We can see this in the CDS markets, particularly in the CDS of Bank of America, Commerzbank, Societe Generale, UniCredit, and Lloyds, which I refer to as the “Failing 5″. What is alarming is that these 5 banks represent very large proportions of GDP (each having over $1 Trillion in assets on the balance sheet) of 5 of the largest economies of the world, respectively the US, Germany, France, Italy, and the UK.

Here’s the graph:

CDS of the 5 Failing Banks - BofA, Commerzbank, SocGen, UniCredit, and Lloyds

All banks are above their 2008 wides except for BofA which is very near its 2008 wide.

Not surprisingly, the banks’ equities are trading near their 2009 lows. Below is a normalized graph of the equity prices of each bank:

Equity Prices of the Failing 5 Banks - BofA, Commerzbank, SocGen, UniCredit, and Lloyds

What is alarming (or serves as a warning) is that while these banks are trading near their lows, the market is not yet. Important to realize is that the banking models simply stop functioning at these levels. Banks can’t fund themselves in the long run at these levels and keep a business model. Many clients only borrow money at spreads of 100-200bps. So at 300bps spread of marginal funding costs, the banks will have to start to de-lever rather than take on new business (this is an optimistic scenario). A worse case is that the market loses faith in the bank, and a bank run ensues (the Lehman scenario).

So while Equities on valuations-terms may look cheap, current valuations do not capture the distinct possibility of at least one important bank failure (much less 5).

They also do not incorporate the forthcoming negative earnings revisions, as currently very few earnings have been revised down on the single name level, even though GDP is being rapidly revised down throughout all Wall Street banks.

ECRI leading indicators are already starting to turn down, and it is likely that the SP 500 continues to follow the ECRI LI downward. Here’s the current graph:

ECRI Weekly Leading Indicator at 2011-08-21

It’s not a perfect comparison, and I have more sophisticated ways of looking at the market, but simplistically, given that the current correlation between ECRI and S&P 500 price level continues to hold, we can see downside in the S&P to the 1000 level as ECRI continues to deteriorate.

Latin American corporate bond spreads continue to widen, though recently it has just been that the treasury bond rally has not been accompanied by a rally in corporate yields. Yields themselves have stopped widening for now. Here’s the current picture for Latin American Bond Spreads:

Latin American Corporate Bond Spreads at 2011-08-21

We are at a real crossroads, just as we are with bank CDS’s. The current level of 400bps is not stable. Either we continue on the path to 800, or the world returns back to the 300bps level. Spreads look juicy relative to the last 2 years though a longer term chart demonstrates the razors edge where we now stand:

Long-term Latam Corporate Bond Spreads Screen Shot 2011-08-21

Given the lack of clarity and resolution that is coming out of the European leadership, my bet is that spread go wider and equities go lower in the coming days and weeks.

The one positive thing I can say is that the problems of the world right now are not due to Latin America where things continue to progress and slowly get better. Credit is still difficult here (in Brazil credit costs at least 1 percent per month) and so there is much less risk of a debt driven deflation directly. We are, however, still linked to the world and are unlikely to avoid slowing substantially with a US recession. If a European bank breaks, Brazil and the rest of Latin America will suffer from the rapid decline in liquidity as EM bonds get sold.

Investing right now is 90% macro, and the dominant macro factors are outside of the region – predominantly Europe with a heavy dose of the US thrown in and both are in trouble.

Be careful out there.

Abraço, Arthur O’Keefe, São Paulo Value

Latam corporate bond spreads are at their May crisis wides:

Latam Corporate Spreads at 2011-08-10

Treasuries rates are at their lows:

US Treasury Rates at 2011-08-10

This is helping to maintain a steady yield in aggregate Latam Corporate Yields though this “calm” is not reflective of the dislocations occurring in the market as higher yield paper has no hard bids:

Latam Corporate Yields at 2011-08-10

The Latin American Corporate Bond Index is showing down 1.7% from its peak and down 1% month-to-date though I am not sure how much stale marks may play in these figures:

Latam Corporate Bond Index Value at 2011-08-10

According to my S&P 500 model, fair value of the S&P 500 is not 1220-1250, so the market is still in oversold territory by the model, but the unfolding banking crisis occurring in Europe (discussed below) renders statements about fair value extremely suspect:

S&P 500 Index Model at 2011-08-10

The state of the bank CDS market is extremely alarming. 5 year CDS spreads of Societe Generale (France) is bid at 260 – its 3 year high:

Societe Generale 5 Year EUR CDS Spread BID as 2011-08-10

Other banks showing similar type graphs are Unicredito (Italy), Commerzbank (Germany), and Bank of America (US).

To have one megabank in stress is bad enough. To have multiple spread around the world is exceptionally bad. This doesn’t seem to be getting much press – perhaps for fear of causing a bank run, but when one looks at the balance sheets of these banks (European banks are levered 15-20 to 1 and US banks are levered 10 to 1) and the recent equity performance of the banks, one should be worried.

The Fed’s recent announcement of keep rates low for another two years doesn’t address the problem of credit quality and leverage of the balance sheet of these banks.

If these banks start to have funding problems, the market will spiral down again.

To me this argues for very low leverage and moving as high up in the capital structure as possible, though the indications are there for a repeat of 2008.

Latin America is not the problem in all of this – its banks are strong and corporations are performing (more or less), but it should continue to trade in sympathy until capital reallocates.

On the whole, a bad situation….

Um abraço,

Arthur O’Keefe, São Paulo Value

Latin America Corporate Bond Spreads for bonds in USD:

Latam Corporate Spreads at 2011-08-07

At the current level of 340bps the market is nearing the May 2010 (Greece part 1) liquidity crisis levels.

Treasuries helped make July a stellar month for Latin American Corporate Bonds, but, now that they are choppy, they are not helping as much to maintain a steady yield for the Latam Bond Index. 10 year US Treasuries are 20bps tighter month-to-date at 2.56%

US Treasuries:

US Treasury Rates at 2011-08-07

As a result Latam Corporate Bond Yields are roughly 10 bps wider from month end to yield about 6.00%:

Latam Corporate Yields at 2011-08-07

Given the duration of Latam bonds, this has driven the bond index down about 90bps month-to-date:

Latam Corporate Bond Index Value at 2011-08-07

Will see where this finds a bottom, but generally sell-offs in Latam Corporate Bonds, considering the growth characteristics and fiscal condition of the region, presents an attractive investment opportunity.

Another sign that things may improve for the asset space is that 26 week (6 month) correlation of spread returns (lately negative) to the returns of the S&P 500 (very negative) is approaching a high:

Rolling 26 Week Correlations between Latam Spread Returns and S&P 500 Returns at 2011-08-07

Given that the primary concerns are growth (and secondary concerns are the futures of various developed markets) we may see equities continue to lag while credit spreads may hold or rally given their elevated levels.

A variant scenario is that current fair value of the S&P is 1180-1315 with best guess of value at 1260, so with the S&P at 1200 we may see a relief rally which would aid Latam Corporate Bond spreads in tightening driving returns.

Current S&P 500 Model:

S&P 500 Index Model Valuation at 2011-08-07

S&P earnings are still strong and estimates have yet to come down, which is a very different scenario from 2008 when earnings were falling with estimates also being revised down by the time the Lehman led liquidity crisis struck.

On the bear side, a government/sovereign credit crisis is uncharted territory in recent times. I believe this last happened in the 30s.

So much more analysis and monitoring is required. Will keep you posted.

Abraço,

Arthur O’Keefe, São Paulo Value

Still I think he could be a little less thrifty and pay up for a web-admin.

EJ’s latest article is entitled: The Big Bet revisited and is divided into two parts: Part I: Turkeys grounded and Part II: Mining memes for money. Part II requires a subscription which I recommend if you have some spare bucks to allocate to provocative newsletters.

The article is about how debates are reframed to benefit some controlling group (the group who pushes for the reframing of the debate) and how sometimes (maybe many times or always) there are unintended consequences of reframing and opportunities to profit knowing that this game of reframing is going on. EJ calls this “Meme Management”.

Janszen is rather direct (refreshingly so actually) and claims that he derives investment themes and subsequently profits knowing that “Meme Management” happens. His article is structured as an interview, and in it he states:

CI: You shorted the meme management?
EJ: Sort of. It’s more complicated than that, of course. But in effect, yes. I bet that the program to force a deficit cut deal using the debt ceiling as a political forcing function would succeed, but that the consequences would be the opposite of the meme-jacking originators’ intention. That will not always be the case. Sometimes we will trade with it and at other times against it.

CI: How does it work?
EJ: I’m not sure it will work in the short-term. Several past experiments have been successful, but not two are alike. There are no guarantees.

CI: What’s your methodology?
EJ: It’s not appropriate for me to explain how meme analysis investing works, how the machinery of meme management operates, how it can be deconstructed, and how it can be used to inform trades. That’s our secret sauce, plus it’s a highly complicated analytical process that is not at all easy to explain anyway. I will say that it grew out of my research phase of my book on the US media, “The Kazoo and the Bullhorn: The American System of Propaganda.”

CI: You are working on that book?
EJ: Not at the moment. I figure I could make a few hundred grand on a book or millions on the insight into meme analysis. Not so touch a choice.

The logic is interesting, and I believe that this goes on and that Janszen is successful at times. But regardless of wether or not the reader agrees that this takes place or with Janszen’s premise that this has occurred with the most recent financial crisis, at least one could argue that this MIGHT happen in general and therefore that reframing may or may not be taking place should in itself be newsworthy and a subject to be fleshed out in the public forum.

But this never happens. There is never a self reflection of the media that it may be hijacked or reframed or “Meme Managed” for someone’s or some group’s interest.

So why is mainstream press’s financial writing and analysis so bad?

The second part of EJ’s comment gives a clue:

CI: You are working on that book?
EJ: Not at the moment. I figure I could make a few hundred grand on a book or millions on the insight into meme analysis. Not so touch a choice.

Apparently report and raising issues in public forums doesn’t pay and never will.

On one level there is a cynical and depressing message in that. On another level, though, accepting that it does happen, and guarding against it happening to oneself allows one to identify the situation and at least protect capital and in other instances to make better investments.

The Lesson: On a larger scale, because media and other information sources are not all encompassing (covering every angle and bringing to light every fact), this contributes to market inefficiency (I am not an efficient markets believer) and is one reason why investment opportunities exist. Said another way, not all information can become widely distributed or emerges in a timely manner. One reason for this is that incentives are strongly in place for those with “the knowledge” to profit from it rather than to distribute it. It’s not nearly as profitable to distribute knowledge – in the form of blogs, books, newspapers, or otherwise – as it is to simply act on it.

EJ: Not at the moment. I figure I could make a few hundred grand on a book or millions on the insight into meme analysis. Not so touch a choice. [emphasis mine]

To the extent this remains in place (and I believe it always will), those who devote efforts to developing “knowledge” of markets and understanding interests of parties involved can have an edge to uninformed investors. And to the extent that there are 401k’s, retail mutual funds, and index funds, and other pure intermediary sources that don’t have 100% alignment of interest with the underlying investor, there will always be uninformed traders.

Invest accordingly and try not to lose money.

Abraço,

Arthur O’Keefe, São Paulo Value

Technicals of the S&P look very oversold. Fair value still looks to be around the 1250-1275 levels. Given the Fed meeting next week, there could be a short bounce to play of buying today at the close. The model is recommending to long at the close today.

S&P 500 Model at 2011-0805

We are in the midst of a liquidity crisis, but it is a different flavor from 2008 which was driven by corporate (bank) failures. Today we are looking at government failures. Corporations are relatively resilient still.

S&P 500 sales are rock solid:

S&P 500 Sales at 2011-08-05

Back in 2008, sales margin (earnings to sales) had already turned for a while. Today they are still at the peak:

S&P 500 Margins at 2011-08-05

Neither sales or sales margin are predicted to soften in the next 3 months.

Which means the big question is what’s going to happen to earnings multiple. Finally we are approaching a short term reasonable multiple which points to a tactical (short term call) bottom:

S&P 500 Price to Earnings (PE) at 2011-08-05

The cheapest sector that I can see is Healthcare (ETF: XLV) which is even more predictable that the S&P in aggregate. Healthcare is a defensive play is it does not have nearly the level of fluctuations in sales and margins. Here are all 4 graphs of the index underlying XLV:

XLV Healthcare Index Model at 2011-08-05

XLV Healthcare Index Sales at 2011-08-05

XLV Healthcare Index Margins at 2011-08-05

XLV Healthcare Index Price to Earnings (PE) at 2011-08-05

As a side note, tech (XLK) is also starting to look cheap, but I need to dig in more.

Good luck today.

Abraço,

Arthur, São Paulo Value

S&P 500 Model at 2011-08-04 with Fair Value 1250-1275

A red flag would be downward revisions in forecasted earnings (shown in red as BEst_EPS). Also a liquidity crisis would cause temporary stress.

I advocate being very cautious in this environment.

Cheap sectors are: Tech and Healthcare. Rich sectors are: Energy and Industrials.

Abraço,

Arthur, Sao Paulo Value

Credit investing and rates investing are sensitive to investor relative return perceptions between asset classes. At the end of the day most bonds get paid back, yet there is still volatility in the asst class as funds flow into and out of credit and rates. Why is this?

