shares of DSW, no par value per share, which are issuable upon exchange of DSW Class B common shares, no par value per share, beneficially owned by RVI. On the maturity date, each holder of the PIES will receive a number of DSW Class A common Shares per $50.00 principal amount of PIES equal to the "exchange ratio" or if RVI elects, the cash equivalent thereof or a combination of cash and DSW Class A Common Shares.
The exchange ratio is equal to the number of DSW Class A Common Shares determined as follows:
(i) if the applicable market value of DSW Class A Common Shares equals or exceeds $34.95, the exchange ratio will be 1.4306 shares;
(ii) if the applicable market value of DSW Class A Common Shares is less than $34.95 but greater than $27.41, the exchange ratio will be between 1.4306 and 1.8242 shares; and
(iii) if the applicable market value of DSW Class A Common Shares is less than or equal to $27.41, the exchange ratio will be 1.8242 shares, subject to adjustment as provided in the PIES.
The maximum aggregate number of DSW Class A Common Shares deliverable upon exchange of the PIES is 5,244,575 DSW Class A Common Shares, subject to adjustment as provided in the PIES.
DSW is a leading U.S. specialty branded footwear retailer. It was wholly owned by RVI. DSW had its initial public offering on July 5, 2005. DSW operates 303 shoe stores in 38 US states as of May 2, 2009. DSW offers a wide selection of better-brand dress, casual and athletic footwear for women and men, as well as accessories. DSW also operates 365 leased shoe departments for four other retailers and sell shoes and accessories through dsw.com.
At first glance, this looks like a straight forward arbitrage play. 2 companies, 1 owns a large chunk of the other but is selling at a large discount to its stake. This time round the PIES structured product messes around with the play.
The reason is simple. The debt can be paid back in DSW shares (ie there is a convertible feature). This lessens the value of RIV's stake in DSW and changes the valuation of RIV's stake in DSW. So the effect of the PIES is to put in doubt the actual value of RVI's 62.9% stake in DSW. We know it's less 'coz RVI might elect to pay the principal amount of debt ($143.75M in DSW shares). In fact, if RVI paid back in DSW shares right now, it'll probably only have to pay out the maximum amount of shares (5.244M shares) which is only worth $67.7M right now. The more shares RVI pays out to the PIES holders, the less the difference in the value of the arbitrage. This means you take off $67.7M from the value of RVI's stake, this leaves RVI's holdings in DSW at $288.09M. It also means that the difference in RVI's value and its DSW stake decreases by $67.7M as well ($122.7M left in the arbitrage amount).
Then you need to account for the conversion feature of the PIES, 'coz that's worth something. Right now, it approximately stands at $76.05M (I treat it as a deep in the money option, so it's just the difference between the principal amount of debt and the value of the shares paid out). That leaves $46.65M in the arbitrage amount.
Having said all the above, $46.65M is only 28% of RVI's market cap. I don't think there's a sufficient margin of safety to do this trade.
Investment Thesis
As of May 2, 2009, Retail Ventures (RVI) owns Class B Common Shares of DSW representing approximately 62.9% of DSW’s outstanding common shares and approximately 93.1% of the combined voting power of such shares. DSW currently trades at $12.91 with a market cap of 565.64M (as of market close Aug 10). Therefore RVI's stake should be worth 355.79M.
RVI is currently trading at $3.38 (as of market close Aug 10). RVI's market cap is $165.39M. RVI's book value as of May 2nd, 2009 was $363.1M. The thesis is that there is an arbitrage opportunity since RVI should not trade below its DSW stake. The difference is quite significant and the thinking is that we could take advantage of it.
RVI is basically a holding company. It doesn't have any operating segments. Its main asset is the 62.9% of DSW common shares that it owns, the $103.3M in cash, $10.3M in restricted cash and $81.4M in short-term investments.
RVI does have $128.1M in long-term obligations and $100.4M in Other non-current liabilities. The $128.1M consists entirely of Premium Income Exchangeable Securities (PIES). PIES are a structured product. The total principal amount of PIES is $143.75M. The PIES bear a coupon at an annual rate of 6.625% of the principal amount and mature on Sept 15th, 2011. Except to the extent RVI exercises its cash settlement option, the PIES are mandatorily exchangeable on the maturity date, into Class A common shares of DSW, no par value per share, which are issuable upon exchange of DSW Class B common shares, no par value per share, beneficially owned by RVI. On the maturity date, each holder of the PIES will receive a number of DSW Class A common Shares per $50.00 principal amount of PIES equal to the "exchange ratio" or if RVI elects, the cash equivalent thereof or a combination of cash and DSW Class A Common Shares.
The exchange ratio is equal to the number of DSW Class A Common Shares determined as follows:
(i) if the applicable market value of DSW Class A Common Shares equals or exceeds $34.95, the exchange ratio will be 1.4306 shares;
(ii) if the applicable market value of DSW Class A Common Shares is less than $34.95 but greater than $27.41, the exchange ratio will be between 1.4306 and 1.8242 shares; and
(iii) if the applicable market value of DSW Class A Common Shares is less than or equal to $27.41, the exchange ratio will be 1.8242 shares, subject to adjustment as provided in the PIES.
The maximum aggregate number of DSW Class A Common Shares deliverable upon exchange of the PIES is 5,244,575 DSW Class A Common Shares, subject to adjustment as provided in the PIES.
DSW is a leading U.S. specialty branded footwear retailer. It was wholly owned by RVI. DSW had its initial public offering on July 5, 2005. DSW operates 303 shoe stores in 38 US states as of May 2, 2009. DSW offers a wide selection of better-brand dress, casual and athletic footwear for women and men, as well as accessories. DSW also operates 365 leased shoe departments for four other retailers and sell shoes and accessories through dsw.com.
At first glance, this looks like a straight forward arbitrage play. 2 companies, 1 owns a large chunk of the other but is selling at a large discount to its stake. This time round the PIES structured product messes around with the play.
The reason is simple. The debt can be paid back in DSW shares (ie there is a convertible feature). This lessens the value of RIV's stake in DSW and changes the valuation of RIV's stake in DSW. So the effect of the PIES is to put in doubt the actual value of RVI's 62.9% stake in DSW. We know it's less 'coz RVI might elect to pay the principal amount of debt ($143.75M in DSW shares). In fact, if RVI paid back in DSW shares right now, it'll probably only have to pay out the maximum amount of shares (5.244M shares) which is only worth $67.7M right now. The more shares RVI pays out to the PIES holders, the less the difference in the value of the arbitrage. This means you take off $67.7M from the value of RVI's stake, this leaves RVI's holdings in DSW at $288.09M. It also means that the difference in RVI's value and its DSW stake decreases by $67.7M as well ($122.7M left in the arbitrage amount).
Then you need to account for the conversion feature of the PIES, 'coz that's worth something. Right now, it approximately stands at $76.05M (I treat it as a deep in the money option, so it's just the difference between the principal amount of debt and the value of the shares paid out). That leaves $46.65M in the arbitrage amount.
Having said all the above, $46.65M is only 28% of RVI's market cap. I don't think there's a sufficient margin of safety to do this trade.
Wednesday, August 12, 2009
Paul Tudor Jones on Bear Market Rally
I was over at the Pragmatic Capitalist (http://pragcap.com/) and read this really interesting piece. Thought I'd share it with you too.
As put forward in our last correspondence of late April, global growth performance is turning out to be better than markets and the consensus expected just a few short months ago. The large negative overshooting in economic activity over the turn of the year is now poised to be reversed in a V-shape type of recovery—although with such V stabilizing below pre-crisis levels of trend growth—led by an inventory rebound and the impact of the massive stimulus implemented by global policy makers.
Policy initiatives targeted at eliminating tail risks have successfully reduced risk aversion and risky assets have rallied almost across the board, reversing some of the large wealth losses suffered by global consumers. To be sure, many doubts remain about the sustainability of this recovery, most prominently the weakness of household income growth, and the damage inflicted by the crisis to potential growth in many countries will likely deliver a recovery that will look subdued by the standards of the past decade.
High and persistent levels of unemployment in an environment of very large fiscal deficits will greatly complicate policy making. In fact, as tail risk has diminished significantly, policy makers have started to focus on exit strategies, with sometimes premature and excessive impetus. The lack of understanding by both markets and policy makers of the impact of the mix of large fiscal deficits and quantitative easing policies has increased volatility and generated fears of uncontrolled inflation. In addition, fears of debt monetization have sharply increased central banks’ caution with quantitative easing actions. As a result, despite having some further room to ease, the main central banks have moved into a wait-and-see stance. The Fed is very unlikely to increase its purchases of Treasuries, though it will likely keep rates on hold at 0.25 percent until at least the summer of 2010. The ECB will very likely keep policy rates at 1 percent for a long time while allowing money market rates to remain lower with the effect of engineering looser financial conditions for as long as needed. The BoJ has successfully implemented many credit market initiatives, but is unlikely to increase its Rinban purchases despite surging JGB supply. The complex combination of decelerating inflation, very low short-term rates, rising fiscal deficits, and marginally hawkish central banks will pose a challenge for fixed income markets, as we discuss below.
Overall, the period of fiscal and monetary polices pushing in the same direction is over, and policy makers are starting to weigh the costs and benefits of erring on the side of caution. Even the Chinese authorities are starting to show some policy restraint, after two quarters of very rapid credit growth. Some critical initiatives, mostly related to financial sector restructuring, have been cut short as polls show negative voter sentiment toward active government intervention. As a result, toxic assets remain on balance sheets and credit growth will likely be subdued for a long period of time. Policy stimulus will peak around Q1 2010, and many liquidity facilities and credit guarantees will likely be discontinued around that time; at that point, markets will have to assess the sustainability of growth. Despite the current inflation fear, a deflation scare—driven by the medley of low core inflation, high output gaps, high unemployment rates and very weak wage growth—can’t be ruled out in 2010. But, until then, the return of positive rates of economic growth will likely sustain stock prices and generate a constructive environment for risky assets.
Bond Markets.
The unprecedented financial crisis we have witnessed in the last 12 months has lead to equally unusual fiscal and policy measures. The authorities’ response to the crisis was broad in scope and large in magnitude, such outsized measures aimed at slaying the debt deflation monster perceived to be lurking in the background. We are now pretty much in uncharted territory, since the precedents for these policy responses are very few and far between (especially for industrialized countries). As a result, the implications of these policy measures for inflation, real interest rates and the shape of the yield curve are particularly challenging.
Looking hard for guideposts to help us navigate the fixed income markets, we are focusing on three key themes, namely: the potential inflationary consequences of the explosive growth of the monetary base; the lingering deficit implications of expansionary fiscal policies; and the dampening effect of credit contraction on growth prospects. The inflationary risk would materialize if the seemingly bottomless demand for money became satiated and began to decline. If the monetary authorities were perceived not to be sufficiently quick to drain the excess liquidity in the system, the spillover effect on prices could be substantial. Fixed income markets would come under pressure, in this scenario, as investors would demand an inflation premium to hold nominal assets.
In a similar vein, the fiscal expansions engineered in most regions of the world to counter the drop in private sector demand has left a trail of funding requirements that will stay with us for several years. The resulting supply of government bonds is on the rise globally, and investors may demand a price concession (i.e. higher yields) in order to absorb it.
These bearish fixed income risks, however, could well be swamped by weak consumer spending, a relapse in investment activity (post-inventory re-build) and weak external demand facing the major industrialized countries. This scenario could be underpinned by the reluctance on the part of financial institutions to extend credit, the desire on the part of consumer and businesses to repair their balance sheets, and the protectionist tendencies that emerge internationally during periods of financial strain. The resulting increase in savings, and potential widening output gap, could well offset the negative forces mentioned earlier and lead investors to seek refuge in fixed income assets.
We would expect these opposing forces to ebb and flow over the next few months, as market participants, as well as policy makers, read the tea leaves of economic data as they emerge in the aftermath of this very unusual period. Bond markets will react accordingly, but probably remain range-bound between now and the rest of the year. Excessive rate moves in either direction will raise increasingly greater doubts about their sustainability, given the mixed signals we expect going forward. The trend, for now, need not be a friend. A resolution of this impasse may not come for several months, and until then, our positions in fixed income markets will be more tactical than strategic.
Currencies.
