09-Jul-2006

>Five Key Fund Investment Lessons

The Morningstar Investment Conference is one of the best events of the year for fund investors. But few individual investors actually go; the audience is mostly financial advisers and money management pros, experts who in many cases are worried more about the latest trend than about the basics that make for investment success.

An average investor who came here for the recent Morningstar event and listened carefully would have come away with five big lessons that seemed to come up in session after session:

1. Beware the attraction of short-term bets when looking for long-term outcomes
There have been countless studies of fund investor behavior showing that typical consumers don't do as well as the funds they buy. The discrepancy is caused mostly by losing confidence in a fund and jumping around, constantly trying to make headway with whatever is hot today.
Michael Mauboussin, chief investment strategist for Legg Mason, compared it to grocery checkout lines or changing lanes in the highway, always searching for what appears to be the fastest route to your destination.

"Very rarely does changing lanes get you there significantly faster," Mauboussin said during his keynote address, "but there are risks involved in making the change and you can wind up further behind -- or worse -- if you make the change at the wrong times."

2. When it comes to information, 'availability bias' is a problem
Morningstar is in the investment-research business and has made its name helping investors see through the skin of securities, first mutual funds and then stocks and exchange-traded funds. Where old-time investors had to rely a lot more on blind faith, today's investors have tools -- like Morningstar ratings, regular performance updates and much more -- that they depend on.

But several speakers noted that investors tend to have a problem with "availability bias," where they confuse access to information with relevance. Think of it like the Queen of Hearts in "Alice in Wonderland," where every bit discussed in court is decreed "very important!" although most of it is meaningless.

Investors frequently ascribe significance to short-term performance numbers, or watch the flow of money into various asset classes, thinking they say something important about long-term trends; frequently, this is how people wind up missing out on gains and buying into declines.

3. About half of all funds available today deserve to die
No one actually says this on the podiums at the Morningstar event, but they whisper it in the exhibit hall and in conference rooms.

The exhibit hall featured a number of companies whose best products could charitably be called mediocre, but realistically should be described as awful. Many firms created funds simply more for their ability to sell them rather than their capability for managing them well.
Thousands of laggards would be out of business if fund investing was a meritocracy. Since fund companies won't close these funds, it is up to investors to hold funds to a simple standard, namely that results are not disappointing over a long stretch of time.

4. Expect large-cap stocks to hit their stride in the next 12 months
You can't go to an investment conference without getting some prognostications for where the market is headed, and the consensus among experts at the Morningstar event was that the big names are due for a pick-up.

Large-cap stocks -- particularly for value-oriented investors -- are about as cheap as they have been in a long time, having lagged small-cap stocks for six to eight years (depending on which benchmarks you prefer). Stellar fund managers such as Bill Nygren of the Oakmark fund or Bill Miller of Legg Mason Value Trust have been migrating towards large-cap names.
For buy-and-hold investors -- as well as people who fled the bear market for the comfort of recognizable names -- a boost in the large-cap arena would be good news indeed.

5. There's a balance between running with the herd and being so contrarian you're wrong
Many of the top managers at the event discussed how they like to go against popular thinking, with the basic idea being that when everyone on the deck of the ship tilts to one side, the safest place may be the other side.

But the only difference between a contrarian and a fool is that the contrarian tends to be proven right (eventually), while the fool who kept trying to beat the herd failed to even keep up with it.
In plain speak, that means that when all of the experts start loving, say, large-cap stocks, that doesn't mean it's time to bail out of everything else. Diversification allows you to participate in the best of the market, no matter which way certain asset classes are running.

03-Jul-2006

>Moats and Risks

Finding great companies is as much an art as it is a science. If successful investing were as simple as plugging historical numbers into an equation, excess returns could theoretically be had by all--and therefore by no one.

The best approximation of a firm's intrinsic worth is the present value of its future forecast cash flows discounted at its cost of capital. This definition inherently contains plenty of "science," but the key word here, where the paths of different investors often diverge, is "forecast." It is here where variation of opinion and intuition regarding a firm's profitability, competitive advantages, and cash flow certainty create the opportunity to dig up treasures now that few others see until it's too late.

Bridging the Gap
There are several tools that we can use to interpret the fundamentals of a firm in order to bridge the gap between art and science, hopefully paving the way to a nice profit in the process.

Two of favorite bridges that help us arrive at a prediction of a company's intrinsic value and a "consider buying" price are moat and risk.

Briefly, an economic moat is a firm's ability to utilize its sustainable competitive advantages to outperform rivals and earn returns greater than its cost of capital.