The results of search for the answer to this why are surprising in that the skill-set and way of thinking at the index level of investing is in many ways different than what is requires for investing at the single-name level.

A quick example is earnings misses/beats. Single name investing many time is about knowing which company is better at its business than its competitors. So at the single name level it could be that a business’s competition is better and customers shifted to a competing product, and so the company lost sales and therefore missed earnings. In this case, though, at the index level sales likely stayed the same, and the earnings merely moved to someone else’s bottom line in the index. Who earned them only changed the the total earned in aggregate didn’t. So the index earnings don’t move in this case, and if index P/E doesn’t move, index price stays the same as well.

Inside the index one will see one company rally and one company sell-off but an index investor won’t feel anything. This concept is captured in the average correlation statistics of the S&P 500 (here shown as of July 28, 2011 from a Goldman Sachs report by David Kostin):

When pairwise correlation is very low, as it was in the mid 90s and mid 2000′s, the prevailing stories are idiosyncratic – stories about winners and losers within a sector and between sectors (cyclicals versus non cyclicals, etc).

In todays environment, pairwise correlation is actually quite high by historical standards. This can be thought as prices of all companies (to exaggerate a little bit) are rising and falling together.

This is interesting, because in general, as shown below (also from GS/Kostin), index earnings are slow to change (and they are only reported in 4 two month periods per year effectively).

Given that index earnings don’t change quickly, one might expect index price volatility to be low and therefore in high pair-wise correlation times, one might expect single name volatility to be low. This is not the case. Index volatility is not explained by earnings beats/misses at the index level.

So what’s going on then? The short answer is Index investing is 10% forecasting index earnings which is more or less easy given that they don’t change much/quickly day-to-day as shown above and 90% forecasting Index Price-to-Earnings ratio, which itself can be broken down into price-to-book and ROE forecasts.

Price to Earnings = Price to Book x Book / Earnings

Return on Equity = Earnings / Book, therefore:

Price to Earnings = Price to Book / ROE

This can be counterintuitive, but the implication is that improvements in ROE should lower Price to Earnings if Price to Book doesn’t change.

So bottom line is that Earnings don’t change much, so forecasting index levels becomes of game of forecasting price to earnings and/or price to book and ROE of the index.

The punchline is that what drives Price-to-Earnings many times are factors outside of the equities markets and many analyst equity models. One extremely important factor to watch and understand is 10 year US Treasury rates. They are extremely correlated with price to earnings of the S&P 500 as noted below (here shown as of August 3, 2011 from a UBS report by Jonathan Golub):

 So today the stories are not about individual winners and losers but about the merits of owning equities as opposed to rates.

There are very deep implications. From 2009, at least, to be a US Treasuries trader is to be an Equities Index Trader. Broadly people taking views on the S&P 500 index level are taking views on US Treasury 10 Year rates because the link between the two is that the same factor that drives 10 Year rates drives price-to-earnings ratios.

So to tie everything together, Index Earnings don’t change quickly. Most of the volatility in the index is explained by changes in Index Price-to-Earnings. So Index models (to forecast the Index Price) are really Index Price-to-Earnings models.

Furthermore, given the very high correlation, any equity index model has to consider the interest rate effect on price to earnings or at least have a reality check on whether the forecasted price-to-earnings level of the model checks witch what is likely in the Interest Rate market (particularly 10 Year Treasuries).

So the bottom line is that as growth expectations have been revised down, 10 year Treasuries have rallied, and this has pressured Price-to-Earnings of the S&P 500.

When will this stop? Probably when growth expectations are all repriced, which should finish in the next week or two. Keep an eye on GDP revisions and 10 Year Treasury interest rate action and you’ll get a sense of when it’s safe to be long equities again or when the 10 Year Treasury is at risk of selling off.

Abraço, Arthur

São Paulo Value

This is a view from my apartment looking at the University of Sao Paulo in the direction northwest. The buildings are in an area called Jagare across the river Pinheiros.

Sao Paulo is the city of apartment buildings. They are everywhere.

Here’s another view of the university this time looking west.

Arthur

With two years of on the ground experience am a little older and wiser

My business here has gradually focused to Latin American (LATAM) credit, so that is was I am most likely to write about going forward in this blog.

Have watched a number of blogs (actually I read a substantial number through RSS feeds) and my general thoughts are that to be relevant on a small budget, a blog should be focused. That means that its audience will likely be small, but that is the tradeoff to get read and to be rewarding to the author as well.

To try to appeal to a large audience is tiring, expensive, and uninspiring. The writing will have to be bland, and its impact short lived. Specific punchy articles are more likely to get picked up in search and quoted by someone.

In general I think the trend with instant publishing through Scribd and blogs will be short current articles that will displace much of traditional print media. Books will be focused more on history and fiction. Any reference book is already out of date the minute it is published. Plus the amount of things that one can do with a book is so limited. Hyper-linking and multimedia are one. Also hyperlinking refers outward, books are difficult to refer/cite (how many people read footnotes).

So back to business – mine is focused on Latam Credit, mostly in USD actually (for a number of reasons that may come out in future posts), and my blog will most likely evolve to be an english language blog by some fund manager based in Sao Paulo Brazil who discusses the credit markets generally with a relative value framework that will pull in discussions of currencies, rates, and equities.

It will be one of the first english language LATAM focused blogs in Brazil (where we speak Portuguese), so it will likely attract some following.

Will it be The Big Picture? No. Will it help you make money? Probably. Will it appeal to someone? Definitely.

Abraço,

Arthur O’Keefe, São Paulo Value

p.s. I just moved my hosting to HostGator from FutureQuest, and it’s great. For more advanced features, HostGator is really incredible. Gary North deserves the credit as he writes about them every once in a while. He’s approaching 70 if not already past, and I figure he’s very sensitive about saving time….

Recently have opened a hostgator account and will now transition this blog there and restart it.

More to follow in the coming weeks.

Art

In the meantime, just want to put out that since the beginning of the month, the risk return balance has shifted tremendously to a short vol, long equity with a macro hedge strategy. Sounds complicated but basically it’s that mega-cap equities should outperform in the next couple of years if debt stays at this level more or less. Only in the most dire situation will debt outperform megacap equities and I don’t think we are there yet.

An example is Walmart which has growing foreign business and is the low cost retailer for the us. The stock hasn’t moved in ten years while over the same period earnings per share have quadrupled.

Given that it was a ten year trend to cheapness, I expect the reversion to take at least a year, but there should be money to be made.

Similarly tech is very cheap – MSFT, INTC, HPQ.

Buy long dated calls where you can get the cheaply, sell medium dated puts where you can get paid dearly, and manage risk by hedging in the macro indices.

Try not to lose money,
Arthur O’Keefe
São Paulo Value

I will go into this later, but the yield curve is steep because the low end is pinned down by the fed, and it has an extremely high chance of flattening. And if you follow the line of reasoning of the story, I think you have a decent chance of decreasing your net worth.

I continue to see evidence of an extremely unstable market with little volume. Stocks on a valuation basis don’t look so bad if we didn’t have serious deflationary factors. However we *do* in fact have serious deflationary factors as evidenced by the recent enormous flattening of the yield curve. Indeed one wonders if the writer of the story has looked at the recent price action on the five and ten year treasuries. Very unhealthy indeed!

Will try to update when I get time. In the meantime….

Try not to lose money.

Arthur O’Keefe, São Paulo Value

http://www.bloomberg.com/news/2010-08-22/bonds-showing-no-economy-spoils-for-republicans-as-rates-point-to-recovery.html

Bloomberg News, sent from my iPad.

Bond Yields Showing No Economic Spoils for Republicans in 2010

Aug. 23 (Bloomberg) — Former Republican House Speaker Newt Gingrich says Barack Obama’s policies are “artificially extending the recession.” Congressman John Boehner, the party’s leader in the House, says “stimulus policies aren’t working.” Republican Senator Jim Bunning calls Federal Reserve Chairman Ben S. Bernanke’s tenure “a failure.”

The U.S. bond market disagrees. The economy has never contracted with the difference between short- and long-term Treasury yields as wide as it is now. That gap, at 2.11 percentage points for 2- and 10-year notes, signals a 15.5 percent chance of a recession in the next year, according to the Federal Reserve Bank of Cleveland.

“Reports of the death of the recovery are greatly exaggerated,” said Andrew Busch, a public policy strategist at Bank of Montreal’s BMO Capital Markets in Chicago and former adviser to Republican presidential candidate John McCain and Treasury Secretary Timothy F. Geithner.

As politicians step up their rhetoric ahead of the November midterm elections, bond traders are watching the so-called yield curve for clues to the direction of the economy because before each of the last seven economic contractions, long-term yields fell below short-term debt. While that gap has narrowed since reaching a record 2.91 percentage points in February, it’s still almost double the average since 1990.

Though economists are paring their forecasts, they still predict growth in gross domestic product of 3 percent this year and 2.8 percent in 2011, according to the median of 66 estimates in a Bloomberg News survey. Goldman Sachs Group Inc. economists say most of the sectors that drag down an economy, including housing, employment and capital spending, have “already suffered big hits.”

No Double Dip

“As signs of slower U.S. growth have multiplied, market participants have become worried about the possibility of a double-dip recession,” the firm’s economists wrote in an Aug. 12 report. “The probability is unusually high – between 25 percent and 30 percent – but we do not see double dip as the base case.”

The yield on the two-year notes due in July 2012 fell to a record low of 0.4547 percent last week, as investors pushed the price of the security up 2/32, or 63 cents per $1,000 face amount, to 100 8/32. The yield on the benchmark 10-year note, a 2.625 percent security due in August 2020, declined to as low as 2.53 percent, the lowest since March 2009.

The $8.18 trillion market for Treasuries, which help determine the cost of funds for everything from mortgages to corporate bonds, has returned 8.05 percent this year, including reinvested interest, Bank of America Merrill Lynch index data show. They lost 3.7 percent in 2009.

‘Policies Aren’t Working’

Republicans, who lost control of the House of Representatives and Senate in 2006, are pointing to rising demand for bonds, falling yields and faltering stocks as a sure sign the economy is poised to contract. The Standard & Poor’s 500 index is down 3.9 percent this year.

It is time for Obama to “face up to the fact that his stimulus policies aren’t working,” Boehner of Ohio said Aug. 7, a day after the government reported the unemployment rate held at 9.5 percent in July.

The White House hasn’t made much progress in selling the stimulus spending to voters. Asked how their opinion of the programs had changed in recent months, respondents to a Bloomberg National Poll were divided almost evenly among those who say they had become more supportive, those who are less supportive and those who haven’t changed their view.

‘We’ve Gotten Through’

A steep yield curve traditionally indicates economic growth as investors demand more compensation for the risk of faster inflation. A flatter yield curve signals contraction and little threat of inflation.

Though yields are hovering near record lows, the curve as measured by projections of the three-month Treasury bill rate to 10-year note yield suggest the economy will strengthen by about 1.14 percent over the next year, according to a July report from the Federal Reserve Bank of Cleveland.

“The growth trajectory in the economy is sluggish, but positive, with no contraction on the horizon” said Wan-Chong Kung, a money manager who helps invest $89 billion at FAF Advisors in Minneapolis. “We’ve gotten through a really tough downturn in the economy. It could have been much worse if we didn’t have the type of policy that was put in place on the fiscal and monetary front that.”

Inverted Yield Curve

There have been 33 official recessions since 1850, and only three times has the economy fallen back into negative growth within a year, according to data at the National Bureau of Economic Research.

The difference between 2- and 10-year yields is up from negative 0.19 percentage point in December 2006, just before the economy began to shrink.

An inverted yield curve has twice failed to predict a recession — in late 1966 and late 1998. The bears say bonds may be sending another “false positive.” With the Fed’s target rate for overnight loans between banks at a record low of zero to 0.25 percent, it may be impossible for long-term yields to fall below short-term debt.

“As long as the Fed continues with ultra easy policy the yield curve’s relative importance as an economic signal is diminished,” said Christopher Sullivan, who oversees $1.6 billion as chief investment officer at United Nations Federal Credit Union in New York.

A gradual recovery may not be enough to bolster Democrats in the November elections, BMO’s Busch said. “The number one thing on voters’ minds are still jobs, and we haven’t seen any significant progress on the employment front.”

Signs of Improvement

Since the stimulus legislation was approved in February 2009, the U.S. unemployment rate has climbed to 9.5 percent in July from 8.2 percent. The administration projects the jobless rate will average 9.7 percent for the year. Spending by consumers has slowed, with the savings rate rising to 6.4 percent in June, from 1.7 percent in August 2007.

There are signs of improvement, as production in the U.S. rose more than forecast in July. Production at factories, mines and utilities climbed 1 percent, twice the median forecast in a Bloomberg News survey, figures from the Fed showed last week.

Companies in the U.S. added workers in July for a seventh straight month as private payrolls that exclude government agencies rose by 71,000 after a June gain of 31,000, Labor Department figures showed. Corporate spending on equipment and software jumped at a 22 percent annual rate last quarter, the biggest increase since 1997, signaling confidence among company executives.

