September 30, 2008
Now talk about too big to fail. Those banks will never be allowed to fail and they can take all the risk they want. But expect tighter regulation by the government to make them even quasi government entities.
Welcome to the Canadian banking model, where few banks monopolize the industry. Canadian have always called for deregulation to open up banking for outside competition but the government relented. The results higher fees, lousy customer service and high lending rates.
So to my friends in the US get ready for a lousy banking model.
September 27, 2008
Emerging markets (EM) equities and debt look very appealing, debt in particular. Emerging markets index has declined more than 33% this year, while EM debt spread have soared to 300 basis points over treasuries, its spread was 170 BPS in 2007.
Investors over the past few months have scaled down their holdings in emerging market equities and debt considerably. Capital flight from these markets was due to the credit issues faced by the developed world. Investors feared that credit issues will spread eventually to the Emerging Markets. EM funds have seen an outflow of $26 billion, compared with an inflow of $100 billion in the previous five years (source: Financial times, Economist).
I think the changed perception of EM risk is an opportunity. I see that a good risk/ reward proposition is in EM, debt in particular. Although perception of risk has changed, the fundamentals do not support the increased risk due to the following:
- future growth is much more solid in emerging markets with less structural issues and headwinds to limit its progress.
- emerging markets currencies will appreciate against the potential collapse in US currency due to current and trade accounts deficits.
- Developed economies are facing recession and credit risks while EM are facing one headwind in global recession. EM hold surplus foreign reserves as a result their credit situation is
much better than the US and Europe. Its ability to fulfill its debt
obligation is not impaired
For sure emerging markets will slow down as a result of the rescission in the US; there is no decoupling ever and I am not arguing this. But the upward growth trend is not broken by the current credit crises.
First, Emerging markets economies are growing 4 times as fast as developed nation economies according to IMF. They no longer depend on foreigner to make capital investment; now they are capable of doing that on their own to spur growth.
Second, Emerging markets do not produce only cheap goods, but they have produced multinational companies that compete on the same level with developing nations companies. These companies will expand into developing economies to add markets and spurring growth. This will translate into higher job creation at home and higher wages.
Third, by the numbers emerging markets account for 80% world's population and 50% of GDP growth but only 8% of stock markets capitalization. The imbalance have to be corrected by owning more of the world's assets and occupying more in market capitalization.
Fourth, EM are cash rich and own a large portion in basic resources. As a group, they are in far better shape than ever before.
Many are commodity exporters and many commodities are at record highs.
Recently, crude oil is around $100 a barrel while
other commodities prices have also been increasing, although they came off their recent highs lately. Moreover, over the
past five years, many emerging market governments have taken steps to
insulate themselves from the effects of a global financial crisis.
EM governments are cash rich with reserves at record level. They are sitting at 75% of global cash reserves. Those reserves will support their currencies against the euro and dollar. Although currency appreciation is not the outcome those couturiers want to happen, there is no escaping it. The US dollar faces lots of head winds: ballooning trade deficits and ever increasing debt load. Treasury and the fed are continuing to pump dollars in the system debasing its value; it is astonishing that the dollar has not fell off cliff thus far.
This brings me to what will Sovereign Wealth Funds (SWFs) and cash rich countries do with this capital. The recent credit issues of US have given SWFs and cash rich countries pause and hesitance to invest in the US. These parties want to diversify away from the US to reduce their exposure. EM assets allows them to do just that, particularly EM debt.
My strategy is to be a buyer of EM debt and patient accumulator of equity, as it is highly correlated with global equity markets. I do not know when markets will recover therefore EM equities may languish a bit so I will cost average over the next little while. This strategy will provide me with the following:
- income as EM debt spread is high for no fundamental reason
- hedge against US dollar decline
- appreciation once investors come back to the market
- improve my asset allocation by increasing debt portion in my portfolio.
Now, emerging markets are trading once more at a significant discount. There
are some good reasons for this. The turmoil in states bordering Russia
suggests a rise in political risk. For example, stocks in the Ukraine
doubled in barely 18 months, but since January they have halved.
A lot of emerging markets are in the low double digit PE. Falling to single digit PE would provide very attractive entry point.The chart to the left displays that EM equities on PE basis are trading at a discount of 50% to the S&P, while debt has a spread of more than 300 basis points to treasuries. (Charts courtesy of Financial Times)
Next post I will discuss the risk associated with investing in EM also what type of instruments to use to monetize the idea.