The risk of a company, on the other hand, is the strength of the underlying business and the predictability and certainty of its future cash flows. Risk is determined by analyzing factors such as cyclicality, leverage, legal issues, and other outside events. In turn, risk ratings affect the size of the margin of safety that we build into our investment.

But not everyone's opinion, interpretation, or prediction of these metrics is the same. This is where we believe value can be found: by correctly selecting firms with economic moats that are trading at attractive discounts to our fair value estimate, given the margin of safety implied by risk rating.

Causation or Correlation?
So how exactly should moat and risk be interpreted in the investment decision-making process? Below is a breakdown of the 1,797 stocks we cover at Morningstar as of June 28, 2006:

The critical point is that, in general, stocks with moats tend to have lower risk ratings, and no-moat stocks tend to have higher risk ratings.

One can conclude from these figures that there is indeed a strong correlation between moat and risk. However, it's not a causal relationship. Not all stocks with moats carry low risk, and not all risky stocks lack moats.

The Great Sports Metaphor
Let's compare moat and risk in the context of something a bit less intricate: baseball. What makes a moat for a baseball team? Perhaps it is the club's ability to earn returns (score runs) greater than its costs (its opponents' runs). Let's go with that. If a team can do this--outscore its opponents--for an extended period, it will have an excellent record. A baseball "investor" would want to own a team with competitive advantages--such as strong hitting and pitching--that wins more games than it loses in the long run.

So what determines the riskiness of a team? Remember, we believe that the risk of a firm represents the certainty of its future cash flows, or our confidence in our fair value estimate and the price at which we would recommend investing. Baseball risk would therefore be the year-to-year predictability of a team's record. Contributing factors would be those such as the club's experience, performance consistency, player turnover, and injury-proneness.

Whether you're a fan or not, the New York Yankees are one of the most consistent baseball teams in history. They would most likely be awarded a low risk rating. But not only are the Yankees consistent, they are consistently successful. It is not hard to see how a set of low risk factors can coincide nicely with a winning record. After all, a steadily performing, experienced team of healthy veterans (a team with low risk) has little else to worry about except getting better; consequently, it may very often be able to best its opponents throughout the season.

Back to finance. Take companies like Microsoft MSFT, Coca-Cola KO, or Fastenal FAST--all firms that we believe have both wide moats and below-average risk. Like the Yankees, we think that the likelihood of these corporations outshining their respective competitors in the long run is good. We also believe that the transparency and certainty of their future cash flows is rather high--hence the low risk rating and small margin of safety.

While a wide moat and low level of risk do not cause one another, they are certainly related, or derived from the same kinds of "scientific" metrics.

Think of it this way: A firm's ability to outperform peers and earn more than it spends usually results in strong cash-flow generation.

In an "iron-sharpens-iron" sort of manner, strong cash flow can often build on itself, muting cyclicality, reducing the need for leverage, and making returns more predictable. Just like the low-risk baseball team, more-predictable returns mean that the company can better concentrate on moat-widening operations rather than risk-narrowing ones.

There Are Always Exceptions
Just because a firm has a moat or wins more games than it loses does not mean it is without sizable risk. Every so often, an inexperienced, "risky" baseball team with a more-uncertain future emerges as a league-power. This kind of team may be much more unpredictable than your typical moaty team, but its ability to defeat its opponents may nonetheless be undeniable. Might this team still be a good "investment"? Certainly, we would say, but only at a much larger discount to our fair value estimate!

A great corporate parallel here is Merck MRK. We believe that Merck has an economic moat; its successful portfolio of proprietary drugs has enabled it to outperform competitors and generate high returns on capital. If all goes well, we expect this to continue. However, our certainty in the level of its profits and cash flow is less than with a typical firm. Merck's shares may be subject to considerable volatility, as lawsuits and legal costs related to product recalls threaten to stifle its ability to keep cash flows consistent.

Finally, let's take a quick look at the opposite extreme: a below-average risk, no-moat stock. The leading bookseller in America, Barnes & Noble BKS, operates in a fairly stable industry with reasonably predictable cash flow. However, the bookselling trade is a rather stagnant business and tends not to provide returns on investment in excess of a firm's cost of capital. Barnes & Noble would therefore be akin to a baseball team that, while reliable, is unfortunately expected to reliably chalk up a losing record year after year (sadly, my beloved Chicago Cubs come to mind).

Clearing the Bases
The key takeaway from this discussion is that risk rating is considered separately from--but is by no means unrelated to--a firm's ability to sustain an economic moat.

Furthermore, while the moat rating affects discounted cash-flow modeling assumptions, the risk rating directly contributes to our margin of safety.

Microsoft and Merck earn similar wide-moat benefits in our valuation model, but we would prefer to buy Merck at a 36% discount to our fair value estimate, while we'd be comfortable buying Microsoft at just a 15% discount.