‘The Facts’

“There seems to be a doom and gloom out there,” Doug Oberhelman, chief executive officer of Peoria, Illinois-based Caterpillar Inc., the world’s largest maker of construction equipment, told analysts in a meeting at the New York Stock Exchange on Aug. 19. “We just don’t see it that way for lots of reasons. The facts aren’t bad in our business.”

The more than 75 percent of the companies in the S&P 500 that reported second-quarter profits exceeded the average analyst estimate since July 12, data compiled by Bloomberg show. Earnings will rise 36 percent this year, the most since 1988, forecasts show. Following the 2001 recession, income growth never exceeded 20 percent.

“The main difference between 2008 and now is that corporations are making money,” said Andrew Brenner, managing director at Guggenheim Capital Markets LLC, a New-York based brokerage for institutional investors.

Not Japan

As earnings rise, companies are cutting their interest expense. The 10 lowest-yielding U.S. corporate bond deals ever were sold in the past 14 months, according to Deutsche Bank AG. Armonk, New York-based International Business Machines Corp. issued $1.5 billion of 1 percent three-year notes on Aug. 2, the lowest coupon on record for that maturity.

The bond market is saying that it may be years before the Fed raises rates to foster the recovery, said Carl Lantz, head of interest-rate strategy in New York at Credit Suisse Group AG, one of 18 primary dealers of U.S. government securities that trade with the central bank.

Slow, persistent growth will help stave off the fear that the U.S. is starting to look like Japan in the 1990s, when the Bank of Japan struggled to revive its economy amid a combination of deflation and recessions, he said.

“The economy is improving and the yield curve will stay steep as the market is pricing in a return to more normal rates further out the curve,” said Lantz. “It will feel like Japan for awhile, but ultimately we are not Japan. We are seeing subpar growth, and a muddling along that is not particularly satisfying, but we are on the path to an eventual return to normal growth.”

To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net

Find out more about Bloomberg for iPad: http://m.bloomberg.com/iphone

Sent from my iPad

Having been an options trader and having invested for a while, I have a healthy appreciation and fear of the path of an investment’s returns. AIPC which was a great investment for me by any measure promptly lost half its value before eventually assuming a path that would result in it’s being purchased for over 6 times my first buy print on the stock. Great return, tricky path. At one point the “investment” showed a -50% return. Sticking with it yielded an awesome IRR.

Which brings me to the first half subject of this note…. Do we invest thinking that this is a deflationary envrionement (forget equities and stick to fixed income) or an inflationary environment (the opposite)? Indeed, I find valid arguments from both the deflationists and the inflationists and believe both are right. How is this possible? I suspect that we will have relatively bad deflation in the US before the currency finally weakens and then leads to inflation.

Why won’t we have inflation in the short term? The quick answer is that it would solve too many problems and make life too easy. Following the principal of maximum pain, then this scenario is unlikely. What problems would inflation solve? While I am worried about the budget deficit of the US, I think there are bigger problems in the short term with the various public pensions and entitlements – social security, medicare, state and local workers – as well as a debt overhang from the housing bubble with its associated overhang on banks balance sheets. In short everyone would benefit in a situation where pensions, benefits, and debt obligations are held constant in nominal terms while we experienced a large dose of inflation. The debt load would be alleviated, and everything would strengthen.

But isn’t the US operating like Zimbabwe, you might ask? Isn’t hyperinfation just around the corner due to a currency collapse? In short no. Zimbabwe had a number of things against it. First is that the state actively destroyed production capacity by breaking up and redistributing productive farmland. Second is that it was a small component of the global export market so its sudden competitiveness due to a currency devaluation would not be noticed. Third is that there was little history of rule of law. Forth is that it has no military. Fifth is that it has a limited population base and what it does have is limited in terms of global competitiveness. There are more, but you get the idea. The US, with a currency collapse, would suddenly become a force to be reckoned with. It was once a manufacturing powerhouse, and that can indeed return with the right forces. Furthermore, all its debts are local currency denominated. Yes the US is extremely dependent on oil and would suffer greatly in the short term with a currency crash, but it’s also resilient and would eventually adapt and compete. So bottom line is that while that may eventually happen, it’s just too convenient to happen in the very short term.

So what is likely in the short term? Deflation. The exact opposite of all of the above. Possibly with global competitive currency debasement leading to very little relative devaluation perhaps. States and local municipalities finding ways to cut pensions or perhaps even worse raising taxes on others to continue paying pensions. Either way someone is going to lose purchasing power. Same deal with entitlement programs. It doesn’t look good.

This brings me to the second half of the subject. In an environment like this, where you expect things to continue to deteriorate, there are no great passive investment returns to be made. Shorting (an inherently levered strategy) will get you killed in the long term as the market experiences increased volatility and periodic rallies for whatever sane or insane reason. In the meantime the general trend will be down. To get a feel for what this looks like, look at the graph of SDS: UltraShort S&P500 ProShares (SDS) via wikiinvest:

Flash Player 9 or higher is required to view the chart Click here to download Flash Player now

You got the direction right but still lost money. So what’s the answer? It’s actually not so surprising or depressing. The best thing to invest in when faced with these issues is in whatever is real that you can do to keep employed, keep relavent, and keep producing something of value (which should be rewarded with money if the product is in demand).

With declining per-capita productivity (which is what you get with increasing unemployment), it’s not going to be easy. And I expect the returns for purely passive investments to decline – after all capacity utilization should decline in an environment like this, so what will “investing” pay? What investments are needed when there is steadily increasing capacity due to decline in demand? Bottom line is that it’s going to be tricky.

There’s always money to be made in dealing with short term capital crunches and by making markets where you are matching buyers and sellers, but it’s hard to make a living at that unless you are devoted to it full time. If that’s not your calling or edge, then find something that is your calling or edge that you can become an expert on and trade/get paid for other goods. Invest in yourself – your skills – and try to keep acquiring productive assets and growing your productive skill set.

This is the time for active investing – doing things like building businesses, streamlining production, and anticipating demand and meeting it.

Try not to lose money.

Arthur O’Keefe, São Paulo Value

In any case I continue to read and analyze what’s going on. Volume in the markets has been extremely light and conditions are pretty dangerous in my opinion. Very large moves on very small volume affect asset values of enormous scale. I call that a form a leverage in the system. In a way I think it would be better if the market just remained shut rather than have +/- 2+% days on less than 200mm shares changing hands on the SPY.

I advocate running very small direction either long or short (depends on what you own or are short I suppose) in this market and keeping gross leverage low as well (gross leverage is [ABS(longs) + ABS(shorts)]/[Net Equity] where ABS is absolute value).

If you’re dying to have a position, WMT is looking pretty cheap. HPQ is as well. But hedge out some of the Beta to the market in any positions (including these). Don’t stretch at all in this market and try to get some sort of seniority in the capital structure. I think the general direction continues down in the long term. Maybe some miracle happens and the market somehow rallies, but the risk is more weighted to the downside in my opinion.

So I will leave with this video warning on the state of the market that I came across from Tony Robbins. I am trying to figure out who’s he referring to in his opening (if I do I will post an update), as he never reveals his source. I don’t think, based on the numbers that he mentioned, that his client is Paul Tudor Jones, but it sounds like someone of equal stature. What’s significant is that I have to take Tony’s claim that he is well connected at face value given what I know of him. So if he felt strongly enough to go on the record with a warning saying that his best clients are worried, especially given that Tony doesn’t need to say any of this to gain credibility, it’s worth listening to and considering. It at least adds to the body of data to be analyzed.

Take a look at this video:

Should I buy an iPad? And should I buy an iPad *now*?

It’s pretty clear from using the iPad that the future is moving towards tablet computing based on cloud computing. The general concept is that the instruments of consumption of the internet and of data in general will slowly be separated from the instruments of production of applications and manipulation of the data. In less technical terms it means that you don’t need a super powerful computer that is capable of creating applications and building reports to be able to use the applications and read the reports (even if the reports are interactive) because much less computing power and a much less sophisticated array of input devices are required for consumption as opposed to production.

So there is no doubt in my mind, we are going to see a continued trend to iPad-like devices.

Personally I think given the availability of bluetooth keyboards, VNC, and RDC (two specifications for working remotely) the laptop is dead in the long run. What you will have is personal servers that can keep data and run more sophisticated processes that iPad devices can make use of through cloud computing for low level tasks (like email). Additionally these devices can access a secure/private/VPN link and display server applications remotely for more sensitive data and more computationally intensive applications.

So long story short – you can join the trend now or later, but likely you will get tired of always carrying a laptop when you realize that you only use 10% (at best) of the functionality and can thus shed some weight by carrying an iPad instead.

So then the question is when to buy….

To me there is not a super pressing need to get the iPad if you are content with your laptop given the still developing state of many applications and the price of the top level iPads. So it depends on whether or not you really want to cut carrying weight now. To me the iPad becomes much more compelling after release of iOS4 -the OS of the new iPhone which is currently not released for the iPad yet. I’ve heard that this will come in September. Also many of the applications for the iPad are still buggy and many more are missing as developers are still working out how to best use the iPad’s features.

Should I buy the 3G or WiFi version of the iPad?

To me there is no debate on this given the current state of internet networks in the US and the world. Buy the 3G version (which inclides WiFi) if you don’t already have an iPhone. At some point you’ll make use of the 3G internet, and in any case it allows for more accurate positioning via GPS, which will also increasingly become important. The cost of the internet on the iPad for 1 month is basically equivalent to 1 day’s cost of internet at a hotel. So if you travel for work or leisure it’s worth it just for that.

If you do have an iPhone, then maybe it’s more debatable. My sense is that 3G for the iPad in this case becomes more of a luxury and a bet that in the future you will want to carry around your iPad and make use of advance internet features (beyond just Google Maps or email which you can do on your iPhone). I am pretty sure this will be the case… but the apps just aren’t there yet. There are some clear cases, I suppose when regardless you should get the dual band iPad. If you work in the real estate industry and need to look at land plots on Google Earth, get the 3G version without doubt as the full screen of the iPad is far superior to the iPhone for looking at plots. If you make use of RDC and VNC and want access wherever, then get the 3G version of the iPad. Etc. With time this argument will apply to more and more people as the apps become available.

What size iPad do I need – 16, 32, or 64 GB? 16 GB vs 32 GB vs 64GB

There are two important considerations – the size of your existing music collection and the size of potential videos. If you are not into music and will not watch videos – then the 16 GB will do. If you are a modest music lover and will not watch many videos then the 32GB will do. I have over 32GB of music alone and so there was no option – 64GB – if I want to keep everything on the iPad. In all fairness, I think that with time syncing between the computer and the iPad will get easier (and wireless) negating the need to carry everything and so probably 32GB is the right number. But if you want the luxury and longevity until the hi resolution iPad with a larger screen comes out in a few years, then consider splurging on the 64GB version.

Hope this helps! Now, back to the regularly scheduled programming….

Try not to lose money.

Arthur O’Keefe, São Paulo Value

The above is the FXE Euro Trust Currency Shares vs the S&P Trust. As much as I am fundamentally bearish in today’s environment, the above is Bullish for equity valuations – at least relative to Europe. Why? The general environment continues to me heavily macro and volatility driven. From the strengthening of the Euro, and its recent breakaway/outperformance, we see that despite fundamental weakness, the world is settling down.

So there are a couple of options in this environment. Maintain shorts and try to find high quality that will rally and hopefully hold in the subsequent selloff or cut shorts and delever.

The technicals for the S&P remain fundamentally poor in the long term. My primary fear comes from the 60-120 SMA death cross which marked the Jan 2008 – March 2009 Bear Market as can be seen below:

I remember a paper a number of years ago speaking of the predictive power of the 60-120 cross. Personally I don’t care of its power in a purely academic sense – ie without other inputs is it a decent signal. We *have* other inputs – namely withdrawl of stimulus, massive delveraging, and implicit and explicit increases in taxes to name a few, all of which is deflationary and therefore inherently dangerous for equities. Witness the following from the most recent St. Louis Fed Monetary trendes showing the decline of credit:

So we have short term bullish and long term bearish = continued volatility. Actually I am starting to get excited with investment opportunities now that immediate crises are over (Greece and many state governments will default but not today). Volatility creates great trading opportunities – but they are that – trading opportunities. Money is made in this environment providing liquidity and then taking it back as it becomes plentiful. Said another way – buying low and selling high.

There are core positions to be held, but exposures likely should be “traded around”. Underexposed net as things take off, and overexposed in the worst of times. It’s not an easy business.

Finally just for the record, I mentioned AIPC – American Italian Pasta Company – in a few posts. The company was bought out marking one of my most successful and interesting investments. I started getting into the stock at $9.00 after which is rather promptly went to $5.00 before starting it’s long and rewarding journey to $53.00. All of this occurred during a period of some of the worst returns of the S&P in history. Indeed in 2009 I believe AIPC was the 5th best performing stock in the market.

The point is that not all volatility is warranted and sometimes it takes the market a long times to see things – good and bad.

Try not to lose money.