Last quarter saw market participants embrace risk assets, thus lifting commodity linked currencies and broadly weighing on the US dollar. The path ahead for the US dollar will hinge on reserve accumulation and diversification by surplus countries. As global trade and risk allocations recover, reserve accumulation will prompt diversification into euros, pounds and, to a lesser extent, yen and the Australian and Canadian dollars. Reserve accumulation and diversification trends will be persistent and mutually reinforcing with the direction of the US dollar. The weaker the US dollar the more likely reserve managers are to diversify into the above currencies. The US dollar will have bouts of strength that will surprise markets—for example, the US dollar typically is supported at the close of economic recessions—but it should nonetheless end the year lower than now and the correlation between risk assets and currencies will remain high.
A key question for the Australian dollar, as well as for other commodity currencies, is, “How long will China add raw materials and can usage keep pace with inventory?” China went on a commodity spending spree during the first half of the year as it built inventories and bought controlling interests in mining and other resource corporations. We expect there to be little let-up in Chinese stimulus through year-end which will keep the currency bid. The RBA has been very effective easing financial conditions and likely will be the first G10 bank to shift to a hiking bias, which is also supportive of the Australian currency, in addition to a current strong M&A pipeline.
Yen strength versus the US dollar has surprised many market participants. The cross will continue to present two-way risk. Further yen gains will depend on Japan’s return to trade surplus, corporate earnings repatriation under the Japan HIA tax provision and foreign buying of Japanese equities. Yen depreciation pressures will depend on Japanese domestic demand for high yielding FX denominated investment vehicles. The Japanese domestic sector has been slow to embrace a risk seeking environment but we believe that Q4 may see an increase in these outflows.
Emerging market commodity currencies with solid public sector balance sheets will continue to appreciate over the medium-term.
Equities.
At a gain of over 45% in less than 100 trading days we ask, “Is this a new bull market, or only a bear market rally?” The question is largely irrelevant from a trader’s perspective but we will offer a view: bear market rally. Back at the lows there had been such a large risk premium built into equities, along with a concomitantly large short/underweight position, that when the extreme tail risks were avoided, a rally for the ages resulted. As we previously have written, however, impressive counter-trend rallies are a feature, not an oddity, of secular bear markets. It is tempting to get overly influenced by the percentage change metric, but all moves must be taken in the context of the broader volatility regime within which they occur. Stating the obvious, the last year has been a period of record volatility. While 45% is nothing to ignore, one should take into account that the S&P through July 31 is still down more than 20% on a price basis year-over-year. The bottom line is that we are not inclined to aggressively chase the market here. Rather, we eye a better opportunity to be long equities into year-end on a potential autumnal pullback.
As outlined above, the macro risks are becoming increasingly two-sided. After a period where fiscal and monetary policies neatly aligned globally, they will start to become discordant. While there is no expectation that any central bank of note will actually raise rates this year or perhaps even early next, the fact that “exit strategy” has entered the lexicon is probably worth an incremental notch higher in the risk premium. We are certainly not alone in remembering the catastrophic misstep by the Bank of Japan when its officials attempted to raise rates in August 2000. The ECB last summer serves as more recent reminder of how equity markets treat policy mistakes—none too kindly. Sentiment toward the asset class is improving by the day but it would be a mistake to confuse momentum for resolve. Investor psyche is still fragile. The inevitable slowing of China (the second derivative argument cuts both ways), and the return of swine flu headlines as a front-page topic are further catalysts for global equity markets to pause in September.
Regionally, we are intrigued by Japan. It appears to be the developed equity market in which investors remain the most underweight, and we believe the upcoming Lower House election, which should lead to the LDP losing control for one of the few times in the last 54 years, likely will lead to a considerable closing of this underweight positioning between now and year-end. We are also willing to retain some long beta exposure via emerging markets. Europe and the UK offer more at the moment to distinguish themselves positively from the S&P but come with greater risk from new equity capital raisings, particularly in Europe.
In summary, as impressive as recent price action has been, we do not see the current reward/risk profile for new longs here as compelling. Macro risks are an underpriced consideration and seasonal influences should combine to weigh on the market near-term. Once these play out by mid-fall, the stage should be set for another run of meaningful size into year-end. We will seek our entry point to participate in such rally as autumn unfolds. Ultimately, however, we likely will find even such year-end upswing to have been yet another bear market rally, with markets retracing next year.
As put forward in our last correspondence of late April, global growth performance is turning out to be better than markets and the consensus expected just a few short months ago. The large negative overshooting in economic activity over the turn of the year is now poised to be reversed in a V-shape type of recovery—although with such V stabilizing below pre-crisis levels of trend growth—led by an inventory rebound and the impact of the massive stimulus implemented by global policy makers.
Policy initiatives targeted at eliminating tail risks have successfully reduced risk aversion and risky assets have rallied almost across the board, reversing some of the large wealth losses suffered by global consumers. To be sure, many doubts remain about the sustainability of this recovery, most prominently the weakness of household income growth, and the damage inflicted by the crisis to potential growth in many countries will likely deliver a recovery that will look subdued by the standards of the past decade.
High and persistent levels of unemployment in an environment of very large fiscal deficits will greatly complicate policy making. In fact, as tail risk has diminished significantly, policy makers have started to focus on exit strategies, with sometimes premature and excessive impetus. The lack of understanding by both markets and policy makers of the impact of the mix of large fiscal deficits and quantitative easing policies has increased volatility and generated fears of uncontrolled inflation. In addition, fears of debt monetization have sharply increased central banks’ caution with quantitative easing actions. As a result, despite having some further room to ease, the main central banks have moved into a wait-and-see stance. The Fed is very unlikely to increase its purchases of Treasuries, though it will likely keep rates on hold at 0.25 percent until at least the summer of 2010. The ECB will very likely keep policy rates at 1 percent for a long time while allowing money market rates to remain lower with the effect of engineering looser financial conditions for as long as needed. The BoJ has successfully implemented many credit market initiatives, but is unlikely to increase its Rinban purchases despite surging JGB supply. The complex combination of decelerating inflation, very low short-term rates, rising fiscal deficits, and marginally hawkish central banks will pose a challenge for fixed income markets, as we discuss below.
Overall, the period of fiscal and monetary polices pushing in the same direction is over, and policy makers are starting to weigh the costs and benefits of erring on the side of caution. Even the Chinese authorities are starting to show some policy restraint, after two quarters of very rapid credit growth. Some critical initiatives, mostly related to financial sector restructuring, have been cut short as polls show negative voter sentiment toward active government intervention. As a result, toxic assets remain on balance sheets and credit growth will likely be subdued for a long period of time. Policy stimulus will peak around Q1 2010, and many liquidity facilities and credit guarantees will likely be discontinued around that time; at that point, markets will have to assess the sustainability of growth. Despite the current inflation fear, a deflation scare—driven by the medley of low core inflation, high output gaps, high unemployment rates and very weak wage growth—can’t be ruled out in 2010. But, until then, the return of positive rates of economic growth will likely sustain stock prices and generate a constructive environment for risky assets.
Bond Markets.
The unprecedented financial crisis we have witnessed in the last 12 months has lead to equally unusual fiscal and policy measures. The authorities’ response to the crisis was broad in scope and large in magnitude, such outsized measures aimed at slaying the debt deflation monster perceived to be lurking in the background. We are now pretty much in uncharted territory, since the precedents for these policy responses are very few and far between (especially for industrialized countries). As a result, the implications of these policy measures for inflation, real interest rates and the shape of the yield curve are particularly challenging.
Looking hard for guideposts to help us navigate the fixed income markets, we are focusing on three key themes, namely: the potential inflationary consequences of the explosive growth of the monetary base; the lingering deficit implications of expansionary fiscal policies; and the dampening effect of credit contraction on growth prospects. The inflationary risk would materialize if the seemingly bottomless demand for money became satiated and began to decline. If the monetary authorities were perceived not to be sufficiently quick to drain the excess liquidity in the system, the spillover effect on prices could be substantial. Fixed income markets would come under pressure, in this scenario, as investors would demand an inflation premium to hold nominal assets.
In a similar vein, the fiscal expansions engineered in most regions of the world to counter the drop in private sector demand has left a trail of funding requirements that will stay with us for several years. The resulting supply of government bonds is on the rise globally, and investors may demand a price concession (i.e. higher yields) in order to absorb it.
These bearish fixed income risks, however, could well be swamped by weak consumer spending, a relapse in investment activity (post-inventory re-build) and weak external demand facing the major industrialized countries. This scenario could be underpinned by the reluctance on the part of financial institutions to extend credit, the desire on the part of consumer and businesses to repair their balance sheets, and the protectionist tendencies that emerge internationally during periods of financial strain. The resulting increase in savings, and potential widening output gap, could well offset the negative forces mentioned earlier and lead investors to seek refuge in fixed income assets.
We would expect these opposing forces to ebb and flow over the next few months, as market participants, as well as policy makers, read the tea leaves of economic data as they emerge in the aftermath of this very unusual period. Bond markets will react accordingly, but probably remain range-bound between now and the rest of the year. Excessive rate moves in either direction will raise increasingly greater doubts about their sustainability, given the mixed signals we expect going forward. The trend, for now, need not be a friend. A resolution of this impasse may not come for several months, and until then, our positions in fixed income markets will be more tactical than strategic.
Currencies.
Last quarter saw market participants embrace risk assets, thus lifting commodity linked currencies and broadly weighing on the US dollar. The path ahead for the US dollar will hinge on reserve accumulation and diversification by surplus countries. As global trade and risk allocations recover, reserve accumulation will prompt diversification into euros, pounds and, to a lesser extent, yen and the Australian and Canadian dollars. Reserve accumulation and diversification trends will be persistent and mutually reinforcing with the direction of the US dollar. The weaker the US dollar the more likely reserve managers are to diversify into the above currencies. The US dollar will have bouts of strength that will surprise markets—for example, the US dollar typically is supported at the close of economic recessions—but it should nonetheless end the year lower than now and the correlation between risk assets and currencies will remain high.
A key question for the Australian dollar, as well as for other commodity currencies, is, “How long will China add raw materials and can usage keep pace with inventory?” China went on a commodity spending spree during the first half of the year as it built inventories and bought controlling interests in mining and other resource corporations. We expect there to be little let-up in Chinese stimulus through year-end which will keep the currency bid. The RBA has been very effective easing financial conditions and likely will be the first G10 bank to shift to a hiking bias, which is also supportive of the Australian currency, in addition to a current strong M&A pipeline.
Yen strength versus the US dollar has surprised many market participants. The cross will continue to present two-way risk. Further yen gains will depend on Japan’s return to trade surplus, corporate earnings repatriation under the Japan HIA tax provision and foreign buying of Japanese equities. Yen depreciation pressures will depend on Japanese domestic demand for high yielding FX denominated investment vehicles. The Japanese domestic sector has been slow to embrace a risk seeking environment but we believe that Q4 may see an increase in these outflows.
Emerging market commodity currencies with solid public sector balance sheets will continue to appreciate over the medium-term.
Equities.
At a gain of over 45% in less than 100 trading days we ask, “Is this a new bull market, or only a bear market rally?” The question is largely irrelevant from a trader’s perspective but we will offer a view: bear market rally. Back at the lows there had been such a large risk premium built into equities, along with a concomitantly large short/underweight position, that when the extreme tail risks were avoided, a rally for the ages resulted. As we previously have written, however, impressive counter-trend rallies are a feature, not an oddity, of secular bear markets. It is tempting to get overly influenced by the percentage change metric, but all moves must be taken in the context of the broader volatility regime within which they occur. Stating the obvious, the last year has been a period of record volatility. While 45% is nothing to ignore, one should take into account that the S&P through July 31 is still down more than 20% on a price basis year-over-year. The bottom line is that we are not inclined to aggressively chase the market here. Rather, we eye a better opportunity to be long equities into year-end on a potential autumnal pullback.
As outlined above, the macro risks are becoming increasingly two-sided. After a period where fiscal and monetary policies neatly aligned globally, they will start to become discordant. While there is no expectation that any central bank of note will actually raise rates this year or perhaps even early next, the fact that “exit strategy” has entered the lexicon is probably worth an incremental notch higher in the risk premium. We are certainly not alone in remembering the catastrophic misstep by the Bank of Japan when its officials attempted to raise rates in August 2000. The ECB last summer serves as more recent reminder of how equity markets treat policy mistakes—none too kindly. Sentiment toward the asset class is improving by the day but it would be a mistake to confuse momentum for resolve. Investor psyche is still fragile. The inevitable slowing of China (the second derivative argument cuts both ways), and the return of swine flu headlines as a front-page topic are further catalysts for global equity markets to pause in September.