September 21, 2008
Further commentary about the merit of supermarket banks, the one BofA trying to create with the purchase of Merrill Lynch.
"...... universal banks appear to offer clear advantages to both shareholders and regulators. Yet some of those advantages are illusory. For regulators, larger, diversified institutions may be more stable than investment banks but they pose an even greater systemic risk. “The universal bank is the regulatory equivalent of the super-senior mortgage-backed bond,” says one analyst. “The risks may look lower but they do not go away.” And deposit funding is cheaper than wholesale funding in part because those deposits are insured. Measures to protect customers may end up allowing banks to take on risks that endanger customers.
For shareholders, too, the universal bank may offer false comfort. A model that looks appealing in part because assets are not valued at market prices ought to ring alarm bells. Sprawling conglomerates are just as hard to manage as turbo-charged investment banks. And shareholders at UBS and Citi will derive little comfort from the notion that the model has been proven because their institutions are still standing. If the independent investment banks survive, they will clearly need to change. But they are not the only ones."
September 19, 2008
What I bought on Wednesday during the market decline:
- I added more of Brookfield Properties (BPO) at $17.50. I think BPO has unique assets in high barriers to entry markets. I ignored the noise of higher vacancy rates due to the turmoil on the financial markets and expected layoffs from banks. The company has good management and I think buying it at this time for the long term is worth of the risks.
- I added to the FirstService position. FirstService is commercial real estate service company that is trading now at less than the valuation one division of their holdings, which is residential property management. The company is mistook as a brokerage business and it is being punished because commercial real estate transaction are almost vanished. Sure its brokerage business will suffer but the residential business is solid. The company is being opportunistic and buying other businesses at the moment to position its business for the rebound. Its management is good and they are aligned with shareholders as they have an economic interest of about 25% of the company.
- I have added to Haliburton option position. I am under water on the position but I think HAL has room to run here and very attractive on a valuation basis.
- I sold US Bank corp into today's rally. I bought USB at $30 few months ago and it reached my valuation target I sold at $38, a return of 26% plus dividends received through the holding period. USB is very fine bank it avoided all the nonsense that is plaguing most banks today. It actually closed at 52 week high today. I think the bank is very solid with good management and focused on its core business with no ambition for empire building. But I got to get out right now on valuation basis.
- I sold United Rentals @ $17.45. I have lost on this position as I bought it at $21. I have entered into this trade to take advantage of a tender offer the company initiated but it did not work as I intended.
- Sold small position from my fixed income as yields have came down significantly during the panic. Prices of government bonds have went through the roof lately I am selling into that panic.
Well, I am not enthusiastic. In the best of times large acquisitions like this have high probability of failure so I am not quite sure what is the situation in a troubled time like this. However this is far better than buying Lehman I must say.
I bought the shares of BofA because it is a retail bank with no exposure to investment banking, not a big one anyways. Now BofA is building an empire to reach all corners of US finance. I do not like the business of empire building. Just look at Citi business model of being a banking supermarket. It did not work. It was too difficult to manage and hid risks away from management.
BofA management are good and they have solid experience in integrating acquisitions. But this is an investment bank where its true assets and core competencies lie in its people and the relationship they build with clients. It is very different than a retail bank, which is about processes and customer service.Investment banking encourages the superstar while retail emphasize the system. It is a big culture clash.
I am mulling my position in BofA as I am not sure I can track it or follow it now due to the added complexity. I have not decided to sell yet, so I will keep running scenarios to the merit of the business.
Below is a good article about the marriage between BofA and Merrill that differ from all the typical media stance cheering the deal and celebrating Ken Lewis acumen of deal making.
The big question: In agreeing to buy Merrill Lynch, is Bank of America saddling itself with an unmanageable pile of toxic assets? While the potential long-term benefits for both firms are compelling, the short-term risks of doing such an enormous deal in the middle of a financial panic could end up being too much for BofA to handle.
If there were no credit crisis, the deal would appear to be a steal. For a mere $40 billion or so — the deal value has declined, along with BofA’s stock, from the initial $50 billion — BofA will be able to combine its giant retail-banking network with Merrill’s extensive network of personal financial experts. The cross-selling opportunities and the expected $7 billion in annual cost savings virtually pay for the deal.