Arthur O’Keefe, São Paulo Value

]]> http://www.spvalue.com/2010/07/20/eur-sp-correlation-breaks-down/feed/ 0 http://www.spvalue.com/2010/07/19/return-to-blogging-shift-to-wordpress-3-update-your-rss-feeds/ http://www.spvalue.com/2010/07/19/return-to-blogging-shift-to-wordpress-3-update-your-rss-feeds/#comments Mon, 19 Jul 2010 03:17:23 +0000 Art http://www.saopaulovalue.com/?p=201 Continue reading →]]> Quick announcement. Please update your RSS feeds by coming to http://www.spvalue.com and resubscribing to the RSS feed. Having returned from traveling as well as having finally dealt with a few pressing issues, I found time to rebuild the site including transferring to a more professional and scalable setup with WordPress 3.

I have to say that I am pretty impressed with the software. It wasn’t super easy to install, but it also wasn’t super difficult, and the tools that it gives are very strong.

I will have to write more about this general theme later, but basically I am coming to the conclusion across various levels – professional and personal- that knowing and expressing what to do should be separated from the tedious execution. For instance in this case, one does not need to know how to program to write a Blog. And actually they aren’t necessarily complementary. The best programmers may not write interesting Blogs, and the best Bloggers are probably to busy reading and writing to keep their programming skills up to speed.

Looking forward to starting up again. Lots to discuss.

Try not to lose money.

Arthur O’Keefe, São Paulo Value

Below is the FXE (EURUSD ETF) vs S&P:

Last week saw a head-fake that looked at first like EUR was going to outperform the S&P (how is that even possible??? – note sell any outperformance of EUR to the S&P) and then a couple of instances where it looked like the S&P was going to break away from EUR but failed. I think S&P will eventually strip away from EUR, but probably not while North Korea may go to war or while people are discussing dropping a nuclear weapon on the seabed of the Gulf of Mexico to stop an oil leak.

So not much to report. Value has showed up again in small cap high cash flow companies – names like AIPC, RKT, RSH as well as high quality companies – you’ve basically gotten 6 months of growth in WMT for free at the price it is today, but there is some severe deflationary events (sovereign defaults in Europe) and horrible technicals (is there any retail investment left in the stock market and will it ever come back with this volatility?) that it’s quite possible that “good deals” can persist for a while and get even better.

Thus, this is not the environment to stretch or lever up. Buy “high quality” shorter dated high yield (Brazilian USD denominated debt is interesting at these levels) and nibble at high cash flow stocks using existing cash flow from other sources (dividends, coupons, and operational businesses/personal income) to add slowly. High quality companies should prove to be a hedge when inflation eventually comes back (looks like it will be 2 years away minimum at this point).

In my opinion, this is an incredibly challenging environment to invest in. As the title suggests, keep your eye on currencies to understand what’s happening. That is the driving risk factor right now from every number that I’ve looked at. The equity and debt markets are responding to currency/capital flows and liquidity constraints driven by these flows. So until we see stability in the currency markets (and we are not seeing that yet) we will not see a bull market in my opinion.

So to close, here are some interesting thoughts from the St. Louis Fed Monetary Trends June edition:

First the Title: “Why Do People Dislike Inflation?”
- Can there be any debate of the Fed’s wishes with a question like that?

Nevertheless, looking at the aggregate stats I don’t think they are successful or are likely to be successful in the near term:

I see signs of recovery but that’s expected given the large amount of stimulus pumped into the economy. Considering this and the huge amount of slack between employment and capacity utilization, I don’t see how we can have inflation.

This will help support the dollar, which apparently is bearish for the stock market (empirically), so no rush. Good deals should persist and cash flow is a must in my opinion.

Try not to lose money.

Arthur O’Keefe, São Paulo Value
http://www.spvalue.com

http://www.scribd.com/doc/32312831/Keep-Your-Eye-on-Currencies-EURUSD-is-Still-the-Key

I continue to learn. I admit, my call to cover shorts was premature (and wrong). Obviously one “Fading Near Term Catalyst” I neglected to consider was that politicians would not even recognize that there is a crisis of confidence in their ability to lead and instead would attack the markets as the cause of the EUR crisis instead of a reflection of the judgement of the participants.

Witness: Merkel Pushes Extra EU Rules, Seeks to Widen Short-Selling Ban

The issue is not really the naked short selling ban, which is more or less a ban on counterfeiting and not a bad thing. Rather it’s the following:

“Merkel said Germany will lobby governments to introduce a tax on financial markets, and for ratings companies to come under European supervision so governments regain “primacy” over markets.”

Who knows where this goes… and governments regaining “primacy” over markets sure sounds a lot like not having functional markets. Is the government going to ban downticks? These measures have an extremely high risk of increasing the risk premium required to participate in the market thereby lowering prices.

In my view, there still remains no incentive to own any EUR denominated asset as at this rate, EUR is headed lower still. And it could get worse. My fear is that even the Europeans might not want to own EUR denominated assets.

Seems like Europe will be the first forced to address imbalances, and at this rate they are on the road to addressing imbalances in a non-coordinated way… as separate countries eventually with separate currencies.

If Europe doesn’t print money in mass, then it will suffer a debt driven deflationary depression as governments cut spending to reduce deficits and are then stymied by declining GDP. If it does print money, then EUR denominated debt will be dumped for dollars and reserves will be depleted.

The link to the S&P would be that the dollar value of european revenues of large companies would decline with the economies of europe. And so equity prices would decline is my guess.

I more than suspect that these swings have caused long term damage to retail investors confidence in the functioning of the equity market which removes an important price stabilizer from the market. Expect volatility to remain elevated for a while – weeks or months.

And until there is a base found in EURUSD, volatility will continue and asset prices will head lower.

Therefore, still not adding positions and have cut things that I am not super comfortable owning for years, but I admit that I also trimmed some shorts a bit which in hindsight was super premature.

So…. Low bids are likely to be hit in the coming weeks.

Still trying not to lose money.

Arthur O’Keefe, São Paulo Value
http://www.spvalue.com

Above is S&P, EURUSD, XLF, RKT, and AIPC. First I would note the correlated indicies – S&P, EURUSD, and XLF. It may not be intuitive, but being long the EUR was to be long the S&P and the XLF for the last month. So to be bearish on the EUR was to be bearish on the other two as well.

If there is declining confidence in EUR, I eventually expect that link to break as assets flow to the USD denominated assets. Additionally, structurally, I think the US is stronger than Europe.

By now, as well, European leaders are on notice, and there is a high risk that more drastic action is taken. I don’t think it will be terribly effective in the long term, but there is an increased risk of volatility out of this, and in my opinion volatility should only be borne with a proper compensation for having to lose sleep dealing with it.

So I think it’s worth it to cut USD based shorts being used to hedge EUR risks.

Secondly, observe RKT and AIPC. Both were influenced somewhat by the crisis in that their individual volatilities increased (10% swings in the value of RKT is abnormal) but ultimately their value held – so for now (and I think going forward as well) they are not tied to the EUR which gives confidence that they can be in a portfolio as outsized positions.

I don’t want to be one to flip sentiments on a dime – but trying to make money in a choppy market is a bit like this…. I have long term and short term views. Long term, I expect riots in Europe as the ramifications of austerity measures becomes clear. The measures may or may not hold. Even if they take place, they may not be effective as GDP gets crushed from the withdrawal of government spending (look at the case of Ireland right now). So long term, I am still very scared and very worried for Europe. There has been little done to address imbalances in the banking sector there as well, and I continue to think that there is real risk of continued bad news.

But I don’t expect Europe to bring down the US. From my perspective here in São Paulo, things are booming in Brazil, and I suspect the rest of Latin America, ex Venezuela, is hanging in there as well. I am mildly bullish on the US in that it’s still the technology king of the world, and its people (my people) are amazingly adaptive. Growing up in Louisiana, I’ve seen my share of busts – oil price fluctuations in the 80’s caused a mini-boom accompanied with a property boom that then crashed when oil prices crashed. It took a number of years, but eventually the state recovered. Seeing the after effects of Katrina as well gave some understanding of the power of government stimulus and trials and tribulations to rehabilitate an area. It’s possible that New Orleans is better now than it has ever been on a number of measurements.

So we’ll see. I have little interest in owning anything Euro right now until I understand where this process goes, but I also suspect the link between S&P (and XLF) and EUR will weaken going forward, and so action should be taken in concordance with this view. I’m covering my shorts (which is not to say that I am going 100% allocated), as like most value investors, I don’t really like being short for the long term nor do I try to make money in downturns….

I just try not to lose money.

Arthur O’Keefe, São Paulo Value
http://www.spvalue.com

People should be scared as this is not the currency of a Banana Republic and it is *not* being attacked from outside. The currency is falling from within and this will be very difficult to stop. What we are witnessing is a crisis of confidence from *within* the Eurozone.

Rational people are pulling money out of weak banks and shifting to stronger ones. Similarly people are selling questionable bonds to buy stronger paper. Who’s taking the other side?The lender and buyer of last resort is apparently the ECB which means that debt liquidation/monetization looking like a certainty.

But this doesn’t occur in a vacuum. Europe, possessing lots of quick-thinking and history-studying people, is seeing it’s own inhabitants front-run the ECB by selling Euros and buying gold. This creates a vicious cycle that will be extremely difficult to stop and can go to levels vastly beyond what the mainstream is talking about.

The tricky thing about crisis of confidences is how they can get out of hand very quickly. If all of Europe starts to run, we can see the Euro go to 10 cents. Of course it won’t get there with a European Union intact – stronger countries will be forced to pull out to protect the lifestyles and purchasing powers of their inhabitants.

One thing is for certain, there are some banks already broken in Europe and we haven’t heard anything about it and no one is discussing it. So likely more surprises ahead.

Anyway, my 3 warnings here turned out to be rather timely… and I still don’t see much change. In addition to the debacle of the Euro, the Volcano is back, liquidity has disappeared while the market behaves like a rigged slot machine, and banks are being investigated for various dubious acts during the last excessive lending period.

This is the time to only own things that you are comfortable not selling for a few years – as the market could very well indeed shut down for all purposes.

Do not add risk needlessly in this environment in my opinion. Deflation is back. Use cash to pay down any debts as deflation should continue and any excess should be used only to buy low cost producers on the bid (or below). Low bids are likely to be hit in the coming weeks.

Try not to lose money.

Arthur O’Keefe, São Paulo Value
http://www.spvalue.com

So I don’t see much of a risk of rates increasing. If anything the volatility in Europe should drive assets to the long end of the treasury curve. Trouble for the US, it seems, is not going to be found in the next 3-6 months. Money has to flow somewhere, and the US government is likely to benefit from flights to quality, even if “quality” is only relative.

My general sense is that small caps are not the place to be in this environment. Small cap special situations could still workout, but general perceived “higher-risk” small caps are likely to languish for the next few weeks.

I suspect that there might be opportunities in the large cap quality and, of all things, certain tech names. The US, in my opinion, is set to surprise the world with productivity enhancements yet again.

I still don’t think good money is made in this market, and I prefer to look for opportunities to trim positions and swap into lower vol/higher quality opportunities to wait for disruptions.

Arthur O’Keefe, São Paulo Value
http://www.spvalue.com

For value investors, long bull markets get progressively less fun. Things that were cheap become much less obviously so. One gets forced into less liquid, lower quality cigar butts looking for value, and if discipline is maintained, the portfolio still starts to move into cash as it becomes harder to find ideas that meet investment criteria. The carry of the portfolio declines.

With declining income as a back drop, it’s very difficult to then search for positions that are negative carry (hedges), but that’s what’s required. As can be seen below (also care of Kostin and group at GS), volatility is quickly approaching “normal levels”, and that’s when it’s time to look for cheap options to buy for downside protection.
At least in the short term, these almost always seem painful purchases as they bleed… but if and when they pay off, they pay multiples of their purchase price.

Now is the time to start looking for cheap hedges.

Arthur O’Keefe, São Paulo Value
http://www.spvalue.com

Below: http://www.scribd.com/doc/30479290/Try-Not-to-Lose-Money-When-to-Look-for-Cheap-Hedges

And besides… at the micro and macro level, at the small and large cap level, in equity and credit, everything has had a great runs these last couple of months. A few anecdotes:

The above is a graph of Domtar (UFS). I started analyzing the company at 60ish and in short order it went to $65 and then to $70. The company was cheap, for sure, and after watching the price action, I sold the April $65 puts for $2.40 near then end of march when the stock came in again to around $65. They expired worthless on Friday for an annualized return on capital (assuming 100% capital charge) of over 50%. Whoever owns the stock (actually I know who owns the stock-Baupost) saw it rise $10 over the same period for a periodic return of 15% and an annualized return of over 200%. Not bad.

But this is not a unique story, as likewise, looking at the chart below, we see that since the middle of February alone until the end of last week, the market has gained something like 13% (almost a year’s worth of returns) for an annualized gain of almost 100% (many years of returns). If one goes back even further, returns have been truly spectacular.

So why am I saying this? Having worked in a levered hedge fund before, and at a quantitative hedge fund, and at a bank, I have a healthy fear of the flow of the heard. A pack of wildebeest (aka the market) can easily run you over on their way to running into the mouths of the hungry lions (aka savvy investors… or worse), which is to say that the market has had quite a run, and anything that’s performed with or above the market has probably had its run for a bit. While things cool off, it’s time to cut risk.