Regionally, we are intrigued by Japan. It appears to be the developed equity market in which investors remain the most underweight, and we believe the upcoming Lower House election, which should lead to the LDP losing control for one of the few times in the last 54 years, likely will lead to a considerable closing of this underweight positioning between now and year-end. We are also willing to retain some long beta exposure via emerging markets. Europe and the UK offer more at the moment to distinguish themselves positively from the S&P but come with greater risk from new equity capital raisings, particularly in Europe.
In summary, as impressive as recent price action has been, we do not see the current reward/risk profile for new longs here as compelling. Macro risks are an underpriced consideration and seasonal influences should combine to weigh on the market near-term. Once these play out by mid-fall, the stage should be set for another run of meaningful size into year-end. We will seek our entry point to participate in such rally as autumn unfolds. Ultimately, however, we likely will find even such year-end upswing to have been yet another bear market rally, with markets retracing next year.
Tuesday, August 11, 2009
The Art of Short Selling by Kathryn Staley
Hi,
I've been reading a book called The Art of Short Selling by Kathryn Staley. I think she does a wonderful job of explaining how to go about finding and researching short selling. So I thought that over the next few weeks, I'd summarize the various chapters and share it with my readers.
Chapter 1
Just so we are all clear - Short selling is selling a security that the seller does not own but promises to deliver by borrowing it from someone else, in order to profit from the subsequent price drop.
What sorts of companies are short sellers looking for?
1. Companies whose management lie to investors and obscures events that will affect earnings.
2. Companies with over-inflated stock prices
3. External events that have a negative impact on companies
The only way to find these companies is to read extensively (WSJ, Barrons, various trade publications, SEC filings etc), talk to people in the industry.
The process of researching a short sale has 6 steps:
1. Analysis of the company's financials - cash flow statements, breakdown of its balance sheets and the quality of the earnings.
2. Track insider trading activities and management's salaries through their Form 4s, Sch 13D and DEF 14A filings. Importantly, try to understand how the management views its shareholders. Are they shareholder value driven or are they in it for themselves?
3. Check the company's business strategy execution. Does it run its business well? How does the company stack up against its competitors?
4. Follow the stock's trading patterns, short interest, 13D filings by institutional shareholders.
5. Read anything to determine the consensus.
6. Watch the company over time to see what happens, how earnings and price progresses and what changes.
Risks of short selling:
1. The price moves up after the stock is sold, requiring more cash infusions into the account.
2. Or the lender demands the return of the stock. If the broker cannot find another position to loan to the short seller, the customer will be forced to buy it at the current market price. This is called a buy-in. To avoid the risk of buy-ins, some short sellers only short large cap stocks and never discuss positions or talk to reporters.
All in all, short selling is not for the faint of heart or for the inexperienced investor.
Thanks for reading.
Shaun
I've been reading a book called The Art of Short Selling by Kathryn Staley. I think she does a wonderful job of explaining how to go about finding and researching short selling. So I thought that over the next few weeks, I'd summarize the various chapters and share it with my readers.
Chapter 1
Just so we are all clear - Short selling is selling a security that the seller does not own but promises to deliver by borrowing it from someone else, in order to profit from the subsequent price drop.
What sorts of companies are short sellers looking for?
1. Companies whose management lie to investors and obscures events that will affect earnings.
2. Companies with over-inflated stock prices
3. External events that have a negative impact on companies
The only way to find these companies is to read extensively (WSJ, Barrons, various trade publications, SEC filings etc), talk to people in the industry.
The process of researching a short sale has 6 steps:
1. Analysis of the company's financials - cash flow statements, breakdown of its balance sheets and the quality of the earnings.
2. Track insider trading activities and management's salaries through their Form 4s, Sch 13D and DEF 14A filings. Importantly, try to understand how the management views its shareholders. Are they shareholder value driven or are they in it for themselves?
3. Check the company's business strategy execution. Does it run its business well? How does the company stack up against its competitors?
4. Follow the stock's trading patterns, short interest, 13D filings by institutional shareholders.
5. Read anything to determine the consensus.
6. Watch the company over time to see what happens, how earnings and price progresses and what changes.
Risks of short selling:
1. The price moves up after the stock is sold, requiring more cash infusions into the account.
2. Or the lender demands the return of the stock. If the broker cannot find another position to loan to the short seller, the customer will be forced to buy it at the current market price. This is called a buy-in. To avoid the risk of buy-ins, some short sellers only short large cap stocks and never discuss positions or talk to reporters.
All in all, short selling is not for the faint of heart or for the inexperienced investor.
Thanks for reading.
Shaun
Wednesday, August 5, 2009
Quest Capital Corp (NYSE & TSX: QCC)
I found this Canadian mortgage bank, Quest Capital Corp (NYSE: QCC). It's quite an interesting company. Basically, QCC specializes in construction loans. Meaning that it lends to developers the initial loan to get the building built. These loans are inherently risky due to the numerous issues that could crop up during the construction process and as such the interest rate is also rather high. Normally, developers re-finance these loans at a lower rate once the project is complete. So these loans have a short maturity date.
QCC has
- Market cap of 139M.
- Debt of C$ 46.3M
- Preferred Shares of C$ 38.9M.
- Trading at 0.5 of book value
- Total Assets of C$ 382.824M
- Debt to Asset Ratio of 0.12
- Debt plus Preferred Share to Asset Ratio of 0.22
We are faced with a simple problem here. Banks are essentially blind investing pools, no one knows how good or how bad their underwriting standards are until it's too late. So we need to figure out how much losses they can take. QCC is unique 'coz its equity cushion is so high (78% of their asset base is funded by equity) and you are only paying 50 cents on a dollar for that equity.
The company's total asset base is C$ 382.824M. 97% of that comprises of loans (C$ 370.382M). 1% comprises of cash (C$ 3.875M). 1% - future income tax assets (C$ 4.232M). 1% - other (C$4.335M). These figures are from their Q1 report, which is the latest report available.
As at March 31, 2009, QCC’s loan portfolio consisted of 54 loans of which 51 were mortgages secured by real estate and 3 were bridge loans secured by various mining and energy related assets.
As at March 31, 2009, the mortgage portfolio was comprised of 99% first mortgages and 1% second mortgages. The above table shows the evolution of the portfolio. As at March 31, 2009, the mortgage portfolio was concentrated in western Canada, with loans in British Columbia representing 40% of the portfolio, the Prairies 46% and Ontario 14%.
Credit Quality and Non-Performing Loans
As at March 31, 2009, the Company had fifteen non-performing loans in the amount of $113.8 million (31% of their loan portfolio) (2008 - 4 non-performing in the amount of $12.6 million) on which remedial action has been undertaken. On eleven of these loans totaling $66.8 million, the Company has provided aggregate specific reserves for credit losses of $16.3 million. For the remaining four impaired loans, totaling $47.0 million, management has not provided for any specific loan losses as the estimated net realizable value of the collateral securing the loans is in excess of the carrying value of the impaired loans.
From year end 2008, QCC continued to have 14 loans which are classified as impaired and added another loan for a total of 15 loans, of which 11 have a specific loan loss provision. As at March 31, 2009, the Company’s allowance for loan losses increased to $16.3 million, mainly as a result of an increase in the specific loan loss provision related to 4 loans, 3 of which continued to be impaired from December 31, 2008.
Loan Loss provisions are as follows:
1. QCC has 3 impaired loans in the Okanagan region of British Columbia, which are primarily land loans awaiting re-development amounting to $31.9 million. As a result of further development costs to maintain the property value, QCC increased the specific provisions on one of these loans by $0.3 million.
2. QCC has a $4.7 million loan located in northern Alberta whose specific loan loss reserve has increased by $1.0 million to $1.4 million. Marketing efforts on this property to date have made it necessary to increase the reserve.
3. QCC has a resource loan for $2.7 million on which the loan loss allowance has been increased by $0.6 million to $1.9 million mainly as a result of further deterioration in the value of the collateral.
4. QCC has a residential construction loan in northern Alberta with a current net loan exposure of $6.3 million. In order to maximize value and ultimately collect on the security, Quest will continue to fund the construction until completion. Quest has taken a specific loan loss of $0.9 million on this loan.
In addition, QCC has a net loan exposure of $25.8 million on a property in downtown Vancouver, British Columbia which is currently subject to receivership proceedings. The loan continues to be classified as impaired however no provision for any loan loss has been determined as required as at March 31, 2009. An independent appraisal from a qualified third party obtained in early 2009 has a value in excess of Quest’s carrying value. However, the appraisal is based on a number of significant conditions including the condominium project being built on a timely basis, which is subject to the receivership proceedings being successfully concluded in the short term.
After all the information download onto you, there still remains the analysis that has yet to be answered. How should we analyze this company? Obviously with 31% of its loan portfolio classified as Non-Performing, this company is definitely risky. We have to wonder about its underwriting standards. On the other hand, I must also highlight that the company has a 78% equity cushion and that one is buying that equity cushion at 50 cents on a dollar. Is that worth the risk?
I've been attempting to answer that question by trying to find mortgage loan default rates in British Columbia, Ontario and the Canadian Prairies. I've not been successful. If anyone out there knows of relevant data, please please email me at shaunhhh@gmail.com. Thanks.
QCC has
- Market cap of 139M.
- Debt of C$ 46.3M
- Preferred Shares of C$ 38.9M.
- Trading at 0.5 of book value
- Total Assets of C$ 382.824M
- Debt to Asset Ratio of 0.12
- Debt plus Preferred Share to Asset Ratio of 0.22
We are faced with a simple problem here. Banks are essentially blind investing pools, no one knows how good or how bad their underwriting standards are until it's too late. So we need to figure out how much losses they can take. QCC is unique 'coz its equity cushion is so high (78% of their asset base is funded by equity) and you are only paying 50 cents on a dollar for that equity.
The company's total asset base is C$ 382.824M. 97% of that comprises of loans (C$ 370.382M). 1% comprises of cash (C$ 3.875M). 1% - future income tax assets (C$ 4.232M). 1% - other (C$4.335M). These figures are from their Q1 report, which is the latest report available.
As at March 31, 2009, QCC’s loan portfolio consisted of 54 loans of which 51 were mortgages secured by real estate and 3 were bridge loans secured by various mining and energy related assets.
As at March 31, 2009, the mortgage portfolio was comprised of 99% first mortgages and 1% second mortgages. The above table shows the evolution of the portfolio. As at March 31, 2009, the mortgage portfolio was concentrated in western Canada, with loans in British Columbia representing 40% of the portfolio, the Prairies 46% and Ontario 14%.
Credit Quality and Non-Performing Loans
As at March 31, 2009, the Company had fifteen non-performing loans in the amount of $113.8 million (31% of their loan portfolio) (2008 - 4 non-performing in the amount of $12.6 million) on which remedial action has been undertaken. On eleven of these loans totaling $66.8 million, the Company has provided aggregate specific reserves for credit losses of $16.3 million. For the remaining four impaired loans, totaling $47.0 million, management has not provided for any specific loan losses as the estimated net realizable value of the collateral securing the loans is in excess of the carrying value of the impaired loans.
From year end 2008, QCC continued to have 14 loans which are classified as impaired and added another loan for a total of 15 loans, of which 11 have a specific loan loss provision. As at March 31, 2009, the Company’s allowance for loan losses increased to $16.3 million, mainly as a result of an increase in the specific loan loss provision related to 4 loans, 3 of which continued to be impaired from December 31, 2008.
Loan Loss provisions are as follows:
1. QCC has 3 impaired loans in the Okanagan region of British Columbia, which are primarily land loans awaiting re-development amounting to $31.9 million. As a result of further development costs to maintain the property value, QCC increased the specific provisions on one of these loans by $0.3 million.
2. QCC has a $4.7 million loan located in northern Alberta whose specific loan loss reserve has increased by $1.0 million to $1.4 million. Marketing efforts on this property to date have made it necessary to increase the reserve.
