For this post I pull out one of the points from the last post: I believe the natural rate of return of the U.S. economy has declined due to aggressive monetary policies over the past few decades. This raises the question: Is it more attractive to invest outside the U.S.?
Of course investing outside the U.S. involves greater risks, including currency and political risks. However, if the natural rate of returns are more attractive in other countries, they should in theory provide more attractive investment opportunities. I've been pondering both this question and how to execute such a strategy.
Ideally, an investor wants a politically stable country with a deep and broad and healthy economy, offering efficient capital markets. Additionally, the outlook should also include appreciation of the local currency relative to the U.S. and the local economy is not significantly correlated to the U.S. economy.
One can narrow the list down fairly quickly by excluding countries with relatively high debt loads that may cause distress and countries whose economies are not large enough to offer a reasonable breadth of opportunities without undue risks and costs. While I haven't arrived at specific list of countries or investments, at this point I am planning on putting a fairly large percentage of my portfolio in a mix of international equities and debt.
At this point my timing is based on the following steps unfolding in the near-term are:
(1) Stock markets pull back around the world due to slowing U.S. economy with possible deflation, European debt market gyrations, and risks for an Asian slowdown. I am looking for a cathartic move, but not sure we'll get it. When this happens the U.S. dollar likely rises as investors run to perceived safe havens.
(2) U.S. government reacts aggressively with both fiscal and non-traditional monetary policies, which may include direct efforts to raise inflation expectations. The U.S. dollar weakens due to rising debt, uncertain U.S. growth, and inflation risks.
(3) Stock markets rebound somewhat with investors expecting a recovery in private spending that enables at least one year of an improving outlook.
So I'm looking to time my re-entry around a cathartic move in the markets, which may happen in the next five months. I also expect a fairly volatile period with many unexpected events significantly impacting the markets, so the outlook likely evolves as we move through the summer.
Wednesday, June 30, 2010
Saturday, June 26, 2010
Liquidity Trap
Forgive me for the gap in entries, my last entry spurred me to circle back and think harder about the direction of the economy and I've picked up "Managing Investment Portfolios. A Dynamic Approach." in order to refresh my memory on portfolio management theory.
Inflation or Deflation? What is the outlook?
Are we headed down the road paved by Japan of a lost decade with deflation or are we on the precipice of accelerating inflation? Answering this question is a key step in settling on an outlook, and thereby constructing a portfolio.
Currently we are stuck in what the economist Keynes termed a "Liquidity Trap." This occurs when interest rates approach zero and basically means that traditional monetary levers have little impact on stimulating the economy because the demand for money has become almost infinitely elastic. Therefore, non-traditional monetary policies and fiscal policies must be relied on to stimulate the economy.
Clearly the government has been quite active with its fiscal policies in order to stimulate the economy. These policies have had some positive effect, although the extent of the impact is a political hot potato. I argue there are a couple problems with these classic "cut taxes versus increase spending" fiscal debates. The first is that we already cut taxes during the Bush era, reducing both the impact of further tax cuts and our ability to materially increase debt levels (after adding trillions during America's "deficits don't matter" era). The second problem concerns the obvious statement that the increased government spending must lead to greater private spending, or else any recovery is unsustainable. This second problem is where we find ourselves currently, debating whether private spending will now lead us out of the liquidity trap with corresponding rising interest rates, or will the slowing government stimulus and continued lackluster private spending produce a "double-dip" recession with potentially deflationary prices.
Eventually Poor Investment Spending Decisions Catches Up With Us
The next segment looks at the Liquidity Trap problem from a financial perspective by bringing in the growing use of the financial analysis methodology "Economic Value Add," or EVA. Basically this analysis looks at the difference between a company's cost of capital (basically the blended interest rate on debt outstanding and cost of equity) and its Return on Invested Capital (ROIC) to determine whether the business is creating or destroying economic value. If ROIC is greater than the cost of capital, then economic value is created. From my own analysis, and what one would intuitively expect, I believe the expected EVA of a company describes over 95% of its stock price with swings in ROIC through management decisions dominating.