Fundamentally the market is still has room to grow in my opinion, but the technicals are pretty terrible right now. I do (or at least did) think there’s a very decent chance that the market finishes above 1300 for the year, but that’s only 8% up and there’s 8 months more to run to get there (and to top it off many people would call 1300 optimistic)…. But considering that the market has returned 13% in 2.5 months, to realize 8% in the remaining 8 months is going to be extremely difficult as things are probably not going to suddenly taper off to a nice 1% a month for the remainder of the year without triggering a correction.

Why? The simple act of (1) decelerating prices will cause (2) selling for profit taking which will then cause (3) selling for de-levering to stem losses which then leads to (4) forced selling which leads to (5) speculative front-running selling until (6) finally the value funds step in and stop the process.
I think we have rapidly moved from (1) to (2) and the risk is that we continue into the full cycle. This is the mechanics of technical trading, and it points to taking a break for a few weeks.

Throw on top of this the Goldman news and a volcano that is shutting down Europe and an earnings season that is pretty much already priced into the stock market considering the fast run up, and the risk-reward is just really not there.

A note on the SEC’s Goldman case. The charges against Goldman can be read here and below (as the SEC’s website is a bit spotty on downloads). This is bad news for Goldman and bad news for banks and a serious potential disruption to valuations of the financial sector. Where to start….

Undoubtedly charges against Goldman will get all kinds of analysis, but I suspect most of it will be on judging Goldman and Paulson. So let’s sidestep those issues and look at the human elements of this case to understand the SEC’s strategy and see if that could be predictive of an outcome.

The most interesting is the naming of Tourre as the only natural person defendant (with the only other defendant being Goldman as a company). From the allegations we see that Tourre is 31 years old and a director at Goldman London, and at the time of the alleged fraud he was a 27 year old VP on the correlation trading desk. We also see that the deal netted Goldman $15mm and the gratitude of a high profile client that eventually made $1bb and paid who-knows-how-many other fees elsewhere in the firm.

Well, anyone who’s worked on Wall Street can tell you that a VP is a great title with limited authority. It basically means that you made it out of the training program and survived a couple of years as an associate and were deemed to be stable enough to put on a career track at the bank. Tourre was probably ultimately promoted to director some time after the deal for being a good coverage of an important account (Paulson) and getting a very decent P/L ($15mm on one deal), but it’s extremely unlikely he was calling any shots while he was a VP.

So why name him and no others? It’s pretty clear that the SEC is going for blood on this suit. They likely have named Tourre to dangle in front of him huge fines and a lifetime bar from the industry unless he coughs up a bunch of incriminating evidence… and names.

If the SEC were just looking for a nice headline fine to impose, they would’t be going after the then 27 year old VP. Goldman, not being stupid, gets this as well which is why they haven’t shown Tourre the door. But it’s not clear that they have figured out how to counter this looking at their press releases.

A second interesting point is the brilliance (or luck) of picking a product where the wronged parties were Europeans – namely the Germans through IKB, and the Brits through ABN via ACA. This creates a multi-front war for Goldman and also makes it almost impossible to settle the suit cheaply with any remote admission of wrong doing. If Goldman settles with the SEC, it’s going to have to pay back the Germans and the British.

Next, is that by starting in a civil matter, the SEC is basically given a fishing license to look for other civil, and worse – criminal, offenses. What else will they find?

Finally, a must read is Sam Antar’s analysis of the prosecutor in an article called “The Kiss of Death” here. Richard Simpson sounds like their worst nightmare. For Tourre, he’s going to be even worse.

Then there’s the question of who’s next in line…. The Magnatar trade has been getting tons of press recently and doesn’t sound so different. Who knows where this goes?

Finally, if all of this wasn’t enough, we have the Volcano in Iceland…. I haven’t had a chance to do in depth research on this, but surely the airlines are bleeding money and many forms of commerce in Europe are slowing, which translates to GDP reduction in an already fragile region. This can’t be good.

Put everything together and why not take a break? I don’t see the potential upside paying for the risk in downside. For me, it seems clear that if it hasn’t already been done, this is a decent time to lock in some profits, cut some risk, and reassess the situation in a few weeks.

Arthur O’Keefe, São Paulo Value

Below: http://www.scribd.com/doc/30152414/Goldman-Sachs-SEC-Complaint and
http://www.scribd.com/doc/30318258/Try-Not-to-Lose-Money-Buffett-Gekko-Goldman-and-Volcanoes

The above is a graph of American Italian Pasta Company (AIPC), a company I have owned since April 2007. At various points in time I have traded around the position, always keeping a long bias (since April 2007), and today I remain long. It’s probably one of the cheapest stocks I see right now, even considering that it is up 13% YTD, 18% in the last year, and 566% in the last 2 years. There are many ways to “play the name” – short puts (vol is high), buying calls (stock trends up), or owning the stock (stock is up), and my view is that owning the stock is the best way to play it right now as the company will likely merge or recapitalize in some fashion in the next two years.

I could also discuss some other ideas that undoubtedly would probably sound highly convincing…. Indeed, I could even point to experience: as of today, my personal investment trailing 24 month internal rate of return is over 50% annualized and my personal investment internal rate of return since October 2005 is 34% annualized. But I think it’s more important to focus on the big picture, as based on my experience, returns in general are produced by two things that go beyond a good story: distress, and macro value.

I suppose it’s possible to add a third – growth / technological change (the Googles, Apples, and Microsofts) but for whatever reason, those are not my edge or interest. As much as I do actually believe the iPad will revolutionize business by reducing paper and bringing in multi-media reports that will greatly enhance productivity, risk adjusted, I don’t find interesting Apple, Google, vmware, and many other grow techs that will benefit with this trend, so I will focus on the first two factors – distress and macro value trends.

What is distress? American Italian Pasta Company (AIPC) was a distressed story (the company sustained an accounting fraud as the management tried to find growth in the pasta industry where little existed), and to some extent, is still recovering (and producing outsized distressed recovery returns). The distress will end when the capital structure of the company normalizes. Similarly, CIT Group, which I mentioned here, is a distressed story that will take a few more years to play out. In the case of CIT, I think the recovery will be best felt in the debt securities (at least initially). In any case, these are decent examples of distressed value trades.

What is macro value? The stock market of 2007 – 2008 (from a short perspective) and the various other trades related to housing were macro trades. The macro trend was extension and over-extension of credit paired with declining lending standards.

So to the question at the top: Why am I not currently focusing on single name stock ideas, and, conversely, why do I currently discuss macro trends like evidence of recovery and whether or not equities are a “buy” as an asset class? In short, I think the distressed play is largely over – until we go through another cycle of distress which could happen around late 2011 to early 2012 in my opinion – and so the focus now shifts to understanding fund flows and macro trends (see the graph left – focus is especially on where funds will be flowing next as opposed to where funds have been flowing).

So that brings us to equities as an asset class. In short, I continue to see evidence of a recovery which is beneficial to equities at todays valuations. For instance, the graph to the left from Charles Grom and team at JP Morgan shows furniture buying improving after two years of weakness.

Sure, it’s easy to still be bearish on all asset classes – obviously the spending by the governments of the world is not sustainable and will end badly in many cases, but that doesn’t mean that it will be equities that suffer, or, for that matter, that it will be equities that suffer now.

From what I can see, bonds are getting very late in the recovery cycle, and focus is likely to shift to equities in the coming months. So given that as a backdrop, I am stressing the macro trend because it is likely that what one buys is less important than just recognizing that in buying an equity, the “wind is at your back” today: “a rising tide lifts all boats.”

Actually, the boats are already rising…. The S&P is up 5% YTD and 39% in the last year, meaning one could have bought an “average” stock – or just have bought the market, and have gotten an above average return (at least relative to history) that is as good as or better than a value investor return. Said even more simply – with the market putting up those kinds of returns, one could have bought practically anything and made money. Indeed, during this time period, the worse quality companies have posted the highest returns.

I do note that the recent return of the market is not a reason to fear a change of fortunes in my opinion, as it seems more likely that the investing public will take notice of these returns and “pile in”, especially considering cash and bond yields today. And regardless, even after these returns, valuations seems decent as the equity market lows were truly distressed valuations.

A note about Value Investing: Yes, I think it’s easier to sleep at night with a value investor’s mentality, and in owning companies that are inherently more stable or cheaper, and through trade strategies that have a natural margin of safety – and I employ all of these tools – but these are only ways to make decent investment materials better. If the market as a whole is unsuitable, these tools will dampen the impact of, but not save one from, a correction. And make no mistake: Value Investing is ultimately about maximizing the compounding of investment capital, which means a primary focus is on side-stepping declines, and participating in rallies.

So in conclusion, some equity rallies may be irrational and predictive of future declines (like the dot com bubble and the debt led boom into 2007), but I don’t think we’re there yet, at least not in today’s equity market. We’ll know more about the bond market in a few weeks….

Arthur O’Keefe, São Paulo Value

He states:
“During 2007, under constant pressure from my investors, I liquidated most of our credit default swaps at a substantial profit. By early 2008, I feared the effects of government intervention and exited all our remaining credit default positions — by auctioning them to the many Wall Street banks that were themselves by then desperate to buy protection against default. This was well in advance of the government bailouts. Because I had been operating in the face of strong opposition from both my investors and the Wall Street community, it took everything I had to see these trades through to completion. Disheartened on many fronts, I shut down Scion Capital in 2008.”

Indeed, Michael Burry, according to Michael Lewis in Vanity Fair, eventually returned a 5x return (“489.34 percent” actually) which under almost any time horizon is a great IRR, but still he failed as a money manager to the extent that, by his own admission, he alienated his own investors and lost his business (even if by his own choice).

What happened? This brings me to the interesting grouping in the graphic at the top of the page. We can gain some insights by looking at the fund raising experiences of other questionable investors- a fraud (Fairfield Sentry – Bernard Madoff) and an alleged fraud (Stanford Financial Group – Allen Stanford), and comparing them to a (ex-post) well regarded/successful investment firm (Scion Capital – Michael Burry). The first two (questionable investors) raised tremendous assets while the third (highly successful investor) struggled – even after years of great returns. All three operated in the private wealth space. A quick recap:

Fairfield Greenwich (FG) was invested in Bernard Madoff and at its peak apparently managed over $15bb. One of FG’s funds, Fairfield Sentry (left), alone, was able to raise $7bb of assets under management by showing ~10.9% return with a ~2.5% volatility. We now know (based on Madoff’s allocution) that these returns were fraudulent, but what is useful to know is that the fund was able to draw and maintain $7bb of assets under the assumption that this performance would continue. So presumably, the lesson is at least $7bb of demand exists at the risk preference of 10.9% return with 2.5% volatility. If FG’s other funds (besides Sentry) exhibited similar return profiles, then we can say at least $15bb of demand existed at this risk/return point.

Next, the Stanford Financial Group (SFG) was seized by the US for allegedly perpetrating a ponzi scheme that attracted $8bb of assets. Not commenting on the merits of the case, what we do know (at least from this WSJ article on the SEC’s accusations) is that “from 1992 to 2006, Stanford International Bank reported steady returns of from 6% to 10% annually on its certificates of deposit, according to the SEC” and based on these “steady returns” SFG was able to draw and maintain $8bb of assets. I remember reading in Bloomberg (though unfortunately I can’t find the source) that much of the returns promised were around 8% per year which checks with WSJ’s statement. So from this we can surmise that another $8bb (at least) of demand existed at low/no risk and 8% return.

Lastly, not much is public about Burry’s Scion Capital, but from the Vanity Fair article, we can surmise that assets peaked at $1bb after a 5x gain and after shoving a significant portion of assets into side-pockets (as discussed in Burry’s 2006 letter to investors) which was so poorly received as to eventually merit shutting down the firm as noted in the above quote in Burry’s New York Times Op-Ed. If we assume that 5x was garnered in 3 years, then we can estimate that the yearly return was 70%. Based on Burry’s other writings and letters we can make a rough guess that his fund had a volatility of 30% annualized. Reducing the $1bb to the original investment and adding a factor to make it comparable to FG, perhaps it’s fair to say that Burry eventually raised $300mm and was able to grow it, though he was not able to hold on to it even after significant gains. So from this it’s perhaps fair to say that very little demand exists in the private wealth space at 30% risk with lock-ups (side-pockets) even if the return is exceptional.

Insights and Conclusions
* So what seems to be a common theme is that private wealth investors are more sensitive to risk (or perceived risk) than return. In short investors prefer low risk – low return strategies.
* Along this line, FG and SFG were able to raise a combined $23bb of assets by showing returns of at most 11% per year but possessing very low volatility.
* Additionally, Scion was not able to keep assets after requiring lockups and demonstrating significant volatility even if over time exceptional returns were generated.
* So investor behavior seems to indicate that investors prefer to delegate total wealth management to an asset manager – low risk / low return strategies tend to have an easier time raising assets, even after correcting for risk that presumably the investors could do themselves.
* Yet, investment managers tend to offer only a one-size-fits-all product (medium to high risk with high returns) even when the investment market clearly rewards more de-levered products (like a low risk CD returning high single digits or a fund consistently giving a 10% return at low vol).
* Therefore there is an opportunity to offer a menu of products – ie a menu of risk – to investors and allow them to indicate their own risk tolerance. At least offer a “capital preservation” strategy that has a volatility of no greater than 8% per year.
* If this were done, many managers would likely find that they need to de-lever their portfolios but would be able to buy more of the same risk assets over a much larger asset base.