3. QCC has a resource loan for $2.7 million on which the loan loss allowance has been increased by $0.6 million to $1.9 million mainly as a result of further deterioration in the value of the collateral.
4. QCC has a residential construction loan in northern Alberta with a current net loan exposure of $6.3 million. In order to maximize value and ultimately collect on the security, Quest will continue to fund the construction until completion. Quest has taken a specific loan loss of $0.9 million on this loan.
In addition, QCC has a net loan exposure of $25.8 million on a property in downtown Vancouver, British Columbia which is currently subject to receivership proceedings. The loan continues to be classified as impaired however no provision for any loan loss has been determined as required as at March 31, 2009. An independent appraisal from a qualified third party obtained in early 2009 has a value in excess of Quest’s carrying value. However, the appraisal is based on a number of significant conditions including the condominium project being built on a timely basis, which is subject to the receivership proceedings being successfully concluded in the short term.
After all the information download onto you, there still remains the analysis that has yet to be answered. How should we analyze this company? Obviously with 31% of its loan portfolio classified as Non-Performing, this company is definitely risky. We have to wonder about its underwriting standards. On the other hand, I must also highlight that the company has a 78% equity cushion and that one is buying that equity cushion at 50 cents on a dollar. Is that worth the risk?
I've been attempting to answer that question by trying to find mortgage loan default rates in British Columbia, Ontario and the Canadian Prairies. I've not been successful. If anyone out there knows of relevant data, please please email me at shaunhhh@gmail.com. Thanks.
Monday, July 27, 2009
NCTY Part 2
I wrote about The9 Limited (NASDAQ: NCTY) last week. I'd just thought I'd give you a update on what I've found after more in-depth research.
1. Investment Thesis
The investment thesis for shorting NCTY is this: NCTY's main business is World of Warcraft (WoW) in China. It recently lost its license to run the game in China. It is spending its remaining cash position to develop new games to generate new revenue. I believe that that is unlikely to occur for the following reasons:
A. These games are very very complex and difficult to program. They take years to build. You can't do it on the fly, burning cash and under pressure from the market to deliver revenue. As it is, most computer games are only delivered years past originally promised completion dates and are notoriously buggy. And for them to have the game gain wide acceptance would take years because consumers need to get accustomed to the game, slowly explore it and recommend it to their friends.
B. They simply don't have the technical capability. NCTY's original function was as a server platform for WoW. They didn't add new functions to the game ie they are not game developers. They wouldn't exist if not for the Chinese gov insistence on having a local entity run these computer games. Blizzard sells WoW to the rest of the world directly without a 3rd party intermediary.
2. Financials
WoW's financial position is actually quite good right now. They are sitting on a US$ 315.5M cash pile right now. Plus US$42M in investments in 4 companies, 9Webzen HK, Object Software, Sunmi Rise and Ideas. The Company invested US$ 3.5M in preferred and common shares in Ideas (a Korean online game developer). NCTY wrote down the US$ 2.1M that they invested in the preferred shares to 0. The Company also invested in a college called Shanghai Institute of Visual Arts (SIVA) a sum of US$1.5M. Their total assets stand at US$ 478.3M as of 31 Dec 2008.
3. Pricing & Valuation
Having said all this, I'm waiting for a rally to around $12 to short the stock. At $8, there is not enough of a margin of safety. The stock did rally to $12 around June for some odd reason. (The announcement for the loss of license was in April.) At $8, their market cap is at USD$240M, which is a 24% discount to their cash value. At $12, their market cap is USD$360M. There is no discount to their cash value and gives us the necessary margin of safety to short the stock.
Extra Data
1. WoW China consists of about 5 million subscribers. The total WoW subscriber base is more than 11.5 million. That means China accounts for about 43% of WoW's subscriber base.
2. NCTY's founder Jun Zhu owns 39.6% of the outstanding stock of NCTY either directly or indirectly as of 31 Dec 2008 from his 13G filings. It is uncertain as to whether he has been selling his stock because the SEC does not require foreign issuers to fill in Form 4s.
3. The reason for the move from NCTY to NetEase is because NetEase agreed to better royalty terms with Blizzard. Wedbush Morgan analyst Michael Pachter thinks that the switch from The9 to NetEase was done for primarily financial reasons: While Blizzard has an estimated 22% royalty rate for WoW income in their partnership with The9 (about 50-55 million USD annually), analysts are predicting that the NetEase agreement would come with royalties of at least 55% - resulting in annual revenue of more than $140 million every year. So switching to NetEase puts approximately $90 million more in Blizzard's pockets every year.
4. The WoW swap from NCTY to NetEase has not been smooth. As of June 7, 2009, WoW has been down in China. It continues to be unavailable in China as of today. There has been rumors that a Beta version of it will be available to existing users July 30, 2009. It is estimated that this will cost Blizzard between US$10 to US$15M.
In my opinion, Blizzard swapping to NetEase is a greed call. They should know that moving from one server to another is always a messy process. For an increase in profits, they cut off more than 43% of their subscriber base for more than 2 months! What are they thinking?! Lost profits aside, they could potentially lose subscribers. Unlike the rest of the world, WoW users in China can play WoW through a prepaid card system. So they are not stuck with a useless monthly subscription. They could easily walk away from the whole thing.
Furthermore, since Blizzard constitutes 91% of NCTY's revenue, I'm sure they could ask for an increase in royalties. I don't quite know what occurred in the negotiations between NCTY and Blizzard. All in all, this is a real big mess.
Hopefully, at least some people can benefit out of it!
1. Investment Thesis
The investment thesis for shorting NCTY is this: NCTY's main business is World of Warcraft (WoW) in China. It recently lost its license to run the game in China. It is spending its remaining cash position to develop new games to generate new revenue. I believe that that is unlikely to occur for the following reasons:
A. These games are very very complex and difficult to program. They take years to build. You can't do it on the fly, burning cash and under pressure from the market to deliver revenue. As it is, most computer games are only delivered years past originally promised completion dates and are notoriously buggy. And for them to have the game gain wide acceptance would take years because consumers need to get accustomed to the game, slowly explore it and recommend it to their friends.
B. They simply don't have the technical capability. NCTY's original function was as a server platform for WoW. They didn't add new functions to the game ie they are not game developers. They wouldn't exist if not for the Chinese gov insistence on having a local entity run these computer games. Blizzard sells WoW to the rest of the world directly without a 3rd party intermediary.
2. Financials
WoW's financial position is actually quite good right now. They are sitting on a US$ 315.5M cash pile right now. Plus US$42M in investments in 4 companies, 9Webzen HK, Object Software, Sunmi Rise and Ideas. The Company invested US$ 3.5M in preferred and common shares in Ideas (a Korean online game developer). NCTY wrote down the US$ 2.1M that they invested in the preferred shares to 0. The Company also invested in a college called Shanghai Institute of Visual Arts (SIVA) a sum of US$1.5M. Their total assets stand at US$ 478.3M as of 31 Dec 2008.
3. Pricing & Valuation
Having said all this, I'm waiting for a rally to around $12 to short the stock. At $8, there is not enough of a margin of safety. The stock did rally to $12 around June for some odd reason. (The announcement for the loss of license was in April.) At $8, their market cap is at USD$240M, which is a 24% discount to their cash value. At $12, their market cap is USD$360M. There is no discount to their cash value and gives us the necessary margin of safety to short the stock.
Extra Data
1. WoW China consists of about 5 million subscribers. The total WoW subscriber base is more than 11.5 million. That means China accounts for about 43% of WoW's subscriber base.
2. NCTY's founder Jun Zhu owns 39.6% of the outstanding stock of NCTY either directly or indirectly as of 31 Dec 2008 from his 13G filings. It is uncertain as to whether he has been selling his stock because the SEC does not require foreign issuers to fill in Form 4s.
3. The reason for the move from NCTY to NetEase is because NetEase agreed to better royalty terms with Blizzard. Wedbush Morgan analyst Michael Pachter thinks that the switch from The9 to NetEase was done for primarily financial reasons: While Blizzard has an estimated 22% royalty rate for WoW income in their partnership with The9 (about 50-55 million USD annually), analysts are predicting that the NetEase agreement would come with royalties of at least 55% - resulting in annual revenue of more than $140 million every year. So switching to NetEase puts approximately $90 million more in Blizzard's pockets every year.
4. The WoW swap from NCTY to NetEase has not been smooth. As of June 7, 2009, WoW has been down in China. It continues to be unavailable in China as of today. There has been rumors that a Beta version of it will be available to existing users July 30, 2009. It is estimated that this will cost Blizzard between US$10 to US$15M.
In my opinion, Blizzard swapping to NetEase is a greed call. They should know that moving from one server to another is always a messy process. For an increase in profits, they cut off more than 43% of their subscriber base for more than 2 months! What are they thinking?! Lost profits aside, they could potentially lose subscribers. Unlike the rest of the world, WoW users in China can play WoW through a prepaid card system. So they are not stuck with a useless monthly subscription. They could easily walk away from the whole thing.
Furthermore, since Blizzard constitutes 91% of NCTY's revenue, I'm sure they could ask for an increase in royalties. I don't quite know what occurred in the negotiations between NCTY and Blizzard. All in all, this is a real big mess.
Hopefully, at least some people can benefit out of it!
Sunday, July 26, 2009
Psychology
Hi,
I've just been reading a lot about psychology, especially in the context of the markets.
http://www.newyorker.com/reporting/2009/07/27/090727fa_fact_gladwell?currentPage=all
The above article by Malcolm Gladwell, talks about how the older and more experienced we get, we overate the accuracy of our judgments. Specifically, he focused on Jimmy Cayne and how he was overly confident and led to the downfall of Bear Stearns.
I've also been reading Contrarian Investment Strategies by David Dreman. There he talks about how analysts tend to psychologically be unable to handle configural/ interactive processing of information. Configural processing of information is processing information with multiple variables which are interdependent and have unknown and unstable relationships with each other. Thus they have a really difficult time coming up with accurate earnings forecasts. Also, how analysts are overly confident with regards to their forecasts, even though statistics show how inaccurate they are. They keep insisting that this time will be different. Or how they didn't have enough information or made some mistake along the way. Dreman suggests that it's not that we don't have enough information. It's the opposite, we have too much. Humans just aren't able to process all that data and come up with an accurate prediction.
Next comes The Psychology of Human Misjudgement by Charlie Munger. It's a paper that Mr Munger writes about human cognitive biases and how they affect our ability to assess different situations.
Finally, Margin of Safety by Seth Klarman, where he talks about humans continually insisting on assessing risks of securities by their past rates of returns/ default rates. We just somehow don't understand the concept that "Past performance is no guarantee of future returns". This line is constantly written in every single prospectus out there but we just don't get it that the past is no guarantee for the future. The future is dynamic and constantly changing.
The most curious thing I found in Margin of Safety was when Mr Klarman talks about CBOs (Collateralized Bond Obligations) and how they were able to convince the rating agencies to give Triple A ratings to 75% of the structure. Basically, CBOs are securitized junk bonds. Doesn't this seem familiar? Doesn't it remind you of the Collateralized Mortgage Obligations (CMOs) and the Collateralized Debt Obligations (CDOs) from our recent past? They spun the same trick of getting the ratings agency to rate most of the structure as triple A as well. The question is how did we manage to fall for the same trick over again? Come on, they barely changed the name! We really don't learn, do we?!
My main worry is this how can I overcome the problems with my cognition?! It's part of me. I can't change it. Worst of all, I don't know where my limits lie. Or when my brain is failing me or it's just simply I didn't do enough homework on the investment. I guess there is no answer as to where our limits lie and how much we should trust our judgment in any given situation. The flip side of the coin is analysis paralysis. We just have to admit that there are some situations where we simply don't/ can't know about - the Unknown Unknowns - as Mr Rumsfeld so eloquently puts it. Guess this makes the game all the more interesting eh?
I've just been reading a lot about psychology, especially in the context of the markets.
http://www.newyorker.com/reporting/2009/07/27/090727fa_fact_gladwell?currentPage=all
The above article by Malcolm Gladwell, talks about how the older and more experienced we get, we overate the accuracy of our judgments. Specifically, he focused on Jimmy Cayne and how he was overly confident and led to the downfall of Bear Stearns.