Nevertheless, the price that BofA paid and the savings it promises to reap could take a back seat to its ability to support Merrill’s assets on its balance sheet.
BofA cannot use its large depository capital base to back up much of Merrill’s riskier assets, so it needs to be stocked and ready with cash. If BofA does not have the required amounts of capital to absorb these assets, some of which are particularly radioactive, it could find itself in the same boat as its broker-dealer rivals, begging for cash at a time when the world’s wallets are closed.
To complicate things, BofA is still in the process of absorbing the troubled mortgage lender Countrywide Financial, which it bought earlier this year. That deal will force it to put $172 billion worth of risky mortgage assets on its books. Countrywide is still hemorrhaging money and more write-downs are expected. About 35 percent of Countrywide’s subprime mortgages are said to be in default, and it could get worse.
Merrill Lynch still has $5.6 billion in subprime assets on its books, according to analysts at Oppenheimer & Company. That would combine with Bank of America’s $5.2 billion for a total of $11.5 billion in sludge. That is more subprime exposure than UBS, Morgan Stanley, Goldman Sachs and Wachovia — combined.
BofA says that the combination of Merrill and Countrywide’s assets on its balance sheet is expected to bring its Tier 1 capital ratio — a key measure of financial strength — down to about 7.4 percent. That would be the lowest of all the major financial institutions and not too far from the 6 percent mandatory level required by the government.
It could be worse: David Trone, an analyst Fox-Pitt Kelton, says he believes that BofA may have been using marks that overvalue some of its assets. He estimates that BofA’s Tier 1 capital ratio, after the acquisition, would be more like 6.65 percent if Merrill’s portfolio is marked to current market prices.
That would leave a thin margin for error, and there could be a rough road ahead.
Bank of America has billions in personal loans, credit card debt and car loans outstanding. If the economy continues to head south, more people will start defaulting on their commitments. That would burn through BofA’s loan-loss provisions and eat away at its profits. The result could be a tumbling stock price, which might require BofA to raise capital to fill the gap in its common equity. BofA could raise capital by cutting its dividend, but that would cause its stock to fall as well and send a negative signal to the market.
While other banks are deleveraging and selling their troubled assets, BofA is going the opposite direction and taking on more. If the credit crunch ends today, BofA could cross the finish line and make out like a bandit. But if it continues or gets worse, the nation’s largest bank could regret its impulsive wedding.
I am all for government intervention to stop this financial meltdown but banning short salling can prove to have unintended consequences.
Short selling provide liquidity and price discovery to the market. Without these two elements prices are distorted significantly and skewed. Moreover the move can shake investor confidence in market integrity and operations. I do not sell short but now I have less confidence in the market transparency and rules that I base my investment decisions on.
Enforce the rules on naked short selling that already exist. no one should be able to sell a stock that he/she does not own, that makes sense. Banning short selling altogether is a hasty move that can backfire.
September 15, 2008
Bank of America to Buy Merrill - WSJ.com
What a weekend it was, history is being made here. I wanted to be a fly on the walls in the federal reserve and listen in at the negotiations. I can't wait for a book similar to "when Genius failed" that talked about a similar episode of American finance when LTCM failed.
I am a little relieved that BofA backed out of buying Lehman but now it is buying Merrill, a far better acquisition with much better assets. Here are some thoughts:
- Merrill has much better assets than Lehman and the fit is much better. Merrill has good assets, a large network of brokers, good investment bank, stake in BlackRock and other assets. It has been cleaning up its balance sheet since John Thain took over last year, so I think, I hope, that there is far less risk with Merill than Lehman, which did nothing since the credit crises broke. But then again investment banks balance sheets are very obscure and I do not know what is on Merrill books.
- Dividend cut: there is a higher probability now that BofA will cut its divided to boost its capital base.
- The independent investment banks model will fail. Only Goldman and Morgan Stanley are left standing and you got to think how are they going to finance their operations. Leverage in the hands of bankers are like ticking bomb, the story throughout history has been repeated so many times. JP Morgan can take Morgan Stanley and reunite the firm that once was broken up by US regulators.
- I view my investment in BofA as speculative now. The bank will either make incredible returns or will languish around dealing with losses and law suits.