Therein lies the difference. Moat reflects our confidence in a firm's competitive position, while risk reflects our confidence in its future cash flows and the price at which we'd consider buying.

27-Jun-2006

>Historical Posts

For old Gold dig here.

26-Jun-2006

>The secret behind great investments

The secret behind great investments is `gutsy moves'

The masters don't gamble. "They invest deliberately and purposefully, and they outperform the average investor as a result."

Markets have been going down and up. If that makes you feel queasy, here is help. "You can achieve success in the stock market if you follow a set of well-defined investment principles and refuse to abandon them when the market acts irrationally," assures Scott Kays in 5 Key Lessons from Top Money Managers, from Wiley (www.wiley.com).

First check if you belong to the majority in the world of investment that comprises those who want hot stock tips. "Unwilling to learn the rudiments of investing, they invest in companies because `they've been going up.' The thrill of the action is as important to them as the profits they make." To them, investing is not about maximising the returns over time.

The minority are the few who study the art of investing "in a constant effort to increase their knowledge and improve their skills." Kays points out that these people take time to learn what matters when buying the stocks. "They don't gamble; they invest deliberately and purposefully, and they outperform the average investor as a result."

Chapter 1, titled `The return of common sense', reminds us that many complex investment strategies only veer investors away from the crux. "What kind of pattern is the stock's price chart forming? What was the stock's relative strength last week? The masters classify these questions as irrelevant distractions."

More right than wrong

Great investments are about `gutsy moves,' requiring the execution of the fundamentals, using `straightforward methodologies,' even as lesser mortals look for `something flashy, something unusual, to give them an edge.' The difference is simple: "The naïve talk of what should do well over the next few weeks; the masters consider the long term."

The author devotes a chapter each to five top money managers, beginning with Andy Stephens of Artisan Mid-Cap Fund. The art of portfolio management, the way Stephens does it, is to be right more than being wrong — at least to be right in a bigger way. "It's a trade-off between capitalising on opportunities and protecting my downside if I make a mistake," he says.

Structural competitive advantage that he seeks in enterprises has four components, viz. dominant market share, proprietary asset, lowest cost structure, and defensible brand. "Firms that possess two or more of these advantages will likely perform in the upper quartiles of their industries. Because their cash flow is safeguarded, investors can value these firms with a higher level of confidence."

Lessons from mother

Next expert is Bill Nygren of Oakmark Select Fund, who learnt all about investing from his mother. She kept the family on a strict budget, he remembers. "A true value shopper, she visited three supermarkets each week, checking out the specials they were each running... If an item was fully priced, she bought less of it or passed on it completely."

Kays notes that buying quality, undervalued-companies gets you only halfway to a successful investment experience. "Knowing when to sell a security is just as important. Fortunes have been lost because investors have tried to squeeze every penny out of winning situations and held on to positions long after they should have gotten rid of them."

Sell a company when its price reaches 90 per cent of its fair valuation, Nygren advises. "Liquidate a position when a company fails to perform fundamentally as you expected. If you realise you made a mistake, the sooner you admit it and deal with it, the more likely you will minimise its impact on your performance," are further insights of immense value.

No lottery tickets

The third expert that Kays introduces you to is Christopher C. Davis of Selected American Shares. The foundational principle he adopts to select securities is, "Stocks are not pieces of paper like lottery tickets, but they represent ownership interests in real businesses." Once you accept that, answer the following two questions: "What kind of businesses do you want to own? And, how much should you pay for them?"

According to Davis, "Businesses that grow their values at above average rates for long periods of time make the best investments." His three criteria of superior businesses are: Financial strength (as evidenced by a strong balance sheet and high returns on invested capital), competitive advantages (such as brands, patents and economies of scale), and shareholder-oriented management (with a strategic vision and a realistic plan).

To assess the last criterion, that is, shareholder orientation, Davis digs deep to understand `the thought process and logic' of the company managers' capital allocation decisions. "Before he invests in a company, he ensures that managers have a strong understanding of their cost of capital and the return they expect to achieve on investments."

Compound mystery

Bill Fries of Thornburg Value Fund, the fourth expert you encounter in the book, recounts how his eighth-grade teacher unlocked the mystery of compound interest, and sparked his interest in saving and earning money on money!

What is his investment technique? He divides his portfolio into three types, viz. basic value, consistent earners, and emerging franchisees. Fundamental research that he uses filters out for promise and discount. "A cheap stock can remain cheap indefinitely," he cautions. Identifying cheap stocks is easy; what's tough is "finding companies that can achieve a healthier than generally expected future."