I've also been reading Contrarian Investment Strategies by David Dreman. There he talks about how analysts tend to psychologically be unable to handle configural/ interactive processing of information. Configural processing of information is processing information with multiple variables which are interdependent and have unknown and unstable relationships with each other. Thus they have a really difficult time coming up with accurate earnings forecasts. Also, how analysts are overly confident with regards to their forecasts, even though statistics show how inaccurate they are. They keep insisting that this time will be different. Or how they didn't have enough information or made some mistake along the way. Dreman suggests that it's not that we don't have enough information. It's the opposite, we have too much. Humans just aren't able to process all that data and come up with an accurate prediction.
Next comes The Psychology of Human Misjudgement by Charlie Munger. It's a paper that Mr Munger writes about human cognitive biases and how they affect our ability to assess different situations.
Finally, Margin of Safety by Seth Klarman, where he talks about humans continually insisting on assessing risks of securities by their past rates of returns/ default rates. We just somehow don't understand the concept that "Past performance is no guarantee of future returns". This line is constantly written in every single prospectus out there but we just don't get it that the past is no guarantee for the future. The future is dynamic and constantly changing.
The most curious thing I found in Margin of Safety was when Mr Klarman talks about CBOs (Collateralized Bond Obligations) and how they were able to convince the rating agencies to give Triple A ratings to 75% of the structure. Basically, CBOs are securitized junk bonds. Doesn't this seem familiar? Doesn't it remind you of the Collateralized Mortgage Obligations (CMOs) and the Collateralized Debt Obligations (CDOs) from our recent past? They spun the same trick of getting the ratings agency to rate most of the structure as triple A as well. The question is how did we manage to fall for the same trick over again? Come on, they barely changed the name! We really don't learn, do we?!
My main worry is this how can I overcome the problems with my cognition?! It's part of me. I can't change it. Worst of all, I don't know where my limits lie. Or when my brain is failing me or it's just simply I didn't do enough homework on the investment. I guess there is no answer as to where our limits lie and how much we should trust our judgment in any given situation. The flip side of the coin is analysis paralysis. We just have to admit that there are some situations where we simply don't/ can't know about - the Unknown Unknowns - as Mr Rumsfeld so eloquently puts it. Guess this makes the game all the more interesting eh?
Thursday, July 23, 2009
GGP Valuation
Hi, I just ran a valuation table. My estimate of 2008's NOI is around $2,100M. Ackman has the NOI figure around $2,500. At around $2,100M NOI, the valuation of the firm ranges from $35,000M to $26,250 depending on the cap rate. GGP being a REIT won't want to emerge from this too highly leverage 'coz of the mandatory 90% payout of all earnings, making it really hard to build new equity. Assuming that it comes out with 35% equity and 65% debt as its new capital structure, that would mean that it has to have a cap rate of 5.0% and a Enterprise Value of $42,000M. I think these figures show that Ackman has a rather optimistic point of view of GGP.
Another thing, occupancy rates in terms of commercial property have been continually falling. That should not come as a surprise given the level of unemployment and falling consumption by the general population. All my NOI calculations assume that NOI is stable and does not fall in the interim. Even that might be an overly optimistic assumption.
Although the long term debt stands at $24.3B, the total liabilities stand at around $27.3B. I believe that total indebtedness is a better yard stick than just pure long term debt. 'coz any debt/ liabilities come ahead of equity.
Given my conservative estimates, I don't believe that there is an adequate margin of safety with GGP common stock. I guess I'm going to pass on this one.
Wednesday, July 22, 2009
Financial Engineering, CDOs & Gaussian Copula
I was talking to an old friend last night. Our conversations led to us talking about Collateralized Debt Obligations (CDOs) and Collateralized Mortgage Obligations (CMOs) and the financial crisis. I referred him to this article from Wired Magazine on CDOs, titled Recipe for Disaster: The Formula that killed Wall Street. It does a pretty good job of explaining the CDO problem.
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
We were talking about what went wrong and how we got into this state. A lot of the blame has fallen on the quants that created many of these products. Since I have a Masters in Financial Engineering, my buddy asked me if it was true.
My belief is that I think the quants tried their best to come up with pricing and formulas for a lot of the products out there. There are a lot of limitations as to what they understood and could predict. I'm not too sure if they communicated these limitations through to management and the sales team properly. Or if the management just over simplified these limitations or they just ignored it since they couldn't understand it. But somewhere along the line, these limitations were lost. And people took the math as the gospel truth. No where is this more evident than in CDOs.
Just a short summary of the above article for those of you who are interested.
For those of you that are unfamiliar with CDOs (Collateralized Debt Obligations). Basically, CDOs are pools of different types of debt all lumped into one. You have car loans, credit card debt, slices of housing loans (probably bottom tranches of CMOs), etc. You get the idea.
Now Wall Street had a problem - how to price these things? The issue was there was a lack of data on defaults and default correlations of these varied pools of debt. No one knew the historical default data and the correlation rates. So how do we go about pricing them?
Enter David Li. A bright quant working for JP Morgan Chase. He wrote an article called "On Default Correlation - A Copula Function Approach". Li came up with a way to figure out the correlations without historical data. He used these instruments called Credit Default Swaps (CDS). A CDS is a way of insuring your debt. ie if you own a bond or type of debt and you were afraid that the borrower couldn't pay back the debt, you bought a CDS, a kind of default protection. Li reasoned that the CDS of various debt pools/ instruments are a good approximation for historical default rates after all CDS are meant as protection for defaults of those debt pools/ instruments. Li now has a method of pricing CDOs. The formula used to price CDOs is the Gaussian Copula.
The effect was to energize the CDO market. Now people could put a price to these pools of debt, they could sell them or trade with them. They used the formula everywhere. They priced hundreds of billions of dollars of CDOs with it. A lot of the banks realized that the debt was very sensitive to the rise or fall of housing prices. No one put a stop to raised a flag because selling CDOs were so profitable. Furthermore, the managers who were empowered to stop this did not fully understand the math behind the problems and did not fully understand the various arguments.
So we are here today. The housing market blew up. The CDO/ CMO market blew up. Billions lost.
Will we learn from our mistakes? I don't think so. We'll probably make some new variation of the old mistake.
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
We were talking about what went wrong and how we got into this state. A lot of the blame has fallen on the quants that created many of these products. Since I have a Masters in Financial Engineering, my buddy asked me if it was true.
My belief is that I think the quants tried their best to come up with pricing and formulas for a lot of the products out there. There are a lot of limitations as to what they understood and could predict. I'm not too sure if they communicated these limitations through to management and the sales team properly. Or if the management just over simplified these limitations or they just ignored it since they couldn't understand it. But somewhere along the line, these limitations were lost. And people took the math as the gospel truth. No where is this more evident than in CDOs.
Just a short summary of the above article for those of you who are interested.
For those of you that are unfamiliar with CDOs (Collateralized Debt Obligations). Basically, CDOs are pools of different types of debt all lumped into one. You have car loans, credit card debt, slices of housing loans (probably bottom tranches of CMOs), etc. You get the idea.
Now Wall Street had a problem - how to price these things? The issue was there was a lack of data on defaults and default correlations of these varied pools of debt. No one knew the historical default data and the correlation rates. So how do we go about pricing them?
Enter David Li. A bright quant working for JP Morgan Chase. He wrote an article called "On Default Correlation - A Copula Function Approach". Li came up with a way to figure out the correlations without historical data. He used these instruments called Credit Default Swaps (CDS). A CDS is a way of insuring your debt. ie if you own a bond or type of debt and you were afraid that the borrower couldn't pay back the debt, you bought a CDS, a kind of default protection. Li reasoned that the CDS of various debt pools/ instruments are a good approximation for historical default rates after all CDS are meant as protection for defaults of those debt pools/ instruments. Li now has a method of pricing CDOs. The formula used to price CDOs is the Gaussian Copula.
The effect was to energize the CDO market. Now people could put a price to these pools of debt, they could sell them or trade with them. They used the formula everywhere. They priced hundreds of billions of dollars of CDOs with it. A lot of the banks realized that the debt was very sensitive to the rise or fall of housing prices. No one put a stop to raised a flag because selling CDOs were so profitable. Furthermore, the managers who were empowered to stop this did not fully understand the math behind the problems and did not fully understand the various arguments.
So we are here today. The housing market blew up. The CDO/ CMO market blew up. Billions lost.
Will we learn from our mistakes? I don't think so. We'll probably make some new variation of the old mistake.
Friday, July 17, 2009
Death of a Business Model: The9Limited (NASDAQ: NCTY)
Some years back, I was asking my prof at Rutgers what to look for in a short? He said simply the death of its business model. My reaction was how in the world to run a stock screen on that? Today I might have just that stock.
The9Limited (NASDAQ: NCTY) is a computer game company. It held the license to run to the world's most popular online Massive Multi-player Online Role Playing Game (MMORPG) - the World of Warcraft (WoW) by Blizzard Entertainment - in China. In April 2009, the company announced that Blizzard will not be renewing its license and has awarded it to another company. WoW accounts for 91% of NCTY's 2008 revenue (from 2008 20-F, pg 29). The license was terminated on June 7, 2009. NCTY's other game franchises include Hellgate: London, Soul of the Ultimate Nation, EA Sports FIFA Online and Granado Espada. None of which approach the size of WoW.
It will be hard for NCTY to replace the revenue because MMORPG's are subject to the network effect. Simply put, the more people in any given network, the greater the ability to draw new people into the network. Other examples are mobile phone networks. What makes MMORPGs so fun is that you get to explore a large online world with your friends, go on quests and campaigns with them or challenge them to fights online. WoW is the largest MMORPG (11.5M subscribers as of Dec 23, 2008). It is really difficult to create a new MMORPG from scratch, reach the critical mass/ level of popularity such that young people will pay for it. These MMORPGs are notoriously complex and hard to create because they aim to create whole new worlds online. Furthermore, it is hard for the game to gain enough acceptance to reach that critical mass.
The company has in the past (2007 20-F) run into accounting issues, specifically inadequate financial controls in its financial reporting, leading its auditor, PWC Shanghai, to explicitly state in NCTY's 2007 20-F. This is really unusual. Normally, the auditor's letter in the 20-F or 10-K will give the company a clean bill of health. Any deviation/ failings from the standard norms should be rectified before it comes to the auditor reporting it in the 20-F. All in all, this does not reflect well on the management.
The stock is down around 40% to 50% from the first announcement in April 2008. Currently, it is trading at $8.45 as of last Friday's close. The price rallied to $12 in June. So there might be opportunities for profit on the short end of this trade. I'd recommend to wait for a rally, then short the stock.
The9Limited (NASDAQ: NCTY) is a computer game company. It held the license to run to the world's most popular online Massive Multi-player Online Role Playing Game (MMORPG) - the World of Warcraft (WoW) by Blizzard Entertainment - in China. In April 2009, the company announced that Blizzard will not be renewing its license and has awarded it to another company. WoW accounts for 91% of NCTY's 2008 revenue (from 2008 20-F, pg 29). The license was terminated on June 7, 2009. NCTY's other game franchises include Hellgate: London, Soul of the Ultimate Nation, EA Sports FIFA Online and Granado Espada. None of which approach the size of WoW.
It will be hard for NCTY to replace the revenue because MMORPG's are subject to the network effect. Simply put, the more people in any given network, the greater the ability to draw new people into the network. Other examples are mobile phone networks. What makes MMORPGs so fun is that you get to explore a large online world with your friends, go on quests and campaigns with them or challenge them to fights online. WoW is the largest MMORPG (11.5M subscribers as of Dec 23, 2008). It is really difficult to create a new MMORPG from scratch, reach the critical mass/ level of popularity such that young people will pay for it. These MMORPGs are notoriously complex and hard to create because they aim to create whole new worlds online. Furthermore, it is hard for the game to gain enough acceptance to reach that critical mass.
The company has in the past (2007 20-F) run into accounting issues, specifically inadequate financial controls in its financial reporting, leading its auditor, PWC Shanghai, to explicitly state in NCTY's 2007 20-F. This is really unusual. Normally, the auditor's letter in the 20-F or 10-K will give the company a clean bill of health. Any deviation/ failings from the standard norms should be rectified before it comes to the auditor reporting it in the 20-F. All in all, this does not reflect well on the management.