For the past few decades the cost of capital for businesses has been declining, highlighted by the declining interest rates but also likely a result of more efficient capital markets. Thus, managers have had a lower and lower ROIC hurdle rate to clear in order to produce a positive EVA. Looking at monetary policy through this prism, the government can actively increase the country's EVA by lowering the interest rates, thereby lowering the cost of capital for companies and making previously negative EVA projects appear positive, even though the cash flow dynamics have not changed. Nice trick, unless you use it too often and for too long and thus managers start making investment decisions based on expected lower financing costs going forward, effectively lowering the returns produced by the economy. If abused, I believe an overly aggressive traditional monetary policy, which does not force the healthy pruning of marginal projects through periodic recessions, becomes a race to the bottom that eventually produces negative returns and thus deflation.
The outcome of the declining cost of capital are large pools of invested capital with low return levels, or bubbles like the housing market. If the macroeconomic forces deteriorate, these low returns can swing to negative returns. The cumulative effect of these management decisions to fund low-level return projects is a glut of assets, highlighted in overcapacity in industries like the restaurant industry. Should lending standards tighten, as banks have recently done, the economy has a tougher time recovering until these low return assets are absorbed by growing demand or shrunk to in-line with demand trends. My concern is that both fiscal and traditional monetary stimulative efforts cannot overcome the structural problems created over the past 10-15 years due to the low returns inherent in the country's investment base.
Paying the Piper, or not
The next three to six months likely answers the question of whether private spending picks up enough to drive a recovery, or remains muted and we slide back into a recession. There are clearly signs that the economy is improving, including an expansionary ISM Manufacturing Survey data, higher volume of freight shipments, and improving consumer sentiment. However, there are also data points that suggest a more muted recovery. Relatively low raw industrial prices and commodity prices offer a mixed picture on demand. The Conference Board Leading Economic Index grew modestly at 0.4% in May, slightly lower than expectations, slower than the 1.4% in March, and following a weaker result in April of flat. One of the main reasons offered for the weaker recovery is the expiration of the federal housing credit in April. (Eek!)
Of course the government can provide additional spending stimulants and pursue non-traditional monetary actions. The increasing debt load likely makes increased spending measures more politically challenging, especially if the Republicans win more seats in Congress and unseat President Obama. Tax cuts might be offered, but these are likely viewed as more short-term in nature and therefore likely won't have as big a bang, or at least only drive growth in high-end markets while segments catering to the middle class languish. If the economy slips backward I would expect to see more focus on non-traditional monetary policies to stimulate inflation, including active currency devaluation, monetization of the country's debt, and efforts to raise the expected inflation rate in the future through high level policy announcements. If it gets to this point we may see another period of expansion during which I would hope the underlying structural problems are solved. The risk is that either these "hail maries" don't work or the government overshoots and inflation balloons.
If government efforts cannot spur the economy, or burden businesses with excessive regulations and costs for businesses, then the next decade may be lost as business works off the marginal investments of the past.
Investment Strategy
Currently I have a blank canvas, with my portfolio almost entirely in cash. Not ideal, I know, but one of the main reasons I started this blog in order to re-engage and determine an investment strategy. I will also mention that my liquid portfolio is predominantly in a tax sheltered vehicle, thus reducing my interest in more tax efficient investments like municipal bonds. I also have a relatively long term horizon of over 25 years.
My next post will talk about my investment strategy.
Inflation or Deflation? What is the outlook?
Are we headed down the road paved by Japan of a lost decade with deflation or are we on the precipice of accelerating inflation? Answering this question is a key step in settling on an outlook, and thereby constructing a portfolio.
Currently we are stuck in what the economist Keynes termed a "Liquidity Trap." This occurs when interest rates approach zero and basically means that traditional monetary levers have little impact on stimulating the economy because the demand for money has become almost infinitely elastic. Therefore, non-traditional monetary policies and fiscal policies must be relied on to stimulate the economy.
Clearly the government has been quite active with its fiscal policies in order to stimulate the economy. These policies have had some positive effect, although the extent of the impact is a political hot potato. I argue there are a couple problems with these classic "cut taxes versus increase spending" fiscal debates. The first is that we already cut taxes during the Bush era, reducing both the impact of further tax cuts and our ability to materially increase debt levels (after adding trillions during America's "deficits don't matter" era). The second problem concerns the obvious statement that the increased government spending must lead to greater private spending, or else any recovery is unsustainable. This second problem is where we find ourselves currently, debating whether private spending will now lead us out of the liquidity trap with corresponding rising interest rates, or will the slowing government stimulus and continued lackluster private spending produce a "double-dip" recession with potentially deflationary prices.