So even though investors claim to want 20+% per year, the general risk tolerance seems to be more at the 8% vol level. Assuming a sharpe ratio of 1 and a 2% alpha, 8% vol gets you to 10% return. Therefore returning 10% (net after fees) at 8% vol (roughly half of the S&P) should raise significant assets.

Consider the implications. A fund that has a strategy that yields 15% per year net at 10% vol on its investment style, would be much better suited taking the same style and de-levering it roughly by a third (ie putting 1/3rd of assets into cash or something similarly low risk) and reducing vol to 7-8% and return to 10% and could probably then raise 50% to 100% or more in assets.

So in Burry’s case, I actually sympathize more with the investors. They thought they were getting a more liquid strategy than they ultimately discovered they had. Yes, Burry was spectacularly right on his investments, but investors did not want to take that level of volatility. Presumably he could have exercised the same strategy, but much less concentrated, and would keep his firm. Alternatively he could have solicited a side pocket strategy (much as Paulson did) and been clearer with the liquidity. If he had done either, likely he’d be running/managing billions now. His choice, however, was to produce a 500% return – great for him personally as incentive fees yielded $100mm and the story led to a book but at the cost of the business.

It’s a questionable choice, professionally. Consider that a firm producing 10% net of fees is probably making 13% before fees and extracting 3% in fees. If 10% net raises $2bb in assets, then fees on those assets amount to $60mm per year. In two years, the $100mm payout is surpassed. Such is the asset management business. In the end, profits are more sensitive to time than returns.

Feliz Páscoa,
Arthur O’Keefe, São Paulo Value

So what does it mean? First is that the majority of the area is below 100 which means that US earnings estimates are, on average, overly optimistic. Only in the period of 2005-2007 were earnings consistently revised upwards. Looking at the green lines, though, we can also see that earnings estimates made at the bottom of the recession two years forward actually tend to be more or less accurate and even can be subject to upwards revisions. For example, look at earnings two years out in the 1986, 1992, and 2003 recessions. Subsequently they were all met or exceeded. Only in the 2000 double dip recession (which dipped into 2003) were earnings lower, by about 10%.

So how to apply this? To the left is a graph from Morgan Stanley showing actual earnings estimates for the S&P 500. We see that 2009 earnings estimates were as high as 105 and ended at 57 (with the end of the 2009 reporting season in the first quarter of 2010). So final earnings were roughly 54% of the peak forecast which checks with the chart at the top of the page showing a trough end of year earnings as a percent of original forecast of around 52%.

2010 earnings are forecast to be a healthy 40% higher, and 2011 earnings are looking to be stronger still approaching 2008 levels. Both Financial and Non Financial Firms are expected to show the same trend.

So is this believable? Using only analyst track records through previous recessions as a guide, I would hazard to say that, yes, if history holds (and I think it will), earnings will be surprisingly strong. I do not see indications of a double dip recession for now.

So what are the implications? A lot is being written about S&P P/E ratios being high. But if earnings are going to rise to the extent shown above and also considering that today’s capital structures are much less levered (if only because the credit markets have been shut forcing de-leverage) and looking at things like price to trailing 10 year earnings (as shown left) which shows valuations in line with history, then there is room to the upside in equities.

One final check is to look at profits as a share of GDP (to the left). We see that there is more than ample room for improvement either way one slices it.

It will likely be a volatile ride, but the market should continue higher, in my opinion.

Feliz Páscoa,
Arthur O’Keefe, São Paulo Value

Arthur O’Keefe, São Paulo Value

Arthur O’Keefe, São Paulo Value

First a look at 10 year swap spreads (now negative) in the following graph:
The recent decline below 0 (now – 9bps as can be seen at the far right of the graph) is getting a lot of press recently. For instance here is a Bloomberg article which blames the phenomenon on corporate hedging. Later Bloomberg changed its story to say that the negative swap spreads were due to a glut in Treasury securities, and this seems to have caught on a wider following.

Personally my first reaction was that there must be some structural stress going on with the market, but that does not necessarily mean that the stress is due to a view of government credit quality relative to corporate credit quality. The graph at the left, though, shows swap spreads around the world, and one can certainly see that there is a strong correlation between negative swap spreads and countries having deficit problems. Correlation, though, does not equate to causality. Also what might be causing negative swap spreads in one market does not necessarily cause them in another.

To really dig to the bottom of this, I looked at the swap system using a framework developed by one of my professor’s at Harvard Business School, Robert C. Merton (not to be confused with Robert K. Merton, his father and acclaimed sociologist whom I will discuss as well at the end of this entry). Bob (Robert C.) Merton is best known for winning the Nobel Prize in Economics for his insight of using Ito calculus to price options (ie developing the continuos time implementation of the Black-Scholes option pricing formula) and later for participating in the rise and fall of Long Term Capital Management. So since Merton already has a Nobel and a bit of fame/notoriety, his more recent work on things like pensions (with Zvi Bodie) and structures of financial systems has not garnered much attention. In some ways, though, his more recent work is even more impactful, in my opinion, than the closed form options pricing equation (Black-Scholes) which is widely used but nevertheless confined to the universe of options and derivatives traders. In any case, Merton with Bodie (link here:) postulates that the outputs of a financial system are dependent on financial institutions and intermediaries that evolve with the politics, customs, and behaviors of a society and so apparent distortions in the financial market would therefore be partly due to a structural deficiency or friction within the institutions.

So it can be that government deficits do indeed lead to negative swap spreads, but it is not at all clear why that should be the case and how it actually happens. Where exactly is the stress of government deficits showing up and who is really bearing the risk? Is it in the banks again as zero hedge postulates? Or is it somewhere else?

Hence the graph at the top of this post dissecting the sources of fixed and floating rate exposures in the market. Along the lines of Merton’s framework, the bank is seen as an intermediary in the whole process and acts only to transmit risk between entities, though it does introduce a friction in the form of a spread that it charges for its risk transmission service. So let’s translate this intricate graph:

Corporation Block and Corporation – Bank Relationship:
Starting at the bank/corporate relationship (since that was where Bloomberg originally postulated the problem started and where the stress was most evident) we see that corporations issue bonds (mostly) to hedge funds and insurers paying a fixed rate – assume for 10 years to keep with the analysis of swap spreads. Bloomberg argued that corporations then enter into a swap arrangement with Banks to receive fixed and pay floating rates for the term of the bond issuance (10 years in this case).

Before analyzing how or why a Bank would do this, let’s think like a corporate treasurer/CFO in today’s interest rate environment. Specifically let’s think like the CFO of a generic BBB corporation today. The iBoxx Domestic Corporate BBB Spread to Libor index shown to the left shows a BBB credit spread of 1.92%. This is the credit spread to swap rates that a corporation of BBB credit quality pays and is generally in line with what one sees in the market today. 10 year swap rates (also shown on the left) shows that banks borrow for 10 years at 3.71% (the 10 year Libor or Swap rate) so the cost of borrowing to the treasurer is 1.92%+3.71% = 5.63%.

So if the CFO issues a bond and does nothing else, he has locked up 10 year financing at 5.63%. But is there anything else the CFO can do to lower borrowing costs today that might also strategically fit in with the companies revenue forecasts? Yes, the CFO can swap from fixed to floating by agreeing to pay 3 month Libor resetting every 3 months for the next 10 years and in return receive the 10 year Swap rate. 3 month libor is today .28% annualized (as can be seen in the chart at the left), so if the CFO does this, borrowing costs then become 5.63% – 3.71% + .28% = 2.2%. This is a 60% reduction in costs. And what risk is being taken for this reduction? Mainly the risk that short term rates increase. But under what circumstances will short term rates increase? Probably only a recovery, and in a recovery revenues will rise before and faster than interest rates (given the large amount of excess capacity in the system, the recovery will be well underway before rates rise), so from a business perspective, this is manageable. In the meantime if the recovery is delayed, the company continues to pay 60% less in interest than it would under a 10 year fixed arrangement. So really, the decision is a “no brainer” for the CFO. Swap to floating.

Notice in this entire analysis, the CFO does not care where 10 year government rates are trading. Actually as can be seen in the chart on the left, investing in a 10 year government bonds will pay 3.83%, whereas the bank will only pay 3.71% as noted above, so the CFO will receive 10bps less than investing in government bonds, but the CFO still does the deal because the CFO is not looking to invest money – rather merely switch from a fixed rate to floating. Said another way, the CFO is not concerned that the fixed rate the company will receive is less that the rate that the company would receive if the company because the CFO is not looking to deploy cash but is rather looking at 2 borrowing options, and in this case the CFO is making the more rational decision and swaps. The CFO’s actions will then push the swap market lower, but nevertheless the swap market will remain attractive for the next CFO who will do the same trade. So absent some other relationship (probably an arbitrage relationship as discussed below) with other actors the swap spread will continue lower until it reaches the point of indifference between swapping from fixed to floating for the marginal corporate borrower. But, there are other relationships as we continue around the diagram at the top of the page.

Government Debt (including mortgages) Block and Government Debt – Bank Relationship:
So continuing right in the graph at the top (using Merton’s framework of analyzing a bank as an intermediary as opposed to a risk taking entity) we look at the Bank’s actions in the government debt market and how these might affect swap rates. There are two items which are critical. First is that the government debt market provides a source of fixed rate exposure and second is that there is spread differential (normally positive but now negative) between swap rates and the rate in the government debt market. Thus, in theory there is a arbitrage relationship between swaps and rates that prevents swap spreads from getting too negative (with the negative value representing frictions in the banking sector). That relationship is that at a certain point it becomes very profitable for a bank to buy government debt, receive fixed, pay fixed at a higher spread, receive floating, and pay floating to receive cash to buy government debt. So linking back to the CFO above, the CFO does not need to take a view on rates but rather can rely on this arbitrage relationship to ensure that the swap rate the company receiving is not too low. There are, however, limits of arbitrage. Here the limit is the amount of leverage that a bank can employ to buy government securities (a cash obligation) to pay fixed and receive floating in a swap transaction (a cashless transaction) relative to other investment opportunities to provide a return on the same amount of equity posted to borrow to buy the government bonds. As shown above to get a 15% return on equity with a -9bps swap spread would require leverage of 15/.09 = 167x. For a 5% ROE the leverage required would be 55x. Even at the very low range of acceptable return on equity we see that the amount of leverage required is a bit extraordinary (in today’s environment), therefore it is probably safe to say that swap spreads have not yet hit a lower bound to where arbitrageurs/banks can act between bonds and the swap market to stabilize spreads. Luckily there are other relationships.

A brief note about mortgages backed by Fannie and Freddie (the vast majority in today’s environment) is that to the extent that the government or Federal reserve takes actions to “keep mortgage rates low”, ie at a low spread to government rates, these will behave like government securities in the arbitrage relationship outlined and will fail to influence swap spreads until spreads widen to a meaningful point to leverage mortgage securities to receive fixed from the mortgage market (after adjusting for all prepayment options) and pay fixed in the swap market. So an unintended consequence (see below for discussion on the general topic) of the Federal Reserve capping mortgage rates (as can be seen in the above graph from the St. Louis Fed Monetary Trends publication) is that it lowers the floor on swap spreads.

Bank Borrowers (Debtors) and Debtor – Bank Relationship:
The graphs at the left taken from the St. Louis Federal Reserve Monetary Trends monthly publication give some insight into a potential cause of negative swap spreads: the decline of fixed rate borrowers. More so than from the government debt and mortgage markets, Banks source a material amount of fixed rate exposure from corporate, small business, and consumer loans. Given the recession and previous bubble in borrowings (evident left), borrowers are repaying loans and de-levering rapidly even as Banks (given swap spreads and signs of an improving economy) are getting more eager to lend as can be seen left with loosening lending standards. So we have a real sign that a critical supply of fixed payers is drying up. Normally a bank will lend at fixed + a credit spread (and recently given the crisis that credit spread has been very high) and then swap out to floating in the swaps market to receive floating which they then pay to depositors to receive money to lend. With the decline of borrowers, it’s possible that banks are having to lend to the government in the bond market at a less attractive rate pressuring swap spreads as the banks try to maintain a profit margin.

A quick note on personal and state balance sheet repair through federal deficits which I have previously commented on. If this analysis holds, an unintended consequence of transferring private debts to the federal balance sheet is lowering (or negative) swap spreads. This is not necessarily a view on government credit quality as much as it is a result of reducing profitability of a key market intermediary- the Bank.

Bank Lenders (Bank Bond Buyers) and Lender – Bank Relationship:
Banks have a outlet to pay fixed if they find themselves get long receiving fixed rates. They can issue bonds to the market which pay fixed rates. Given the obvious stress in the swap spreads market as banks get asked to pay more and more fixed rates and receive floating, it seems that banks are actually short fixed rates and so are more interested in other forms of raising cash (namely equity or deposits).

Equity Holders (Stock Holders) and Equity – Bank Relationship:
Banks can raise permanent capital in the equity market (without the obligation to pay fixed rates per se) but are held accountable on their return on equity. This relationship serves to enforce on the bank that it only makes economic decisions. This contributes to the negative swap rate by imposing a limit of arbitrage in the government debt – swap rate interaction outlined above.