The stock is down around 40% to 50% from the first announcement in April 2008. Currently, it is trading at $8.45 as of last Friday's close. The price rallied to $12 in June. So there might be opportunities for profit on the short end of this trade. I'd recommend to wait for a rally, then short the stock.
Wednesday, July 15, 2009
How to do analysis of a company? Part 1
The one thing that really frustrated me at school and at work was the lack of systematic ways of going about doing analysis of companies and industries. I remember asking my professors and my old bosses, so just how do you go about researching a company? What are the things that you need to cover? Meaning critical areas that you need to check into when you research a company and more importantly, how to interpret your findings, what their implications on the stock price and the company performance.
So I decided that I was going to do a series on research and analysis. What are the key things to look at? Where to find them? What do they mean?
First, the financials. Normally, I find companies through my friendly stock screener, either google stock screener or yahoo stock screener. I find both very useful. I key different parameters in and it comes up with a list of companies. Thus the companies I look at already fall within certain parameters in terms of their financials.
First thing I look at is the balance sheet and income statement. I look up the leverage of the company. Debt is neither inherently good nor bad. It's just a form of capital. The company needs to balance its needs to match its current economic situation. Having said that, in the current economic climate, having too much debt is a definitely liability. Especially if its coming due. Companies, like GGP, have gone bankrupt due to their inability to re-finance its debt. Others like Cemex (NYSE: CX) have had their share price greatly depressed due to the overhang of the re-financing question on the company's future.
Bear in mind the absolute amount of debt is only part of the picture. The amount of debt should be thought of in relation to the amount of revenue (long term debt to EBIT or EBITDA etc), debt as a proportion of total capitalization, amount of debt versus equity. All this can be quickly calculated. My rule of thumb is 3.5x EBITDA for an ordinary business (by which I mean manufacturing or simple, non-financial services) is about as high as I am comfortable with. In this current climate, 3.5x is kinda steep. Not because the company can't pay its interest expense but more because some of that debt will probably not be able to re-finance if it comes due. Having said that, there are some industries like utilities that operate consistently with very high leverage (6 or 7 times EBITDA) and have no issues. But they are more often the exception.
After that I look at revenue trends. Is it going up? Or is it going down? Are there any large jumps in revenue? Why is that so? Did they acquire another company? Do they consistently keep buying companies? Does that result in an increase in net profit margins?
There are a number of companies out there that are serial acquirers. Esp during times when credit is cheap. Most often their acquisitions fail to deliver the goods. I've realized that big acquisitions are really hard to pull off successfully. It's often easier to do small acquisitions and integrate them well. A good example of a serial acquirer that adds value is Danaher (NYSE: DHR). These guys have a dedicated team that conducts M&A. They have a whole business system set up around acquiring companies and integrating them into DHR. They are very meticulous and stick to their knitting. They don't venture out of their space. They acquire only specialty instrument companies. That's their niche and they are very good at it. However, DHR is the exception, rather than the rule. Most companies don't have the discipline to acquire businesses that they understand or the setup to integrate their acquisitions. And so they should just not do it.
One more point, where would I find all these financials? A good starting point is yahoo finance. I don't trust the numbers absolutely, there are sometimes mistakes. But it's a good starting point. The reason it's good is 'coz all the stats and ratios are contained in the key stats tab. Later, I go to the Edgar website for the 10Ks and 10Qs. Another good place is the company website. Often the company has the 10Ks and 10Qs in pdf format, so I go there and download them. It's a lot easier to read and I can save it on my computer.
I'll post more on research and analysis as we go on. Hope you enjoy reading this blog.
If you have any suggestions, case studies or ideas. Please feel free to tell me (shaunhhh@gmail.com).
PS. A good book I found on equity analysis is "The Art of Short Selling" by Kathryn F. Staley. It gives a good thorough, all bases covered look at equity analysis. 'coz you often have to be more cautious and thorough when you are short a stock.
Another good book is the Interpretation of Financial Statements by Benjamin Graham. This one is shorter and more of an introduction. It's a classic though.
So I decided that I was going to do a series on research and analysis. What are the key things to look at? Where to find them? What do they mean?
First, the financials. Normally, I find companies through my friendly stock screener, either google stock screener or yahoo stock screener. I find both very useful. I key different parameters in and it comes up with a list of companies. Thus the companies I look at already fall within certain parameters in terms of their financials.
First thing I look at is the balance sheet and income statement. I look up the leverage of the company. Debt is neither inherently good nor bad. It's just a form of capital. The company needs to balance its needs to match its current economic situation. Having said that, in the current economic climate, having too much debt is a definitely liability. Especially if its coming due. Companies, like GGP, have gone bankrupt due to their inability to re-finance its debt. Others like Cemex (NYSE: CX) have had their share price greatly depressed due to the overhang of the re-financing question on the company's future.
Bear in mind the absolute amount of debt is only part of the picture. The amount of debt should be thought of in relation to the amount of revenue (long term debt to EBIT or EBITDA etc), debt as a proportion of total capitalization, amount of debt versus equity. All this can be quickly calculated. My rule of thumb is 3.5x EBITDA for an ordinary business (by which I mean manufacturing or simple, non-financial services) is about as high as I am comfortable with. In this current climate, 3.5x is kinda steep. Not because the company can't pay its interest expense but more because some of that debt will probably not be able to re-finance if it comes due. Having said that, there are some industries like utilities that operate consistently with very high leverage (6 or 7 times EBITDA) and have no issues. But they are more often the exception.
After that I look at revenue trends. Is it going up? Or is it going down? Are there any large jumps in revenue? Why is that so? Did they acquire another company? Do they consistently keep buying companies? Does that result in an increase in net profit margins?
There are a number of companies out there that are serial acquirers. Esp during times when credit is cheap. Most often their acquisitions fail to deliver the goods. I've realized that big acquisitions are really hard to pull off successfully. It's often easier to do small acquisitions and integrate them well. A good example of a serial acquirer that adds value is Danaher (NYSE: DHR). These guys have a dedicated team that conducts M&A. They have a whole business system set up around acquiring companies and integrating them into DHR. They are very meticulous and stick to their knitting. They don't venture out of their space. They acquire only specialty instrument companies. That's their niche and they are very good at it. However, DHR is the exception, rather than the rule. Most companies don't have the discipline to acquire businesses that they understand or the setup to integrate their acquisitions. And so they should just not do it.
One more point, where would I find all these financials? A good starting point is yahoo finance. I don't trust the numbers absolutely, there are sometimes mistakes. But it's a good starting point. The reason it's good is 'coz all the stats and ratios are contained in the key stats tab. Later, I go to the Edgar website for the 10Ks and 10Qs. Another good place is the company website. Often the company has the 10Ks and 10Qs in pdf format, so I go there and download them. It's a lot easier to read and I can save it on my computer.
I'll post more on research and analysis as we go on. Hope you enjoy reading this blog.
If you have any suggestions, case studies or ideas. Please feel free to tell me (shaunhhh@gmail.com).
PS. A good book I found on equity analysis is "The Art of Short Selling" by Kathryn F. Staley. It gives a good thorough, all bases covered look at equity analysis. 'coz you often have to be more cautious and thorough when you are short a stock.
Another good book is the Interpretation of Financial Statements by Benjamin Graham. This one is shorter and more of an introduction. It's a classic though.
Thursday, July 2, 2009
GGP Update 2
Hi I've just been going through the GGP bankruptcy docs. I think there are some important points that it makes. It's incredible that GGP is in bankruptcy. Basically, the whole CMBS market froze up and the company was unable to re-finance its debt as it came due. It is still able to pay its interest obligations. In fact, as a show of good faith it has decide to continue paying its interest expense at contractually agreed rates. This shows confidence in the strength of cash flow from shopping centers and other ops. Considering that they are in bankruptcy, it's quite unprecedented that they are paying interest at all. So it wasn't that the company's previous management was incompetent. It's more a question of unprecedented closure of a multi-billion market that they counted on for re-financing.
To answer previous queries about a possible fire sale of all the properties. Apparently, GGP's CEO doesn't think it likely 'coz the potential buyers are going to have problems getting financing. In my opinion, this is true to a certain extent. It might be true now. But as the credit markets start to unfreeze, this will start to change. In fact, I read today in the Journal that Apollo Management and Angelo Gordon might be venturing into REITs. So while the possibility of a fire sale is low right now, it cannot be ruled out in the future. However, the flip side is also true. If others can raise financing, GGP might be able to raise debt to refinance its current obligations.
My final point is that while the current management has cut GGP's capex to $224M from $1.5B for 2009 and from $1.3B to $108M in 2010. Unlike Pershing Sq, I don't believe that this is sustainable for any period of time more than past 2010. The malls need regular face lifts, upgrades and extensive re-investment to keep the public continually coming back to them. If these things are neglected for too long, I do believe this will start to destroy the value of the business. So GGP needs to get itself out of bankruptcy as soon as possible, lest it destroy the value of its assets through neglect.
Here's a summary of GGP's CEO Adam Metz's and restructuring firm, Alix Partner's James Mesterharm's declaration.
"1. GGP’s 2008 company-wide net operating income (NOI), was $2.59 billion, an increase of 4.5 percent over 2007 despite the challenges of the economy.
2. This increase is because the shopping center business is very different from the retail business. GGP’s business is far less cyclical than that of the retail industry because our revenues are insulated by long-term leases, tenant diversity, and the geographic and demographic diversity of our properties.
3. GGP continues to have occupancy rates above 90% - among the highest in the industry – and even now GGP is regularly are entering into new leases with existing and new tenants. As of Dec 31, 2008, GGP Group had 92.5% of its mall and freestanding space leased, and its average lease term was greater than nine years.
4. GGP's resilience to the economic downturn is due to several factors.
- GGP’s shopping centers are well-located and often the leading properties in their respective markets.
- GGP's tenant base is high caliber and well diversified, with no tenant making up more than three percent of our revenues.
- Competition from new shopping malls is likely to be limited in the future because there is no financing available for new developments, and it is extraordinarily difficult to obtain approvals to build competing properties even when financing is available.
- Finally, GGP also has valuable development rights associated with many of its properties, assets which do not generate cash today but in the future have the potential to create enormous value.
5. GGP has sought bankruptcy court assistance to restructure its finances and de-leverage its balance sheet because the collapse of the credit markets has made it impossible for the company to refinance its maturing debt outside of chapter 11.
- the commercial real estate finance markets have ceased to function and effectively are closed, even for loans on quality properties generating stable income. The reasons for this are unrelated to the performance of the shopping center industry generally.
6. GGP has approximately $18.4 billion in outstanding debt obligations that have matured or will mature between now and the end of 2012, including past due maturities of $2.0 billion, $1.3 billion more coming due in the remainder of 2009, and $6.4 billion in 2010.
As of December 31, 2008, the GGP Group as a whole reported approximately $29.6 billion in total assets and approximately $27.3 billion in total liabilities (including the GGP Group’s proportionate share of joint venture indebtedness). Of the $27.3 billion in total liabilities, $24.85 billion represents the aggregate consolidated outstanding indebtedness of consolidated entities, which includes $6.58 billion in unsecured, recourse indebtedness and $18.27 billion in debt secured by properties. For 2008, the GGP Group reported consolidated revenue of approximately $3.4 billion.
7. GGP borrow mortgage loans with low amortizing three to seven year terms, improve the NOI for the property through the company’s operational and management expertise, and refinance those loans at maturity, a model used successfully in the commercial real industry for decades.
8. Default occurred cause on Jan 1, 2009 to the date of the chapter 11 filing, $1.1 billion of additional debt has matured which the company is unable to refinance. GGP’s inability to refinance debt as it matured triggered acceleration of $4.1 billion in debt that otherwise was not currently due.
9. In total, as of the chapter 11 filing GGP had approximately $2.0 billion of past-due indebtedness and an additional $5.9 billion that has been or is subject to acceleration. Another $1.3 billion will mature by its own terms later in 2009. Another $1.3 billion will mature by its own terms later in 2009. GGP has virtually no hope of refinancing either its past-due debts or its upcoming maturities in the current credit markets.
10. GGP tried to re-negotiate the maturing CMBS loans but were unable to because of the constraints on the master servicers and special servicers ability to re-negotiate loans.