Two core philosophies

The fifth expert is John Calamos Sr, of Calamos Growth Fund. His core philosophies are two. One, "to create wealth, you have to give up some of the upside to preserve capital on the downside." Calamos quips, "I'm long-term bullish, short-term scared, all the time." While the economy can create significant prosperity over time, "the stock market can drop unexpectedly at almost any moment," he warns. "When that happens, he wants to maintain his principal intact, even if that means missing out on some of the market's growth during the good times," explains the book.

His second philosophy reads, "No strategy works very well for very long, so you have to keep evolving your process." Calamos says there is no `magic quantitative equation' that works all the time. "If such a formula existed, everyone would use it and it would no longer work. What works at any point in time constantly shifts."

>The Leverage in the System and the Weak US$

We always like to quote Bastiat and highlight that economics is all about what we see, but more importantly, what we do not see. Take consumer leverage as an example. For years, the perma-bores have warned us that the amount of leverage the US consumer was taking on invited an economic disaster. Instead, and despite numerous crisis (9/11, Iraq War, Enron, Sars, Katrina, Refco...), the US consumer has continued to do what he does best: consume. Most people did not see that the increase in leverage (what we saw) was made possible by the fall in the volatility of US economic growth (see Our Brave New World).

A worse trend, also prevalent amongst financial commentators, is to link two events that have strictly nothing to do with one another. Take this weekend's Financial Times headline: US Dollar Takes a Pounding Because of Current Account Deficit (then why doesn't the AU$? Or the GBP?). As our clients know, this is "non sequitur" if ever there was one and it is about as credible as the "interest rates go up because of the budget deficit" argument of a few years ago. The first part of the phrase is true (the US$ is falling), the second part of the statement is true (the US does run a current account deficit) but the link between the two is completely arbitrary (try finding a correlation between current account deficits and currencies). As our readers know, the truth of the matter is that the FT's headline is based on three premises, all of them wrong:

1. That imports and exports should balance over time. This is factually incorrect, the US has had a current account deficit for most of its History, except during a few years after WWII. This has not stopped the US from having a spectacular growth and a relatively stable currency. Moreover, looking at the past fifteen years, we find that the best performing OECD economies (UK, US, Australia, Spain) have run large deficits while the model students with the current account surpluses (Germany, Switzerland, Japan) have been economic laggards. So what is the point of surpluses?

2. That imports and exports have similar margins. Wrong again, if one imports cars and sells software, the margins are not the same. If the US trade balance were to be computed with profits and not with sales the US would have a huge surplus (see What Investors Should Know About the US Current Account Deficit).

3. That one should compare the deficit with the GDP. Wrong yet again. One should compare the deficit with the size of the assets that the foreigners can buy with their excess dollars. As Anatole tried to demonstrate to Steve Roach at the recent Morgan Stanley conference (see Do Imbalances Matter?), the current account deficit is miniscule when put in comparison with the size and the growth rate of the US assets.

But yet the US$ is today very weak. And if it is not the US current account deficit and the ever-forthcoming refusal of foreigners to fund the US' lavish lifestyle, what drives this weakness? And how long will it last?

This brings us back to what we see (the US$ falling, the large US current account deficits...) and what most do not see (the unwinding of the Yen carry trade, the buildup of large amounts of leverage in the system where it is the least monitored etc...).

1- The End of the Yen Carry Trade

We have argued for a while (see The Importance of Japanese Liquidity Flows, or the May Monthly Review...) that the combination of Japan's quantitative easing policy + zero interest rate policy + FX stabilization policy, led to a massive export of capital by Japan to the rest of the world, to an enormous bull market in fixed income everywhere (see Of Bonds and Zombies) and from there, to a bull market in most asset classes (real estate, distressed debt, equities...).


As Japanese authorities pumped money into the system, told investors they could take money for free and re-assured everyone not to worry about potential swings in the value of the Yen, the Yen remained under pressure and stayed far below its purchasing parity against the US$ and Euro.

In our research, we argued that Western central banks could not hope to tighten monetary policy while Japan's three policies (QE, ZIRP, FX stabilization) remained in place. In other words, their tightening efforts would always be negated by Japan's easy and free money. This meant that if Western central banks were serious about removing excess liquidity from the system, they would have to start leaning heavily on Asia's central banks (see The BoJ in the Line of Fire).

And sure enough, this is what happened last month at the G7 meeting. Following its pledge to abandon its policy of quantitative easing (note the collapse in the growth rate of Japanese monetary base-and note the dates previous collapses occurred), Japan seems to have abandoned its policy of FX stabilization. Indeed, the Yen has rallied very violently from Y118 to Y109 without as much of a pip from the MoF or the BoJ.