Depositor (included Fed) and Depositor – Bank Relationship:
Just as banks can shed fixed rate exposure by issuing bonds, they can shed floating rate exposure by attracting deposits.

It is here (looking at depositor actions) that we see more signs of distortions (again from the St. Louis Fed). As noted above, in the corporate swap market we have signs that Banks are increasingly making fixed payments (and receiving floating payments) and are having trouble raising loans to source these fixed payments and are also increasingly looking for leverage in the government bond market given swap spreads but face a limit of arbitrage on leverage.

Another unintended consequence of the steep yield curve (the first being CFO’s swapping to floating) is that money is flowing out of short term (floating rate) deposits because deposits just don’t pay well in the eyes of the depositor. We see some indication of this with Libor very recently ticking up slightly (as can be seen in the graph on the left).

But it is important to remember that it is the Fed that has the largest impact on short term rates (independent of the supply of depositors to the extent that the Fed replaces depositors through open market operations) and so the effect of an unreasonably low deposit rate (that drives depositors away to other higher yielding securities or longer durations and forces the federal reserve to take open market measures to maintain low rates) manifests itself as a steep yield curve (seen left) that makes it very attractive for CFO’s to swap from fixed to floating as discussed above.

Pensions (old age insurance) and other Insurers and Insurance – Bank Relationship:
The enactment of the Pension Protection Act of 2006 had the effect of requiring companies to gradually bring their retirement plans to fully funded status and maintain them that way and consequently gives strong encouragement to immunize their pension liabilities by receiving fixed rates which correspond to fixed future pension obligations. Perhaps a more tenuous link (and one which I admittedly have little evidence to support save the life expectancy chart to the left from the CDC) is that increasing life spans create longer term liabilities in the health insurance and other markets (including an additional effect on pension liabilities). Presumably the pension issue is the dominant factor in this sector and creates a natural bid to receive fixed rates as pensions look for methods to increase portfolio duration to match liabilities.

Hedge Funds and the Hedge Fund – Bank Relationship:
Lastly in the chart at the top is the hedge fund – bank relationship. Hedge funds that buy investment grade corporate debt from companies generally finance the purchases through the banking sector. They have the option to hedge interest rate exposure by swapping in one form or another to floating. Given the combination of credit spreads (at roughly 200bps) and short term interest rates (at 25bps) for a hedge fund to achieve an adequate return on equity (assumed to be 12%) without taking any interest rate risk would require leverage of 6 times (200bps * 6 = 12%). This is probably not acceptable for risk management reasons. If however funds take interest rate exposure, buy buying longer dated bonds and financing the purchase in the short term market, it is possible to achieve such a return with less than 3 times leverage. As a result it is likely that hedge funds investing in investment grade debt are electing to not hedge or to under-hedge interest rate exposure again leading to an imbalance of fixed rate receivers in the market (and an imbalance of paying fixed rates in the banking sector).

Insights, Consequences, Conclusions, Considerations and Trade Ideas:
Reviewing the above discussion, I first note that credit quality of the US has not come into consideration. It can be that there are speculative positions being taken that are increasing the distortion in the swap spread market, but in my opinion this is unlikely. A key difference between the US and the so-called PIIGS – Portugal, Ireland, Italy, Greece, and Spain – is that the PIIGS cannot print their own currency of indebtedness due to the European Monetary Union. I have not explained how that can lead to negative swap rates but suffice it to say that the inability to print money in ones currency of indebtedness leads to credit risk which interferes with the government debt swap rate arbitrage relationship discussed above. The US does not have this problem and so I do not think that it is credit fears that are pushing swap spreads negative.

Instead I would would guess:
* Corporate hedging is likely very strong in the direction of receiving fixed due to the large cost savings with the steep yield curve and the likely alignment with general corporate strategy to make costs variable with the recovery (spend more if the economy recovers).
* Government Bond Interest Rates are not yet high enough or the 10 Year Swap spread is not yet negative enough for the arbitrage relationship to work between these markets.
* An unintended consequence of the steep yield curve and the drive to keep mortgage rates lows is negative swap spreads.
* A reduction of general borrowings is removing an important supply of fixed rate payers which in turn leads to lower swap rates and negative swap spreads.
* An unintended consequence of taking private debts onto the public balance sheet (ie manufacturing savings) is negative swap spreads.
* Banks are at or below their lower range of desired profitability. Cost structures may be higher than historically.
* Banks are constrained by leverage and having difficulty raising deposits.
* Pension funds are increasing the duration of their portfolios, competing to receive fixed.
* Hedge funds are not hedging their interest rate exposure.
This leads to a few themes:
* The market is increasingly getting long fixed rates- that is the market is electing to receive fixed driven largely by the slope of the yield curve.
* The factors outlined above do not appear likely to change anytime soon, and therefore swap rates are likely headed lower along with swap spreads.
* There will be building pressure to flatten the yield curve as capital flows in search of higher returns.
Finally trade ideas:
* Swap spreads are still not an attractive bet at this point. Risk is to even lower swap spread especially while deflationary pressures continue.
* Along these lines, due to short term deflationary pressures, receiving fixed rates is likely going to become a crowded trade. Look for ways to take the other side….
* The key to when to take a position I think is to watch loans. If lending start to pick up, swap rates will likely rise (as will inflation). Given the crowded trade, swap rates have a potential to move sharply higher.
* An environment of rising swap rates has the potential to be positive for financial stocks as it signals a rising profitability in the business model.
* Avoid low return highly levered trades.
* Long term call options on lowly levered companies could perform well as interest rates and volatility increases. In general I like this trade even today with volatility declining as losses due to volatility drops are generally more than made up with rising equity prices.

A Brief Additional Note on Unintended Consequences and Functional Analysis:
Occasionally in Bob Merton’s class at Harvard Business School I would catch hints of reference to his father, Robert King Merton, a brilliant sociologist who coined phases like self-fulfilling prophecy (which his son would reference in discussions of the rationality of bank runs) and unintended consequences. Robert K. Merton was a functionalist and presumably looked at the result of a particular structure to understand what function it was providing and thus understand its structure in a system. Thus the result was the input and the structure was the output – a demand driven analysis, which is not always the most intuitive starting point. Robert C. Merton, his son, later went to apply this same framework to understanding the financial system. Essentially bank are the way they are because that’s the structure needed in a particular society required to fulfill the needs that banks fulfill.

Arthur O’Keefe, São Paulo Value

p.s. Following is this article in print form as posted on Scribd with the original drawing.
http://tinyurl.com/yga6fpu or
http://www.scribd.com/doc/29222286/Negative-10Y-Swap-Spread-Unintended-Consequence-of-Steep-Yield-Curve

This is one of the many reasons that investing in emerging market equities is extremely difficult. Having lived in both India and now Brazil, I am completely certain that fundamentally these markets are completely different – but one wouldn’t know it looking at the above graphs.

What brings this all to mind is a rather insightful story care of Nogger’s Blog – a really strong reminder that there is a whole different world in commodities – on India’s wheat harvest. He picked up on a story out of Punjab talking about India’s pending grain problems:

Above is a photo of rotting Indian wheat care of NDTV. My experience with India is that the story is completely believable – the country has some severe subsidy issues.

But the investment problem is what to do with this information which brings one back to the graph at the start of this entry. What one cannot or should not do is buy or sell India’s stock market based on this story (or any other story bases on fundamentals of India). Perhaps there is a trade in wheat to do, but I would doubt this or any other story unique to India will lead to sizable and profitable trade. This story and its ramifications are unlikely to drive valuations in my experience, even if it should.

So, likewise, recently it is in vogue to discuss the apparent problems of the Chinese market – real estate bubbles, sham government investments, currency manipulations, commodities speculations, etc. Again all rather believable and probably true, but what to do…. Now observe the following graph of the Hang Seng and CSI 300 Chinese Indexes overlaid with the Bovespa and Sensex:Is there any differentiation? I don’t see it personally.

So what’s the point of all of this? EM equity investing at the index level is strictly about understanding two things – fund flows and currencies. It’s a pure macro game. On the long side one makes the most by buying the index with the best appreciating currency at a time when funds are flowing into Emerging Markets. Similarly, on the short side one gains by selling the index with the currency that will weaken the most at a time when funds are flowing out of Emerging Markets. Where are the fundamentals in this process? Not at the micro level.

So back to China. As far as I can tell, a bet against China is a bet against emerging market fund flows and a hope that their currency will actually weaken – not strengthen. Two tricky bets, and timing is everything on them. Be careful in this bet.

For me, I will step out of this and wait an see, as for now, the best opportunities remain in the US in my opinion.

Arthur O’Keefe, São Paulo Value

As I mentioned before, I read a number of newsletters. Sometimes those distributed for free by a small team or a single person are as insightful as (or even more so than) those which charge a fee. On this note, another decent newsletter that I read is from by Absolute Return Partners LLP (ARP) of the UK.

ARP in their March 2010 letter reminds the reader of the following identity:
G – T = (M – X) + (Y – T – (C + I))
Before accepting or commenting on this, though, it’s useful to see where it come from. Macroeconomic analysis is based on the following relationship.
GDP = Private Consumption(C) + Government Spending (G) + Business Investment(I) + (Exports(X) – Imports(M))
Shortened we have: GDP = C + G + I + (X-M)
Basically this says that each year Domestic Production is either consumed by the people or government or saved domestically or sent abroad (X-M is net exports). If the people consume more that what is available domestically, then the shortfall must be made up with imports larger than exports resulting in (X-M) being a negative number as is the case for the US.

One of the interesting things of macroeconomics is that insights come from rather simple things. The above is indeed rather insightful on its own, especially considering that it requires no complex math.

It’s interesting to note that taxes do not come into play in the above as taxes are just a reallocation from one bin (C or I) to another (G). Also the above applies to both nominal (non inflation adjusted) and real (inflation adjusted) accounting. For now, let’s think in nominal terms, as it is a bit easier to conceptualize.

So let’s consider taxes. Since this is an equation we need to apply Taxes (T) to both sides:
GDP – T = C + (G-T) + I + (X-M)
What is (G-T)? It’s the deficit actually. Government spending in excess of taxes.

A little further rearranging gives:
(GDP – T – C) = (G-T) + I + (X-M)
Now we are getting somewhere. This is a permutation of the equation given by ARP (above). But what does it mean? Upon closer inspection we see that it can be translated as:
After Tax National Savings (GDP – T – C) is applied to (=) fund the deficit (G-T) or (+) invest in businesses (I) or (+) be lent/saved abroad (X-M).

Additionally, what ARP so insightfully pointed out is that businesses are dissaving right now. That is to say and they are not accepting any more investment (I) right now. Additionally, US trading partners will not allow their countries to become net importers (so that X-M will not become positive any time soon, although it is currently improving mildly). So, then, until business investment picks up, the only way there can be savings (at least perceived in nominal terms) is to run a deficit (G-T) to give the population something to save into. We can only hope that the deficit is being used to fund some sort of public investment – roads, bridges, schools, and the like, so that the nominal savings is actually real savings.

Which leads to the graph at the top. States don’t have the luxury of running a deficit since they can’t print money, and given the recession, tax receipts are dropping precipitously and even with the increased Federal expenditures, there is a big problem as can be seen in the below from Merrill Lynch (Ethan S. Harris and team):Certainly it is clear that states need to adjust to a new lower revenue stream by reducing expenditures, and they certainly will with time; but as can be seen by the shortfall to the left which is after transfer payment from the federal government, to do so in one shot without a bridge loan of sorts from the federal government would result in higher peak unemployment and another large contraction.

My point is not to pass judgement on this process, but rather to say that there is another side to the federal deficits and taking that into consideration, it is unlikely that the deficit (or concerns about the deficit) will immediately lead to a crisis.

It seems more likely that there will be domestic buyers available recycling savings into government debt either through banks or through direct purchases for the immediate future because there is simply no other place to put the money.

We will see potential problems when demand from businesses for investment capital picks up. If the federal government does not respond then by reducing expenditures, I suspect only then will we see a crisis and it will be in the rates market. So the key is to monitor items indicating renewed business investment – CapEx, Venture Capital, Startups, Increases in Sole Proprietorships, etc.

Arthur O’Keefe, São Paulo Value

Source of graph: JPM – Thomas R. Wadewitz and team

This is really related to port loadings as a material amount of railroad traffic is intermodal. As noted in the graph above from JPM, railroad car loadings are also improving year over year. Still not back to the highs of 2007 but strengthening nonetheless.

Arthur O’Keefe, São Paulo Value

He is generally bearish which makes using his ideas to invest on a little tricky. One thing I noticed in his latest reports is the above graph that indicates that there may be investment opportunities in grocery stores as pricing is stabilizing in food (generally an indication that capacity utilization of the industry is healthy level). Worth investigating.

Arthur O’Keefe, São Paulo Value

Observe the following from page 4 of Greenlight’s Q4 2009 letter (also below in full):

This is pretty interesting. Every investment is evaluated like a private equity investment – through IRR, even though these are public equity investments. I am fairly certain every value investor has some method of performing the same analysis. It is this analysis that causes the value investor to switch between cash and an investment. Essentially cash sits outside of the investment universe and is “called down” (just like a private equity commitment) when needed. Thus the clock for investment returns starts when the capital is invested/“called”.