- Executing a string of mergers is hard and I am concerned about that.
- BofA is building an empire of American finance that sprawls into all corners of the US banking system. Just look what happened to Citi is my initial thought. However there is a big difference between the two: BofA is buying at extremely low valuation and its competitors are disappearing at fast pace. Those two factors increases the likely hood of making a decent return. But manging the empire is what concerns me; it will be a daunting task.
- It is an all stock deal that means I as a shareholder will be diluted.
Again I can't wait for the book!!
September 12, 2008
REI Global, the Lehman spin off, most likely have a portfolio that is mixed and includes the company’s equity position in the Archstone-Smith Trust apartment portfolio, which it purchased in partnership with Tishman Speyer Properties last year. Tishman Speyer and Lehman Brothers completed a $22 billion leveraged buyout of Archstone Smith a year ago last August.
Off course they overpaid for their buyout at the height of real estate valuation in 2007. At the time, Englewood, CO-based Archstone was one of the largest multifamily REITs with about 86,000 units worldwide. Barron's called the deal a "gigantic gamble" because Lehman and Tishman would be paying more than $1 billion in interest -- more than Archstone's $800 million projected NOI for 2007 -- on the $17 billion borrowed for the deal. based on these figures, they did this transaction at a blended cap rate of about 3.6%, a very high valuation.
Here is the breakdown of their portfolio by dollar value:
Geographical break down:
- 57% of the holdings are in the Americas,
- 26% in Europe, and
- 17% in Asia.
- 58% are debt positions,
- 26% are equity positions,
- 16% are securities.
- multifamily properties represent 22%, and
- office properties represent 18%.
September 11, 2008
Since yesterday a lot of news reports came out about Bank of America is in talks to buy Lehman Brothers. Lehman Brothers have fallen pretty hard as market confidence eroded its ability to do business. I do not know if all the talk about its liquidity is warranted or not. But it is in a distressed situation and BofA may scoop it up at dirt cheap prices.
I am not particularly fond of investment banks. I actually hate them. I do not think their earnings are as good as commercial banks. Moreover they are not immune to stupid behaviour. I actually hate that BofA is thinking about acquiring them and that will lead me to rethink my ownership of BofA. Here are few quick thoughts that come to mind:
- Integration and execution risk: BofA just finished acquiring Countrywide and just before that Lassalle bank. Adding another acquisition like this can overwhelm BofA management and lead to distractions and lack of focus therefore letting small things fall and lead to terrible outcomes.
- Culture clash between traditional banking and the bravado of investment banking. Too many times BofA CEO has displayed his contempt to investment banking and now he is acquiring one, albeit a smaller one than more of its competitors. Investment bankers think of themselves as God's children on this earth. How can they coexist with their dominions in the form of commercial bankers especially if the big boss is a commercial banker himself.
- Too many risks in Lehman balance sheet that I can not easily understand and value. BofA is complex as it is adding an investment bank is way too much for me to follow and understand.
- BofA is becoming like Citi bank maybe too big to manage. To be fair Citi is more international and have more insurance business lines and more complicated than the combined BofA and Lehman, but your get the picture.
A lot, as Lehman’s investment-banking strengths don’t overlap with Banc of America Securities. Lehman targets big companies as clients, while Banc of America has much more of a presence in the so-called middle-market because of its commercial-banking experience with midsize companies. Lehman has a credible presence in Europe, while Banc of America doesn’t.
Broken down by business lines, Banc of America is slightly stronger in fixed-income, where it ranks No. 10 in global debt underwriting compared with No. 13 Lehman. Banc of America is one of the top banks in underwriting high-yield debt issuance and leveraged lending, where Lehman barely has firepower.
Lehman Brothers is stronger in equities underwriting, where it ranks No. 9 compared to Banc of America’s No. 14 this year, according to Dealogic.
In individual investment-banking groups, each has its own strengths: Lehman is powerful in advising natural resources, oil-and-gas companies and retailers, while Banc of America is stronger in health care and real estate. And Banc of America has just built a new building in midtown Manhattan, just blocks from Lehman’s current headquarters.
Then there is question of prime brokerage, a business that provides support services to hedge funds. Banc of America Securities recently sold its prime brokerage to BNP Paribas, and in buying Lehman, it would be getting back into that business, just as hedge funds are using less debt and spreading their money thinly across multiple prime brokers.