Now interestingly, the markets initially seemed to brush-off the Yen's rise. But when the Yen passed Y110/US$ last Friday, it was as if someone had cried "fire" in the proverbial over-crowded theatre. Or, as our friend Dennis Gartman likes to say, all of a sudden at Y110/US$, the "margin-clerks took over from the money managers".

And this brings us to a first observation: recent events in the financial markets have had less to do with US$ weakness (hence the stupidity of the FT's headlines) as with strength in the Yen. Indeed, unlike 2004 when the US$ was falling against every currency, this time around, the US$ is falling, but a number of Emerging Market "risky" currency (which had done so well in 2004) are falling even faster. In the past week, against the US$, the Turkish Lira has fallen -13%. Yesterday alone, the Indonesian Ruppiah fell -3.7%, the RSA Rand fell -3% (despite high gold prices), the Polish Zloty lost -1.9%... Undeniably the margin clerks are back in charge and the yen carry trade is being unwound.

So far, so good. And without wanting to crow, we would say that the above developments made sense and seemed to go "according to plan". Apart from one factor: the impressive rise in the Euro (and other European currencies).

2- Listening to Outliers

Given the end of the Yen carry trade, and the mini-squeeze currently happening in financial markets, the rise of the Euro came (as our readers know) as a large surprise. And it is by studying the "surprises" (a pleasant euphemism for mistakes) that one usually finds the most interesting information. Indeed, our work is based on the study of historical relationships, and the application of logic. And when historical relationships and/or logic fails it is usually that something "new" or something "different" is happening. This is why we never shy away from saying that "things are different this time"; as expensive as these words might be, they are a whole heck of a lot cheaper than saying "things are always the same"!

Having said that, looking at the Euro's recent rise, we are inclined to conclude that there is little difference this time. In fact, the situation is very similar to the situation we experienced in the late 1970s. Let us explain.

3- Two Pools of Reserves

Let us start with a few undisputable facts:

Fact #1: Most countries in the World, especially modern developed countries are "short oil"; they do not produce enough oil domestically to meet their needs.

Fact #2: Oil is priced in US$. In fact, since the end of WWII, the US$ has been by and large the recognized currency of international trade. When France buys oil from Algeria, the barrels are quoted in US$. When China buys tin from Malaysia, US$ are exchanged. If Nokia buys chips in Taiwan, the chips are priced in US$...

Fact #3: Given that the world needs US$ to trade, the US is sort of forced to run a current account deficit and export US$ (otherwise, how would Nokia get the US$ to fund its purchases in Taiwan?). This explains why improvements in the US current account deficit usually lead to global economic meltdowns somewhere in the world - all of a sudden, there are not enough US$ to go around (see What Investors Should Know About the US Current Account Deficit) and entire countries can be found "short US$".

Putting the above three facts together, it makes sense that countries whose daily activities cause them to be "short oil" and "short the US$" will want to store either one, or both, to prevent any financial accident from happening. Consequently, we can say that we have two large pool of US$ liquidity in the world at any one time: a pool of oil reserves, and a pool of US$ reserves

These two pools of reserves are of course interconnected and the best way to envision is to imagine a scale on which you place two reservoirs. One reservoir is full of money, and the other reservoir is full oil. Now if the "oil reservoir" starts to cost more (i.e.: move up on the scale) then all else being equal the "money reservoir" should go down. Of course, all else is not equal. If nothing else, the "money reservoir" is fed at all times by the US current account deficit. And this is where it gets interesting.


4- Oil & the US$

As things stand, the World consumes around 85 millions barrels of oil per day. And as we all know (but unfortunately, as we did not foresee), the price of oil has jumped by US$25/bl over the past 12 months. So, if nothing else, the "dollar working capital needs" of the world must have increased by approximately US$775bn (85m barrels of oil * 365days *25 US$). So point #1: given the increase in oil prices, the world needs an extra US$775bn (and note that we do not even go into the need for extra US$ because of higher metal prices, higher soft commodity prices, rapidly growing global trade etc...).

Now let us assume that the world's oil inventories (whether on ships, in refineries, in the SPR...) have stayed more or less flat at around 100 days of consumption. Then the financing of this excess inventory alone costs the world US$212bn (100 days*US$25*85m barrels). So simply between the rise in oil prices, and the rise in the costs of keeping oil inventories, the demand for US$ will have increased by around US$1,000 billion. And with this rising demand, one might have expected (we did!) a rising price for the US$. One might also have expected (we also did!) that the need for US$ will have lead to a reduction in central bank reserves. Indeed, as illustrated in the diagram above, higher oil prices typically lead to weaker central bank reserves. But as we know, central bank reserves did not shrink in late 2005 and early 2006 (against our expectations). Far from it: they continued growing by over 12% per annum or US$ 220bn in the past year.