11. GGP undertakes many measures to increase short-term liquidity.
- GGP suspends its dividends
- GGP reduced their planned spending for development and redevelopment of properties from $1.5B to $224M for 2009, and from $1.3B to $108 million for 2010. These are capex relating to expansion and redev of shopping malls.
12. GGP ability to divest assets is severely limited because prospective buyers also have limited or no ability to finance acquisitions. GGP was only able to sell one parcel of land, two office parks, and three office buildings in 2008. All but one of these sales closed prior to the 4th quarter of 2008.
13. Pershing Square Capital is the agent of GGP’s DIP financing. PS Green Holdings and PS Green Inc as initial lenders of the DIP facility. DIP facility’s interest rate is at LIBOR plus 12%.
14. GGP has proposed to pay its mortgage lenders amounts equal to contract-rate interest payments during the chapter 11 cases."
To answer previous queries about a possible fire sale of all the properties. Apparently, GGP's CEO doesn't think it likely 'coz the potential buyers are going to have problems getting financing. In my opinion, this is true to a certain extent. It might be true now. But as the credit markets start to unfreeze, this will start to change. In fact, I read today in the Journal that Apollo Management and Angelo Gordon might be venturing into REITs. So while the possibility of a fire sale is low right now, it cannot be ruled out in the future. However, the flip side is also true. If others can raise financing, GGP might be able to raise debt to refinance its current obligations.
My final point is that while the current management has cut GGP's capex to $224M from $1.5B for 2009 and from $1.3B to $108M in 2010. Unlike Pershing Sq, I don't believe that this is sustainable for any period of time more than past 2010. The malls need regular face lifts, upgrades and extensive re-investment to keep the public continually coming back to them. If these things are neglected for too long, I do believe this will start to destroy the value of the business. So GGP needs to get itself out of bankruptcy as soon as possible, lest it destroy the value of its assets through neglect.
Here's a summary of GGP's CEO Adam Metz's and restructuring firm, Alix Partner's James Mesterharm's declaration.
"1. GGP’s 2008 company-wide net operating income (NOI), was $2.59 billion, an increase of 4.5 percent over 2007 despite the challenges of the economy.
2. This increase is because the shopping center business is very different from the retail business. GGP’s business is far less cyclical than that of the retail industry because our revenues are insulated by long-term leases, tenant diversity, and the geographic and demographic diversity of our properties.
3. GGP continues to have occupancy rates above 90% - among the highest in the industry – and even now GGP is regularly are entering into new leases with existing and new tenants. As of Dec 31, 2008, GGP Group had 92.5% of its mall and freestanding space leased, and its average lease term was greater than nine years.
4. GGP's resilience to the economic downturn is due to several factors.
- GGP’s shopping centers are well-located and often the leading properties in their respective markets.
- GGP's tenant base is high caliber and well diversified, with no tenant making up more than three percent of our revenues.
- Competition from new shopping malls is likely to be limited in the future because there is no financing available for new developments, and it is extraordinarily difficult to obtain approvals to build competing properties even when financing is available.
- Finally, GGP also has valuable development rights associated with many of its properties, assets which do not generate cash today but in the future have the potential to create enormous value.
5. GGP has sought bankruptcy court assistance to restructure its finances and de-leverage its balance sheet because the collapse of the credit markets has made it impossible for the company to refinance its maturing debt outside of chapter 11.
- the commercial real estate finance markets have ceased to function and effectively are closed, even for loans on quality properties generating stable income. The reasons for this are unrelated to the performance of the shopping center industry generally.
6. GGP has approximately $18.4 billion in outstanding debt obligations that have matured or will mature between now and the end of 2012, including past due maturities of $2.0 billion, $1.3 billion more coming due in the remainder of 2009, and $6.4 billion in 2010.
As of December 31, 2008, the GGP Group as a whole reported approximately $29.6 billion in total assets and approximately $27.3 billion in total liabilities (including the GGP Group’s proportionate share of joint venture indebtedness). Of the $27.3 billion in total liabilities, $24.85 billion represents the aggregate consolidated outstanding indebtedness of consolidated entities, which includes $6.58 billion in unsecured, recourse indebtedness and $18.27 billion in debt secured by properties. For 2008, the GGP Group reported consolidated revenue of approximately $3.4 billion.
7. GGP borrow mortgage loans with low amortizing three to seven year terms, improve the NOI for the property through the company’s operational and management expertise, and refinance those loans at maturity, a model used successfully in the commercial real industry for decades.
8. Default occurred cause on Jan 1, 2009 to the date of the chapter 11 filing, $1.1 billion of additional debt has matured which the company is unable to refinance. GGP’s inability to refinance debt as it matured triggered acceleration of $4.1 billion in debt that otherwise was not currently due.
9. In total, as of the chapter 11 filing GGP had approximately $2.0 billion of past-due indebtedness and an additional $5.9 billion that has been or is subject to acceleration. Another $1.3 billion will mature by its own terms later in 2009. Another $1.3 billion will mature by its own terms later in 2009. GGP has virtually no hope of refinancing either its past-due debts or its upcoming maturities in the current credit markets.
10. GGP tried to re-negotiate the maturing CMBS loans but were unable to because of the constraints on the master servicers and special servicers ability to re-negotiate loans.
11. GGP undertakes many measures to increase short-term liquidity.
- GGP suspends its dividends
- GGP reduced their planned spending for development and redevelopment of properties from $1.5B to $224M for 2009, and from $1.3B to $108 million for 2010. These are capex relating to expansion and redev of shopping malls.
12. GGP ability to divest assets is severely limited because prospective buyers also have limited or no ability to finance acquisitions. GGP was only able to sell one parcel of land, two office parks, and three office buildings in 2008. All but one of these sales closed prior to the 4th quarter of 2008.
13. Pershing Square Capital is the agent of GGP’s DIP financing. PS Green Holdings and PS Green Inc as initial lenders of the DIP facility. DIP facility’s interest rate is at LIBOR plus 12%.
14. GGP has proposed to pay its mortgage lenders amounts equal to contract-rate interest payments during the chapter 11 cases."
Friday, June 26, 2009
GGP Update
Hi, I got some feedback from one reader on GGP. He has some rather interesting insights. He brings to critical issues to the fore:
1. Can the bankrupt REIT take the massive interest rate hikes in order to emerge from bankruptcy? More importantly for the equity investor, how much of its massive debt must be swapped for equity in order for it to emerge a healthy entity? In other words, how much dilution is going to hit the equity holders? And at what price will it be justified to buy GGP stock given the dilution that is about to occur?
2. There is another issue going on in this saga - substantive consolidation. Substantive consolidation (Brasher, Substantive Consolidation: A Critical Examination) is the pooling of the assets and liabilities of technically distinct corporate entities. In simple terms, an individual property secured by an asset is securitized in this case into a CMBS tranche. The key question here is: can you take those cashflows to service other debt in bankruptcy?
I've done some digging on the second issue. It still remains undecided in the US courts. No definitive judgement has been passed on it. If the courts decide that you can't use cash flows of one asset to service other debt in bankruptcy. This will have disasterous consequences for GGP. It will mean it can't cross service its debt held under various structures.
On the first issue, I've run some basic models with the following assumptions.
A. Net Operating Income (NOI) haircut of 10%
B. Average interest rate rise from 5.2% to 10% post bankruptcy
27-Jun-09
GGP (10K) (in M)
Total Debt 24,853
Interest Exp 1,299
Interest Rate 5.2%
NOI 2,105
Assumptions
Debt for Equity 35.0%
Debt Left 16,155
Est Interest Rate 10.0%
Interest Exp 1,615
NOI Haircut 10.0%
NOI (predict) 1,895
Net Profit 279
From the simple model, we see that a 35% reduction in debt is required to get GGP back on its feet again. The model is simple and leaves out a lot of other possible variables, like maintenance Capital expenditure. The point I'm trying to make is the level of debt reduction that must take place for GGP to emerge from bankruptcy is going to be significant.
I took a hard look at Ackman's model as posted in Zero Hedge. There are a few things I'm not too comfortable with. First, maintenance capex is predicted ranging from $156M to $210M over the next 5 years. Now I back checked against GGP's capex in their 2008 10K was $1.19B. That number includes acquisition/development of real estate and property additions/improvements. I've looked through the document the 10K doesn't really mention how much maintenance capex is required. So it's hard to figure out how much maintenance capex is really required on a year to year basis.
Second, I think that the increase in the interest rate to 6.02% post bankruptcy from an average of 5.2% in 2008 is kinda low. What happens if the debtors want an increase interest rate to a higher number (I used 10%) to compensate for the increased risk they are having to take with GGP?
I pose these questions as points to think about. There are probably no right or wrong answers, just educated guesses. On a personal note, I'm going to continue to keep the GGP saga in view before investing in it. I do believe that there is value but I'm waiting to see what the negotiations with the debt holders yield before getting my feet wet.
I want to once again thank my readers for their excellent feedback and insight. If you have something to add to the issues and ideas that I've posted here, please feel free to either post it or contact me at shaunhhh@gmail.com.
1. Can the bankrupt REIT take the massive interest rate hikes in order to emerge from bankruptcy? More importantly for the equity investor, how much of its massive debt must be swapped for equity in order for it to emerge a healthy entity? In other words, how much dilution is going to hit the equity holders? And at what price will it be justified to buy GGP stock given the dilution that is about to occur?
2. There is another issue going on in this saga - substantive consolidation. Substantive consolidation (Brasher, Substantive Consolidation: A Critical Examination) is the pooling of the assets and liabilities of technically distinct corporate entities. In simple terms, an individual property secured by an asset is securitized in this case into a CMBS tranche. The key question here is: can you take those cashflows to service other debt in bankruptcy?
I've done some digging on the second issue. It still remains undecided in the US courts. No definitive judgement has been passed on it. If the courts decide that you can't use cash flows of one asset to service other debt in bankruptcy. This will have disasterous consequences for GGP. It will mean it can't cross service its debt held under various structures.
On the first issue, I've run some basic models with the following assumptions.
A. Net Operating Income (NOI) haircut of 10%
B. Average interest rate rise from 5.2% to 10% post bankruptcy
27-Jun-09
GGP (10K) (in M)
Total Debt 24,853
Interest Exp 1,299
Interest Rate 5.2%
NOI 2,105
Assumptions
Debt for Equity 35.0%
Debt Left 16,155
Est Interest Rate 10.0%
Interest Exp 1,615
NOI Haircut 10.0%
NOI (predict) 1,895
Net Profit 279
From the simple model, we see that a 35% reduction in debt is required to get GGP back on its feet again. The model is simple and leaves out a lot of other possible variables, like maintenance Capital expenditure. The point I'm trying to make is the level of debt reduction that must take place for GGP to emerge from bankruptcy is going to be significant.
I took a hard look at Ackman's model as posted in Zero Hedge. There are a few things I'm not too comfortable with. First, maintenance capex is predicted ranging from $156M to $210M over the next 5 years. Now I back checked against GGP's capex in their 2008 10K was $1.19B. That number includes acquisition/development of real estate and property additions/improvements. I've looked through the document the 10K doesn't really mention how much maintenance capex is required. So it's hard to figure out how much maintenance capex is really required on a year to year basis.
Second, I think that the increase in the interest rate to 6.02% post bankruptcy from an average of 5.2% in 2008 is kinda low. What happens if the debtors want an increase interest rate to a higher number (I used 10%) to compensate for the increased risk they are having to take with GGP?
I pose these questions as points to think about. There are probably no right or wrong answers, just educated guesses. On a personal note, I'm going to continue to keep the GGP saga in view before investing in it. I do believe that there is value but I'm waiting to see what the negotiations with the debt holders yield before getting my feet wet.
I want to once again thank my readers for their excellent feedback and insight. If you have something to add to the issues and ideas that I've posted here, please feel free to either post it or contact me at shaunhhh@gmail.com.
Tuesday, June 9, 2009
General Growth Properties (NYSE: GGP)
I just read this article by Bill Ackman of Pershing Square Capital on why General Growth Properties' (NYSE: GGP) common stock is a buy.
The thesis is rather intriguing. Ackman alleges that GGP was forced into bankruptcy due to a liquidity crisis (ie unable to re-finance its debt). It was heavily dependent on the CMBS market for its debt issues. When that market froze this year, it was unable to re-finance its currently due debt. This lead to its debtors forcing it to declare bankruptcy even though it was not insolvent (ie liabilities more than assets). This mean that even in a liquidation scenario, the common stockholders obtain a payback larger than its share price, which was very low (around $1). He makes a rather convincing case of this scenario.