I hope that this transaction do not go through. If it does BofA will be a speculative holding in my portfolio waiting for a break even price to get out, as I am down some 17% so far on it. I may have to take that loss and move on and add the selling proceeds to US Bank corp, another holding of mine.
The duration and severity of the credit crisis has exceeded the expectations of many; I have under estimated its severity and duration. I have compared it to other liquidity crises events like LTCM and Latin debt crises, but the confluence of events, housing and economic slowdown, prolonged its duration.
Despite repeated government policy initiatives which have gone well beyond traditional monetary response, market volatility and ongoing credit losses have become the norm in 2008. A key underlying theme is a loss of confidence in both the balance sheets of financial intermediaries and in securitized investment products, which has pushed spreads to record wide levels.
Some of the unprecedented moves by government included, in no particular order:
- The Fed cutting interest rates to 2%
- Stimulus cheques to citizens
- Liquidity measure by the fed:
- The Term Auction Facility (TAF)
- The Term Security Lending Facility (TSLF)
- The Primary Dealer Credit Facility (PDCF) that included investment dealers, not just commercial banks
- Shotgun marriage between Bank of America (BAC) and Countrywide Financial (CFC)
- Another shotgun marriage between Bears Stearn's and JP Morgan Chase
- Naked shorting rules selectively enforced to few financial institutions
- Remove lending limits on Fannie Mae (FNM) and Freddie Mac (FRE)
- The Fed granting wavers for private equity firms to invest in banks
- Fannie and Freddie nationalization or takeover, whatever way you want to classify it.
Is there any end? Does any of the government measures will stop the ongoing decline?
I do not know. This part of the uncertainty that I will buy if I find a good business. However I have to adjust my expectation that my holding period should be a lot longer than usual.
September 10, 2008
September 8, 2008
I think BofA will be hurt in the long term as Fannie and Freddie will cut their activities by 10% a year. Countrywide Financial Corp., now part of Bank of America Corp., was the largest provider of loans purchased by Fannie Mae, accounting for 29% of its business in 2007, according to Inside Mortgage Finance, and was the second largest source of loans for Freddie Mac, with a 16% share.
NorthStar Finance and other mortgage reits will benefit as debt spreads over treasuries will come down a lot as some uncertainties have been lifted from the market. Commercial debt and most residential mortgage debt will trade higher as their rates heads down. NRF will have a lot of business lending and making good deals and play the yield curve spread, borrowing low and lending high.
Tax rates: personal tax rates may have to go up to fund all these bailouts. There will be some structural changes to the economy as a result of all these bailouts. What is it? I am not sure. But it will increase budget deficit and tax rates and that can bot be good for future earnings.
Housing recovery may not get affected at all with this takeover. You may have Treasuries interest rates go up while mortgage rates go down and they converge some where higher, therefore not reducing the cost of borrowing much for the homeowners.
I think whatever you think of this takeover, positive or negative, it is very dangerous to decide on any long term investment or action based on this takeover and today's market reaction.
September 5, 2008
Coach, Inc. (COH) is a marketer of fine accessories and gifts for women and men. The Company offers lifestyle accessories. Coach’s handbags and accessories use a range of leathers, fabrics and materials. The Company’s product offerings include handbags, women’s and men’s accessories, footwear, jewelry, wearables, business cases, sunwear, watches, travel bags and fragrance. Coach operates in two business segments: Direct-to-Consumer and Indirect. The Direct-to-Consumer segment consists of channels that provide Coach with immediate, controlled access to consumers, retail stores and factory stores in North America and Japan, the Internet and the Coach catalog. This segment represented approximately 80% of Coach's total net sales, during the fiscal year ended June 28, 2008 (fiscal 2008). The Indirect segment represented approximately 20% of total net sales in fiscal 2008.Business Economics The business is very well managed by all statistical and fundamental measures management has done a superb job. So lets review some of these elements:
- Cash-to-cash cycle has been compressing over the last few years, which always means that inventory and working capital is managed quite well.
- Sales per square foot in north America are increasing while in Japan, where COH has a strong following and a large international presence, has been flat or slightly decreasing over the last few years, but nothing significant. The company reckons that it can have 450 to 500 stores in North America, so I suspect that productivity figures for sales per sqr ft will come down with the expansion plans.