Putting it together, this means that:

A) Demand for US$ resulting from oil has increased by US$1000bn in the past twelve months.

B) Reserves have grown by US$

So in other words, in the past twelve months, the World has spent more dollars, and saved more dollars than ever before. How is this possible?

Did the US central bank dump US$ into the system? Not really.


Did the US consumer push an enormous amount of US$ outside of the US through the current account deficit, hereby allowing for the simultaneous use of dollars and saving of dollars? Not to this extent.


Did the world go out and borrow US$ in size to pay for its oil? Now here is an idea that works! And not only does it work; we have seen it before.

5- Oil & US$ Borrowing in the Late 1970s

In 1979, we experience the Second Oil Shock. At the same time, the general perception in the market was that the United States could not be trusted to keep the US$ as a store of value. Inflation ran rampant and "cash was trash".

With the second oil shock, large amounts of petrodollars fell unto a number of countries and financial participants (Saudi Arabia, Nigeria, Venezuela...) who had neither the skills nor the infrastructure to deal with such amounts. Consequently, large amounts were deposited into OECD bank accounts (Citigroup, JP Morgan, BNP...). These banks immediately turned around and lent the money to countries which had been put in difficulty by the rise in oil prices, and thus had current account deficits (Brazil, Mexico...). It was called recycling the petrodollars.

To justify these policies, the chairman of Citibank (Walter Wriston) reassuringly told investors that countries do not go bankrupt. And sure enough, the trade worked for quite a while: the US$ declined steadily (partly because the dollar recipients were constantly "diversifying" outside of the greenback) and commodities kept rising.

However, one day Mr. Volcker came in and put US short rates at 20%. And, of course, the US current account deficit swung into surplus as US consumers tightened their belt. As this happened, we found that the World not only had an inherent short position on oil; it also had a short position on the US$.

And sure enough, the countries who had borrowed the US$ could not afford the new rates anymore than they could afford the oil prices. They went bankrupt (Mexico first, the rest of Latin America afterwards), and Western commercial banks found themselves on the hook. The commercial banks "rescheduled the loans" which allowed them not to go bankrupt, officially. But, on a cash flow basis, the OECD commercial banks were in fact short the dollar by an amount equivalent to the defaults. They had to purchase the dollar back, regardless of its price and the dollar exchange rate happily doubled from �81 to '84 on the simple necessity to cover a short position which had been established inadvertently.

Incidentally, this is why markets can be violently irrational, and for a long time, simply as an echo of a phenomenon which took place quite a while before and that everybody has forgotten. Markets have memories, and these memories are the positions that have been established in a different period and cannot be disclosed for fear of a run on the institutions which have these wrong positions. But these positions must be liquidated and adjusted nevertheless, and it takes a long, long time...

We had an echo of this very same phenomenon in Asia in the period 1995 to 2000. In 1995, everyone was convinced that the THB, MYR, KRW were massively undervalued and due a large revaluation. Everyone borrowed US$ (since rates were cheaper than local rates) to finance local projects (usually real estate). As money continued to plow in, returns on capital weakened. Soon the returns on capital moved below its cost and Asian currencies were forced to devalue. Asian banks, and the OECD banks that had lent to them, found themselves de facto "short the US$". As Asia repaid its US$ borrowing in the period 1997-2000, the US$ rose higher than anyone expected (including ourselves) and central bank reserves barely grew (despite large current account deficits).

6- Today's Short US$ Position

Over the past year, we have bored clients repetitively with the chart below:


The grey bars represent the annual increase in China's FDI plus China's trade surplus; basically the US$ billion amount that China earns any given year. The red lines represent the annual increase in reserves, or the US$ billion amount that China saves any given year.

As our reader will not fail to notice, something a bit odd started to happen in 2001: China started saving substantially more money than it was earning. An odd fact from which we could only draw the following conclusions:

A) Large amounts of capital found its way to China through unofficial channels (although Macao's growth would have led us to the opposite conclusion!).

B) Chinese and foreigners were betting on a revaluation of the RMB by borrowing US$ and buying RMB assets (real estate, factories...).

Having ourselves participated in such trades (i.e.: buying Beijing apartments with 80% variable rate mortgages in US$), our natural inclination was to think that the explanation might lay there. And in recent weeks, our theory that China has been building up short term US$ borrowing was confirmed by the government who declared: "China's short-term foreign debt far exceeds the level deemed safe by international standards, raising the risk of insolvency for some companies... At the end of 2005, China's outstanding foreign debt totaled $281.05 billion, a 13.6% increase from the year earlier (or an amount equivalent to 32.8% of China's total reserves)...". So according to the government, nearly a third of China's reserves can be accounted for by short term US$ debt. And we would venture to say that the Chinese have not been the only ones to borrow US$ to play the "inevitable decline" of the US$ (remember that in 1980, this was also the perception).