Here's Ackman's original presentation:
http://zerohedge.blogspot.com/2009/05/ackman-on-general-growth.html
I'd like to thank Zero Hedge for highlighting this intriguing opportunity.
The thesis is rather intriguing. Ackman alleges that GGP was forced into bankruptcy due to a liquidity crisis (ie unable to re-finance its debt). It was heavily dependent on the CMBS market for its debt issues. When that market froze this year, it was unable to re-finance its currently due debt. This lead to its debtors forcing it to declare bankruptcy even though it was not insolvent (ie liabilities more than assets). This mean that even in a liquidation scenario, the common stockholders obtain a payback larger than its share price, which was very low (around $1). He makes a rather convincing case of this scenario.
Here's Ackman's original presentation:
http://zerohedge.blogspot.com/2009/05/ackman-on-general-growth.html
I'd like to thank Zero Hedge for highlighting this intriguing opportunity.
Sunday, June 7, 2009
Goodpack (SGX: G05.SI)
I got interested in Goodpack from looking at the list of top losers this morning on Business Times. The company manufactures specialized Intermediate Bulk Containers (IBC). G05 has EBIT margins of 32% to 33% which are remarkably good. But the news reports say that the company has engage Macquarie to sell itself. Its still profitable as of Q1 09. I suspect the reason for the management's pessimism is the US$25.88M in debt coming due this year.
I've seen quite a couple of these re-financing/ liquidity crunch situations occur over the last year. For example, Cemex (NYSE: CX). They provide a good opportunity for a bargain buy, provided that you buy in cheap enough. A good metric to check is price to book. Or EV to EBIT. Often, these companies are selling at way below book. A rule of thumb I use is a minimum price of 40% discount to book value. This accords you a margin of safety.
Risks - The 2 big risks here are first that Goodpack starts a fire sale of its assets to meet the repayment of debt. What this means is that the accounting book measure that you use might not be a good reflection of the price. 'coz assets will be sold at a deep discount to book. It also diminishes your residual book value.
Second risk is that the company gets forced into a liquidity bankruptcy. This means that the debtors put the company into bankruptcy even though the company is not insolvent (ie liabilities more than assets). I believe that the risk of this occurring is slight at best because the company is currently rated by Moody's at Aa2 (spot) and Baa3 over a 5 year median. So currently investment grade debt. This might mean a better chance of re-financing the debt. Also, the company is solidly profitable, which would obviously factor into re-financing discussions. The one concern I have with the company is its CapEx. It's been spending really large amount (in relation to its operating cash flow) on CapEx. Often the figure exceeds operating cash flow and is financed by increased debt levels. The company has a consistent policy over the last few years of spending on CapEx in excess of cash generated from operations. The wisdom of this move is questionable. Although the company has cut back on CapEx in Q1 09, I feel that this is too late.
Overall, I like this company and the business. There are 2 questions that face a value investor. The first question is whether the business can cut back on CapEx without damaging the franchise? The second question is the price. How cheap do I need to buy in to be profitable? Bearing in mind that this might be a fire sale situation or that the company might be sold to a external buyer. I need to do more research on the company both in terms of industry comps as well as historical comps.
I've seen quite a couple of these re-financing/ liquidity crunch situations occur over the last year. For example, Cemex (NYSE: CX). They provide a good opportunity for a bargain buy, provided that you buy in cheap enough. A good metric to check is price to book. Or EV to EBIT. Often, these companies are selling at way below book. A rule of thumb I use is a minimum price of 40% discount to book value. This accords you a margin of safety.
Risks - The 2 big risks here are first that Goodpack starts a fire sale of its assets to meet the repayment of debt. What this means is that the accounting book measure that you use might not be a good reflection of the price. 'coz assets will be sold at a deep discount to book. It also diminishes your residual book value.
Second risk is that the company gets forced into a liquidity bankruptcy. This means that the debtors put the company into bankruptcy even though the company is not insolvent (ie liabilities more than assets). I believe that the risk of this occurring is slight at best because the company is currently rated by Moody's at Aa2 (spot) and Baa3 over a 5 year median. So currently investment grade debt. This might mean a better chance of re-financing the debt. Also, the company is solidly profitable, which would obviously factor into re-financing discussions. The one concern I have with the company is its CapEx. It's been spending really large amount (in relation to its operating cash flow) on CapEx. Often the figure exceeds operating cash flow and is financed by increased debt levels. The company has a consistent policy over the last few years of spending on CapEx in excess of cash generated from operations. The wisdom of this move is questionable. Although the company has cut back on CapEx in Q1 09, I feel that this is too late.
Overall, I like this company and the business. There are 2 questions that face a value investor. The first question is whether the business can cut back on CapEx without damaging the franchise? The second question is the price. How cheap do I need to buy in to be profitable? Bearing in mind that this might be a fire sale situation or that the company might be sold to a external buyer. I need to do more research on the company both in terms of industry comps as well as historical comps.
Friday, June 5, 2009
Nam Tai Electronics Inc
Nam Tai Electronics (NYSE: NTE) is an interesting company. It is a Chinese manufacturer of electronics, basically a contract manufacturing company. The curious thing about Nam Tai is that it has a market cap of about USD 192M, short term debt of USD 1M, no long term debt. As of end of Q1 2009, it has USD 230M in cash and cash equivalents. What we have here is an impossible event under efficient market theory. There is no way that a company can sell under its cash value. Hey... but here it is!
Furthermore, if you look at its competitors Jabil Circuit (NYSE: JBL) and Flextronics (NASDAQ: FLEX), both are trading way above book value. JBL's price to book is 1.28x. FLEX is trading at 1.83x book.
My investment thesis is simple: NTE is a good value play because it is trading way below its book value, even under its cash value. There is no good reason for this occurrence. The fact that it is trading under its cash value offers the necessary safety margin.
Risks - The way I see it there are 2 major risks. First, accounting fraud. The company doesn't have as much cash as it says on the books. This is a possibility, witness Satayam. NTE's CFO has just resigned (9 Mar 09), replaced by the company's founder, Mr Koo. Second, this downturn continues for an indefinite period, burning through NTE's cash reserves.
If you have any questions or comments, either post it on the blog or email me at shaunhhh@gmail.com.
One final comment, I own NTE stock.
Furthermore, if you look at its competitors Jabil Circuit (NYSE: JBL) and Flextronics (NASDAQ: FLEX), both are trading way above book value. JBL's price to book is 1.28x. FLEX is trading at 1.83x book.
My investment thesis is simple: NTE is a good value play because it is trading way below its book value, even under its cash value. There is no good reason for this occurrence. The fact that it is trading under its cash value offers the necessary safety margin.
Risks - The way I see it there are 2 major risks. First, accounting fraud. The company doesn't have as much cash as it says on the books. This is a possibility, witness Satayam. NTE's CFO has just resigned (9 Mar 09), replaced by the company's founder, Mr Koo. Second, this downturn continues for an indefinite period, burning through NTE's cash reserves.
If you have any questions or comments, either post it on the blog or email me at shaunhhh@gmail.com.
One final comment, I own NTE stock.
Just got back to Singapore
Just got back to Singapore. Sorry for the lack of posts for the last one month. Things have been quite busy with the move and all. I'm definitely going to be posting a lot more now.
Monday, May 4, 2009
Analysis of Banks - An interesting perspective
Just heard an interview with Warren Buffett. He spoke about Wells Fargo and why he liked the company. Repeatedly, he said that Wells Fargo has the lowest cost of capital of any major bank in the USA. That's how he looks at banks in general. I haven't looked up the numbers yet. But it's an interesting perspective on how to analyze banks.
One of the big things I struggle with was well... how do you know a bank is good? It's hard to analyze the quality of their loans. You really don't know about their loan default rates and how that will hold up. What we do know how to calculate is that their cost of capital. Normally that is stable, especially if the capital comes from depositors.
One of the big things I struggle with was well... how do you know a bank is good? It's hard to analyze the quality of their loans. You really don't know about their loan default rates and how that will hold up. What we do know how to calculate is that their cost of capital. Normally that is stable, especially if the capital comes from depositors.
Thursday, April 30, 2009
Digital Realty Trust
I've been looking at good dividend plays that both guarantee a decent dividend yield, safety of principal and some upside in terms of capital gains.
As such, I've been digging through REITs. As a sector, they have been crushed by the housing downturn. Many of the REITs dealing in retail or housing are on the verge of bankruptcy. Others have gone under, eg GGP.
However, amid this rubble, I found a few gems. One of them is Digital Realty (NASDAQ: DLR). They build and lease data centers. Data centers generally serve as internet gateway centers, corporate data centers, technology manufacturing properties or offices of tech companies. The key point to note is that these centers are very hard to move once set up. This leads to a high rate of renewal and therefore stability of income.
Going through the past 10Ks, here are the salient points:
1. A key revenue driver is the rental income. That can be further broken down into on-going leases, new leases, lease expirations, renewals and property acquisitions.
2. Tenant Reimbursement is another key revenue driver. Tenants reimburse DLR for part of the real estate taxes, common area maintenance, and some other recoverable costs.
3. $53M out of $404.6M in annual rent is expiring in the next 2 years (13.1%). Depending on market conditions, we might see a dip in same store revenues over the next 2 years.
What attracts me to this company is the preferred stock. The Series B is trading at $17.82, yielding 11.9%. The common stock is yielding 3.6% dividend. Par value is $25, implying a potential capital gains upside of 28.7% upside. This is awesome considering that the dividend is cumulative, protected from cuts and must be paid before common stock.
The one significant downside is the lack of liquidity in the preferred. The 3 month trading volume is negligible. If you need to get out of the position in a pinch, you’re going to be in trouble.
As such, I've been digging through REITs. As a sector, they have been crushed by the housing downturn. Many of the REITs dealing in retail or housing are on the verge of bankruptcy. Others have gone under, eg GGP.
However, amid this rubble, I found a few gems. One of them is Digital Realty (NASDAQ: DLR). They build and lease data centers. Data centers generally serve as internet gateway centers, corporate data centers, technology manufacturing properties or offices of tech companies. The key point to note is that these centers are very hard to move once set up. This leads to a high rate of renewal and therefore stability of income.
Going through the past 10Ks, here are the salient points:
1. A key revenue driver is the rental income. That can be further broken down into on-going leases, new leases, lease expirations, renewals and property acquisitions.
2. Tenant Reimbursement is another key revenue driver. Tenants reimburse DLR for part of the real estate taxes, common area maintenance, and some other recoverable costs.
3. $53M out of $404.6M in annual rent is expiring in the next 2 years (13.1%). Depending on market conditions, we might see a dip in same store revenues over the next 2 years.
What attracts me to this company is the preferred stock. The Series B is trading at $17.82, yielding 11.9%. The common stock is yielding 3.6% dividend. Par value is $25, implying a potential capital gains upside of 28.7% upside. This is awesome considering that the dividend is cumulative, protected from cuts and must be paid before common stock.
The one significant downside is the lack of liquidity in the preferred. The 3 month trading volume is negligible. If you need to get out of the position in a pinch, you’re going to be in trouble.
Friday, April 17, 2009
Introductions
Hi
Shaun here. I'm starting a blog about value investing. I'd love to share ideas about investing and hear some of your comments.
A little bit about myself - I've been a value investor for a while now, since 2000. What really attracts me to value is that it makes sense - Value investors buy good businesses at fair prices. That has been a hallmark of my investing philosophy. I tend towards simple, easy to assess businesses selling for cheap prices. Under current market conditions, there are many of these businesses to be had.
If my investing philosophy appeals to you, do come back and check out my posts as I analyze some of my investment ideas.
Shaun
Shaun here. I'm starting a blog about value investing. I'd love to share ideas about investing and hear some of your comments.
A little bit about myself - I've been a value investor for a while now, since 2000. What really attracts me to value is that it makes sense - Value investors buy good businesses at fair prices. That has been a hallmark of my investing philosophy. I tend towards simple, easy to assess businesses selling for cheap prices. Under current market conditions, there are many of these businesses to be had.
If my investing philosophy appeals to you, do come back and check out my posts as I analyze some of my investment ideas.
Shaun
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