- Revenue growth has been stellar over the last 7 years but it is starting to slow. Some will argue that international growth into China and emerging markets will allow COH to continue its horrid pace, it is a strong possibility if the China story continues, so that remains to be seen. As you can see in COH revenue growth profile its current revenue growth rate is below its 3 year average growth rate and its 3 year average is below its 5 year average growth rate, so growth is starting to slow. Nevertheless we are talking about 19% growth rate in revenue nothing to sneeze at.
- COH margins are very solid and at all time high due to reorganization of their supply chain that managed to reduce their cost of goods sold and better utilize their working capital.
- My only concern here as an investor is the company so well manged that there no more room for improvements. I think margins have reached their limit as most efficiencies from supply chain redesign have been achieved. There is a strong possibility that these efficiencies are going to start reversing. Since their supply chain has gotten longer their transportation costs will increase as a result of higher energy costs.
COH goods are at the lower ladder of luxury goods. Actually they are geared towards consumers who want to trade up from common brands to luxury brands. Certainly they are not a brand to be associated with the rich. COH brands are associated with middle income who want to pretend or look as if they are rich. In other words COH revenue may be susceptible to economic pressures more than a Gucci, Hermes or Louis Vuitton, as the rich spending is impervious to economic cycles. Recently Hermes, Gucci and other luxury goods companies reported solid growth numbers, see here, although COH reported good growth numbers they were relatively tame in comparison.
COH is trying to be more upscale but it is doing so by raising its price for its leather goods. Several of my female family and friends who I surveyed for this analysis said they would rather own Hermes, Burberry or something from Louis Vuitton collection, if they are going to pay what Coach is asking for its leather bags. So COH may price itself out of the market at the new price points that it is rolling out. Moreover many have objected to the logo imprint on coach bags. COH logo imprints on its bags are so aggressive and the trendy may find it tacky.
Another risk to their brands is the distribution channels that COH is pursuing. Their own retail stores obviously is essential to control the brand but the indirect and outlet channels may lead to brand dilution. Their discount stores will never propel the brand into the luxury category they hope to be one day.
Growth rate is what can make this business undervalued or overvalued. COH had an exceptional growth rate over the past several years; it averaged a historical growth rate in revenues 29% over the last 5 years. Do you assume the same growth rate going forward? In my discounted cash flow models I hate to assume anything over 5%, actually I try to assume zero growth to see if the current cash flow stream is undervalued by the market. Take a look at the following table where it displays COH intrinsic value assuming different growth rates. In the vertical column it has revenue growth rates for the next 10 years, while the horizontal line displays its terminal growth rate beyond the initial 10 years. Please see my model here.
As you can see if I assume historical growth rates to continue COH is undervalued but if my expectation is right about slower growth rates then valuation by the market is fair.
I figure COH valuation is somewhere between $19-24 where the growth assumptions are very conservative. If I attempt an Earning Power valuation model I come up with an intrinsic value of $19 per share for COH assets. The main adjustment is for goodwill as COH has no history for M&A so its brand name in not reflected on its balance sheet. I have taken multiples of its competitors and looked at revenue to goodwill ratios and applied similar ratio to COH to arrive to a comparable figure.
In conclusion, COH is a well run company that have a fairly valued stock. I have no problem owning Coach but I would rather own it at $20-22 per share and its future growth can serve as my margin of safety.
September 4, 2008
Russell 2000 YTD returns :-5.57%
Dow Jones YTD returns: -15.47%
S&P 500 YTD returns: -15.59%
Russell 1000 index, Large cap index, YTD returns: -14.59%
That is really surprising because typically small cap stocks are not international and would be hurt the most in a credit crunch, as banks would not lend to them due to their higher risk profile. What is more surprising is small cap index is weighted more to out of favour sectors like consumer discretionary and financial services, see table comparison:
|Russell 2000||Russell 1000Sector|
|9.11%||5.08%||Materials & Processing|
Over the long term typically small cap outperform large cap by a good margin but in this type of market I am very surprised to see this out performance.
- a new manager of the company that have experience in distressed assets, and
- price of no more than 30 cents on the dollar.
Here is a table of recent distressed debt to private equity:
I do not think either company will talk in their registration statements, if there is any, about "unlocking of shareholders value" because they are doing pretty good so far in creating value for their shareholders.