In recent years, we have seen large amounts of US$ borrowing taking place outside of the US. This means that an improvement in the US current account deficit could trigger a massive economic crisis; all the guys who are short would find themselves unable to earn the US$ to service their debt. So policy makers should be careful what they wish for... for if they get it, they won't like it!

Still, we hear our clients say, this is all well and good... but it does not help explain the recent meteoric rise in the Euro! But hopefully, this might.

7- The Impact on the Euro

As we have highlighted above, higher oil prices make for a much higher demand for US$. But of course the US$ also end up in someone's pocket.

Destination #1: Rational and professional investors. When the second oil shock hit the World, most oil producers were not organized to adequately absorb the wall of money that fell onto their (still small) economies. This time around, however, a number of countries have improved their financial infrastructure substantially (growth of ADIA, SAMA, KIF etc...). These professional investors will know that cash in US$ is their source of fund (since it comes from oil). So it makes perfect sense for them to try and diversify away from the US$ (since that is what they earn and will continue earning). So for the cash that befalls them, they can find the following use: a) other currencies (the US$ thus falls). b) global bonds (so the negative correlation between oil and bonds breaks down), c) global equities (so stocks do well, especially the more illiquid ones who benefit disproportionately from liquidity flows), d) other commodities and gold.

Destination #2: Russian oligarchs. The destination of choice for the money here is either their local market (Russian equities and bonds power ahead), Swiss banks (and the CHF/Euro rise), or the UK (the GBP and London property prices go through the roof). Little of that money makes its way back into the United States partly because of distance (the US is much further than Europe) and partly because the US is too often a hassle for private investors to deploy money in (forms to fill in, capital gains taxes, dividend income taxes etc...).

Destination #3: Shady Characters. Unfortunately, we live in a world in which rising oil prices mean higher revenues for shady characters. And we do not mean Louis' in-laws in Oklahoma but places like Venezuela, Iran... These countries, as soon as they receive their US$, will feel a strong urge to sell them and buy Euros, Gold, Sterling or anything else which does not have a picture of George Washington attached to it. Most probably, these monies will stay in bank accounts (Iran), or be invested in silly projects (Venezuela). In any event, the returns on invested capital of that money will likely be low...

So putting it all together, we currently have a nice merry-go round in the financial markets whereas:

1) Oil prices increase, leading to

2) Large US$ borrowing from oil importers to pay for the rise in oil, so

3) Large amounts of "borrowed US$" are received by oil producers who

4) Sell the US$ either for rational diversification or irrational policy, leading to

5) A growing perception that the US$ can only fall, which, in turn re-enforces the willingness to borrow US$ (Point #2)... and off we go around the merry-go round again.

8- How Do We Stop the Merry-Go Round?

The first option is of course that the oil price starts to decline, hereby a) making it less necessary for non-oil countries to borrow US$ and b) pushing less money into the pockets described above.

The second option is that the cost of capital in the US continues to rise to the point where servicing US$ debt starts to become ever more costly. On this point we would note that, if one is a Chinese producer and one feels that the RMB will rise by 5% a year for a long while, then the cost of capital in the US is nowhere near a level which would discourage US$ borrowing. However, after the past week, can a Turkish producer say the same thing? Or an Indonesian producer? Or a South African producer? All these guys might not be as convinced as they were a few weeks ago that the US$ can only go down (for them, lately, it hasn't!).

The bottom line is that oil consumers around the World have decided to postpone as much as they could the moment of reckoning which the increase in oil prices should have triggered. They have decided to borrow dollars (or yens?) to buy oil. As a result, a number of countries are now not only short oil, but are increasingly short the dollar. This means that, slowly but surely, we are building a corner on the US dollar similar to the one we built in the period from 1978 to 1980, or from 1995-97...

To discover the guilty parties, simply look at the last two pages of The Economist, and check which oil importing countries run large current account deficits (Turkey, Poland, Hungary, Slovakia...). As a rule, also avoid the countries with an overvalued exchange rate according to purchasing parity, and/or fixed exchange rates (Euroland, UK, Australia, New Zealand...). Maintaining an overvalued exchange rate by borrowing abroad is a time honored tradition for incompetent governments. It always ends in tears (Argentina, Korea, Mr. Major in the UK...).