Why is this interesting? First is that technically it’s complicated. It requires a more sophisticated MIS (Management Information System) than you can traditionally find off the shelf, and for this reason very few hedge funds engage in this level of analysis.

Secondly in addition to being purely more technically complicated, it’s a much more mentally sophisticated form of analysis – it means that they use a second dimensional statistic other than profit (ie time profit is realized in the form of IRR) to evaluate the success of an investment and to critique the process of making that investment so that it can be replicated where successful or avoided where not.

Lastly, and most subtly, on a strategy and portfolio level this provides and indication of general market conditions by allowing the monitoring of running internal rates of returns on existing positions (that is IRR of the whole portfolio at once or IRR’s of sector or other strategy breakdowns) that can give feedback to where opportunities can be found and when it might be time to harvest a trade or when entire sectors may be over or under valued.

On this last point one can imagine a fund that through its investment style generally generates an IRR of 25% over many years such that there is a reasonable level of confidence in the process. During the October 2008 – March 2009 crisis one could see which strategies were showing the most negative running IRR and identify those as having potentially the best investment opportunities to apply new capital. Similarly if a strategy is showing an IRR well past the average fund IRR, one can at least investigate to see if it may be time to harvest.

This sounds very technical – but isn’t actually – a very similar type of reasoning is used in analyzing businesses. Essentially it’s a bet that the world mean reverts. Margins mean revert, return on equity mean reverts, asset turns mean revert, and leverage mean reverts. Along these lines, performance can have mean reverting properties. There is always room for outperformance in individual investments, but as the pool grows larger to to the point that it then reflects the market, then returns tend to become bounded on either side.

Why does this exist? Because capital can only flow from one sector or one asset class to another so quickly. For this reason we also find momentum in the market. News does not travel instantaneously and investments do not reach fair value over night, and thank goodness for that.

In any case the point is that some level of performance analysis is critical to refining one’s strategy. Essentially as Peter Drucker would say: “What gets measured gets managed.” So it might be wise to follow Greenlight’s example and measure carefully and then manage appropriately.

Arthur O’Keefe, São Paulo Value

Some of the best investments can be explained rather simply. Also I find its easier to understand a business if I reduce its financials to a simple model.

For a non-finance company I use the following income statement flow:
Revs
-COGS pre depreciation
=Gross Rev (implies gross Margin)
-SGA (implies sales costs)
=EBITDA (implies EBITDA margin)
-DA (implies asset life)
-Interest Expense (implies interest rate)
=Profit Before Tax (PBT)
-Taxes (implies tax rate)
=PAT
/Shares (implies dilution rate)
=EPS

I always model a balance sheet – for cash flow is an implied result of the interaction of the income statement and the balance sheet. This is actually the more complicated part of the analysis (though there are many things that can be done to simplify analysis and projection) and where I suspect real money is made (at least in my experience) as balance sheets are not very well understood and are hardly seriously modeled, especially by sell side analysts. This is a topic I will go into later.

Regarding the income statement, at first sight one might think that the model above only applies to retailers or companies with products to sell… but this is not the case. Business is ultimately about selling products or services, and invariably this involves variable (COGS) and fixed (SGA) costs. So for instance, the fuel line item of a railroad’s income statement could be classified as a COGS.

Another consideration in regards to the income statement is that the COGS reported by some companies needs to be adjusted to remove depreciation and amortization if it is reported inclusive. The reasoning is that depreciation and amortization are not always variable with sales – or at least that the link is a bit strenuous. If sales grow the company may be able to boost asset turns, and including D/A in COGS can lead to seeing a margin improvement when none actually exists (as, if the company just improves asset turns, then presumably D/A won’t change much giving a fixed component to COGS while the variable component grows with sales, in effect showing an improvement). Similarly, if sales decline, a company may not immediately go out and sell assets, and as a result an unadjusted COGS line may indicate declining margins masking the real situation.

There are many other nuances, but these give a sense of the interaction of the income and balance sheets. In general I look at 10 years of balance and income statements to understand the various ranges of different parameters – margins, turns, returns on equity, leverage, receivables and payables relative to sales and COGS, etc. Ultimately the goal is to understand how sales growth leads to potential asset growth and consequently to left over cash flow from sales that can be delivered to the shareholder.

To really make it clear, consider this: there are in fact companies where sales growth leads to very little cash flow left over for the shareholders, and, given the level of interest rates and other investment opportunities, it may not make sense to invest in these companies (as they will only produce cash at distant date) even though the rest of the world thinks they are great investments (leading to a very low implied cash flow discount rate). Conversely, there can be other companies that, due to a complete lack of sales growth or the desire to grow sales, have a tremendous amount of excess cash that can be returned to the stockholder quickly while the market punishes the stock leading to a very high implied discount rate of cash flow.

Arthur O’Keefe, São Paulo Value

I remain short term bullish on the US equity market. It’s a difficult place to be, as, it is very easy to see the potential problems with large governmental deficits (particularly in the US and Europe) and weak/worsening demographics (particularly in Europe and Japan and, to a much lesser extent, the US). But the issue is not the severity of these issues, but rather whether these issues are reflected in the prices of various markets.

It’s a bit subjective, but one measure of the extent issues are reflected in prices is the various proportion of coverage various statistics receive. The deficit gets quite a large amount of coverage so it probably has little use in projecting prices lest there be some surprise.

One item (among many) that I look at that doesn’t get a ton of press is container loadings out of the ports of Los Angeles and Long Beach. Why these? A majority of trade that occurs with China and the rest of Asia passes through these two ports. Additionally, they readily report statistics.

From the below (graphs of trailing twelve month and monthly container loadings) it can be inferred that, at least for now, the economy is improving and it is being lead by exports, though imports are also firming up.

I suspect this is not getting coverage, and if it continues, I suspect export oriented manufactures will surprise with earnings on the upside. This helps focus my research for the next few weeks.

Arthur O’Keefe, São Paulo Value

Took a quick look at CIT yesterday and at $37 it’s worth an investment. Stock is probably worth closer to 50 in the next year or so for an IRR of 25-30%. Actually like both the debt and equity. The debt matures in tranches over the next 7 years starting in 2013 and is trading like high yield.

Looking at the pro forma balance sheet of the company (below), I think the equity is cheap and therefore that the debt is money good. The general thesis is simple. Bank’s traditionally have traded around 1.5-2x book even with the normal skeletons in the closet. Here you have a company trading at 1.15x book where all the bad assets have been written down through bankruptcy, with a stellar set of investors who participated in the restructuring of the company through the pre-packaged bankruptcy process, in a space that has little competition, with a new management that’s going to be paid based on performance of the company. All the conditions and incentives are in place for this stock to rise.

Why do banks trade at 1.5x book historically? Using CIT as a model, we can see:
Assets – 60B and Liabilities – 54B
Equity – 6B
Leverage = Assets/Equity = 10

If we assume in the long run that with various fees and services assets yield 9% and that liabilities yield 5% then the pre SGA return on equity will be 9% + 9*(9-5%)=45%. So the company will make 45%*6B = 2.7B pre expenses. If we assume expenses of 1.5B, then the company will make 1.2B of profits at this spread for a book yield of 20%. At a 1.5x book, market value of equity is 9B and so P/E is 7.5 or an earnings yield of 13%. Not bad. Profits are then mostly reinvested in the company. This is a simplistic example, and a 4% spread between assets and liabilities may not be achievable so easily, but it shows the potential.

Arthur O’Keefe, São Paulo Value

So much of value investing rests on the assumption that human nature and investing doesn’t change over time. In that sense, the article below reinforces that the subprime debacle or the internet bust were nothing new. Where you find people, you’ll find excessive or uninformed risk taking and an occasional bubble. One can argue that the actions mentioned below are not much different than the CDS market of today. Perhaps this will lead to the next debacle. While it’s not clear what will happen next, almost certainly *something* will happen again leading to distortions in valuations and opportunities on a systematic level. In the meantime these sorts of things will continue to go on at a micro level creating opportunities in individual investments.

Note, though the article says it’s copyrighted, my understanding is that copyrights for works published before 1923 are expired and the works are free to use. Perhaps value investing is one of the few things that can make use of such old information.

Arthur O’Keefe, São Paulo Value

Arthur O’Keefe, São Paulo Value

Anyway, I’ve just come across a quarterly letter, at Trapeze, that’s decent: http://www.trapezeasset.com/trapezeasset/news.html

Mentions Clorox (CLX) which I’ve been meaning to look at for a while as will as Kroger (KR) and CVS Caremark (CVS). There are a few other names that have come across my screen before, but a really hairy (both an opportunity and a cause for caution). Certainly lots of analysis is warranted.

I am giving them a plug, because they highlight several themes that I also currently believe. I’ll outline those in later posts. In the meantime, if interested, read the letter.

Arthur O’Keefe, São Paulo Value

I got a trial subscription to Value Investor Insight to take a look at the Klarman interview. Not sure if I will continue the subscription or not. I guess it depends on the next issue. I can’t say I found the other investments pitched all that compelling.

As for the article, rather than quote the whole thing (which I question the legality in any case), the following were useful reminders:

4. Risk is not inherent in an investment;
it is always relative to the price paid.
Uncertainty is not the same as risk.
Indeed, when great uncertainty – such
as in the fall of 2008 – drives securities
prices to especially low levels, they
often become less risky investments.

At the same time at low prices, volatility picks up substantially. So quite often, very low risk investments are extremely volatile. Trading becomes very tricky. From my experience, unless you are such a large part of the volume as to influence the price and dampen volatility, it seems like you have to force yourself to buy slowly and try to understand where the technical floor is.

9. You must buy on the way down. There
is far more volume on the way down
than on the way back up, and far less
competition among buyers. It is almost
always better to be too early than too
late, but you must be prepared for
price markdowns on what you buy.

Really related to 4.

12. Be sure that you are well compensated
for illiquidity – especially illiquidity
without control – because it can create
particularly high opportunity costs.

Which helps explain why a lot of funds in illiquid investments hold a decent amount of cash.

17. Having clients with a long-term orientation
is crucial. Nothing else is as
important to the success of an investment
firm.

I will write more about 17 at a later date. For now, it is sufficient to say that Seth Klarman (SK) and Baupost have made this an integral part of their business model, and it is a material reason while it is almost impossible to mirror their business model.

That being the case, SK’s insights should be read with the intent of applying them to another business model.

Arthur O’Keefe, São Paulo Value

Just finished reading Eddy Lampert’s letter here:
http://www.sec.gov/Archives/edgar/data/1310067/000119312510036907/dex992.htm

Haven’t looked at SHLD in a while, but I will when I get a chance.

From my experience there are two components to value investing: Good Companies and Good Prices. Traditional investing has the first and not the latter and value traps have the latter and not the first. To be able to act decisively when there are actual opportunities, it is generally helpful (though not always required) to have a stable of Good Companies that can be bought when they come into a Good Price range.

SHLD has all the makings of being run by someone who “gets it”.

The pace of expansion in retail generally and in big-box retail more specifically has slowed dramatically in the past year. I have written previously about what I believed was the reckless expansion of retail space leading to lower profitability for many retailers and to low or negative returns on the investment required to expand space. In other industries, consolidation rather than expansion has led to a more sensible competitive environment and better returns for shareholders. If you examine the level of capital expenditures over the past decade at many large retailers and compare that expenditure to value created, it would not paint a pretty picture. Additionally, the dramatic declines in capital expenditures over the past couple of years at most large retailers are strong evidence that the level of maintenance capital expenditures for a big box retailer is materially below what many analysts and experts previously believed. Most of the capital spent over the past decade has been largely for store expansion, with some lesser amount required for maintaining existing stores. For a company like Sears Holdings, with over 2,200 stores in the Kmart and Sears Full Line store formats, our need to expand our physical store footprint is much less than many of our competitors. At the same time, our need to improve the productivity of our space is much greater than many of our competitors. We are pursuing a number of alternative solutions in parallel to address this challenge.

One hint of this is a decent understanding of when to spend money.

Rating agencies play an important role in how investors allocate capital by “qualifying” debt for certain investors. By overrating companies and securities, rating agencies can lead to systemic issues and investor losses. Similarly, by underrating companies they can lead to lower growth, less risk taking, and less job creation. Simplistic analyses, which automatically prefer capital investment to share repurchases as a use of cash that “benefits” bondholders, ignore the fact that negative or below market returns on invested capital are as harmful to creditors as to shareholders.
—
Amazon’s domestic business has grown to $12.8 billion in revenues for the year just ended. If you were to apply a 6% sales tax to this revenue (reflecting a rough average of sales taxes across multiple jurisdictions), that would amount to almost $800 million in sales and use taxes owed to state and local governments that is likely not being paid. The good news is that it is $800 million that remains in the hands of the purchasers of products from Amazon, but at the cost of jobs and new fees and taxes required to make up for lost revenue. Having delayed a level playing field for as long as they have already, Amazon has been able to build relationships with many customers that give it an advantage, even playing under the same rules as those it competes against.

Another hint is understanding when institutional rigidities create a distortion in the market.

Arthur O’Keefe, São Paulo Value