As far as the oil producers are concerned, they are getting far more dollars than they expected. So they diversify these excess dollars either irrationally, or rationally. But they do not realize that a lot of the dollars that they are getting are not "earned" dollars, but "borrowed" dollars (see the increased indebtedness of Chinese companies, or individuals in US dollars as an example). As a result, US assets have underperformed the rest of the world assets for no valid reason at all. As soon as the flow of money to these countries will dry, the US assets will go up versus the other assets. This is a very good opportunity to start accumulating assets with positive cash flows in US dollars.

By GaveKal Research

24-Jun-2006

>3 red flags signal a troubled stock


Here's how to identify three of those telltale signs, which I call red flags, warning of future bad news. You can easily check for these red flags using the financial statements. You'll need a calculator, but the calculations are easy. Once you get the hang of it, you'll be able to do the analysis in less than five minutes. You'll find it well worth the effort.

Red flag 1: Deteriorating gross margins

I'll start with gross margins, which are most useful for detecting deteriorating competitive conditions. Gross margins measure the profit a company makes on each widget it sells before accounting for overhead, marketing, research and development cost, interest and taxes. Gross margins tell you a lot about a firm's competitive position. Rising gross margins tell you that a firm is either reducing production costs or raising prices. Whatever the reason, margins tend to move in trends and rising margins point to future positive earnings surprises.

Conversely, deteriorating margins say that either production costs are increasing and the firm can't raise prices proportionally, or that it is cutting prices in an attempt to maintain market share. Since either condition portends future earnings shortfalls, declining gross margins is a red flag.

Calculate gross margins by dividing gross operating profit by sales for the same period. To rule out seasonal variations, always compare the most-recent quarter's gross margin to the same quarter one year ago.

Red flag 2: Accounts receivables vs. sales
Corporations usually don't pay cash when they buy from another company. Instead, they have a predetermined time, say 90 days, to pay for the goods. The amounts owed to a company by its customers for goods received are termed "accounts receivables."

Usually, receivables track sales. For instance, if a company sells twice as much as it did the year before, you would expect its receivables to double. Sometimes sales grow faster than receivables, which signals that the firm is doing better at collecting its bills, which is good.

But beware when receivables increase faster than sales. That means customers are taking longer to pay their bills. Here are three reasons why that could happen:

  • The company is slow in billing its customers.
  • Customers don't have the cash to pay.
  • The firm is giving its customers longer payment terms to encourage them to order products that they really don't need, a practice known as "channel stuffing."

While No. 1 is fixable, reasons No. 2 and No. 3 will likely result in sales and earnings shortfalls in the not-too-distant future.
To analyze receivables, compare the ratio of receivables (found on the quarterly balance sheet) to sales (income statement) for the most recent quarter to the same ratio for the year-ago quarter.

Red flag 3: Rising net income combined with a decline in operating cash flow
Cash flow measures the cash that moved in or out of a company's bank accounts during a reporting period. Since cash flow must be reconciled to actual bank balances, it is a more-reliable measure of a company's results than reported earnings, which are subject to a variety of arbitrary accounting decisions.

Operating cash flow measures the change in bank balances resulting from a firm's main business. When a firm calculates its net income, it deducts a variety of non-cash accounting entries such as depreciation and amortization.

Operating cash flow is mainly net income with those non-cash accounting entries added back in. So, generally, operating cash flow should exceed net income. But in fact, many firms find ways to report positive net income when they are actually losing money when you count the cash.

Recent academic research found that comparing reported net income to operating cash flow is a good way to spot future problems.

Specifically, the researchers found that the combination of rising net income and declining operating cash flow is a red flag pointing to future earnings shortfalls.

Doing the analysis doesn't even require a calculator, but interpreting a cash-flow statement is a little tricky. The quarterly statements show the cumulative year-to-date totals for each quarter instead of each quarter's individual figures. For instance, if a firm's fiscal year starts with January, its June quarter figures include the total of the March and June quarters. To get the June quarter's operating cash flow, you would have to subtract the March totals from the June totals.

However, there's no particular advantage to analyzing the quarters separately. So, I take the easy way and compare the most-recent quarter numbers to the year-ago figures, regardless of whether they represent single or multiple quarters. To do the analysis, simply compare the change in net income to the change in operating cash flow from the year-ago quarter to the most recent quarter.

Here are the numbers you would have found had you checked Jos. A. Bank's cash-flow statement after it reported its January 2006 quarter results (Since the company's fiscal year ends with its January quarter, the cash-flow statement figures for January actually represent the entire fiscal year).

Better safe than sorry. Nothing always works in the stock market and these three red flags are no exception. Sometimes cash flow drops because a company loads up on inventory for a new product introduction, or gross margins drop due to short-term conditions.

Nevertheless, successful investing is more about avoiding disastrous losses than it is about riding hot stocks. Paying attention to these red flags will help you do that.