Eventually Poor Investment Spending Decisions Catches Up With Us
The next segment looks at the Liquidity Trap problem from a financial perspective by bringing in the growing use of the financial analysis methodology "Economic Value Add," or EVA. Basically this analysis looks at the difference between a company's cost of capital (basically the blended interest rate on debt outstanding and cost of equity) and its Return on Invested Capital (ROIC) to determine whether the business is creating or destroying economic value. If ROIC is greater than the cost of capital, then economic value is created. From my own analysis, and what one would intuitively expect, I believe the expected EVA of a company describes over 95% of its stock price with swings in ROIC through management decisions dominating.
For the past few decades the cost of capital for businesses has been declining, highlighted by the declining interest rates but also likely a result of more efficient capital markets. Thus, managers have had a lower and lower ROIC hurdle rate to clear in order to produce a positive EVA. Looking at monetary policy through this prism, the government can actively increase the country's EVA by lowering the interest rates, thereby lowering the cost of capital for companies and making previously negative EVA projects appear positive, even though the cash flow dynamics have not changed. Nice trick, unless you use it too often and for too long and thus managers start making investment decisions based on expected lower financing costs going forward, effectively lowering the returns produced by the economy. If abused, I believe an overly aggressive traditional monetary policy, which does not force the healthy pruning of marginal projects through periodic recessions, becomes a race to the bottom that eventually produces negative returns and thus deflation.
The outcome of the declining cost of capital are large pools of invested capital with low return levels, or bubbles like the housing market. If the macroeconomic forces deteriorate, these low returns can swing to negative returns. The cumulative effect of these management decisions to fund low-level return projects is a glut of assets, highlighted in overcapacity in industries like the restaurant industry. Should lending standards tighten, as banks have recently done, the economy has a tougher time recovering until these low return assets are absorbed by growing demand or shrunk to in-line with demand trends. My concern is that both fiscal and traditional monetary stimulative efforts cannot overcome the structural problems created over the past 10-15 years due to the low returns inherent in the country's investment base.
Paying the Piper, or not
The next three to six months likely answers the question of whether private spending picks up enough to drive a recovery, or remains muted and we slide back into a recession. There are clearly signs that the economy is improving, including an expansionary ISM Manufacturing Survey data, higher volume of freight shipments, and improving consumer sentiment. However, there are also data points that suggest a more muted recovery. Relatively low raw industrial prices and commodity prices offer a mixed picture on demand. The Conference Board Leading Economic Index grew modestly at 0.4% in May, slightly lower than expectations, slower than the 1.4% in March, and following a weaker result in April of flat. One of the main reasons offered for the weaker recovery is the expiration of the federal housing credit in April. (Eek!)
Of course the government can provide additional spending stimulants and pursue non-traditional monetary actions. The increasing debt load likely makes increased spending measures more politically challenging, especially if the Republicans win more seats in Congress and unseat President Obama. Tax cuts might be offered, but these are likely viewed as more short-term in nature and therefore likely won't have as big a bang, or at least only drive growth in high-end markets while segments catering to the middle class languish. If the economy slips backward I would expect to see more focus on non-traditional monetary policies to stimulate inflation, including active currency devaluation, monetization of the country's debt, and efforts to raise the expected inflation rate in the future through high level policy announcements. If it gets to this point we may see another period of expansion during which I would hope the underlying structural problems are solved. The risk is that either these "hail maries" don't work or the government overshoots and inflation balloons.
If government efforts cannot spur the economy, or burden businesses with excessive regulations and costs for businesses, then the next decade may be lost as business works off the marginal investments of the past.
Investment Strategy
Currently I have a blank canvas, with my portfolio almost entirely in cash. Not ideal, I know, but one of the main reasons I started this blog in order to re-engage and determine an investment strategy. I will also mention that my liquid portfolio is predominantly in a tax sheltered vehicle, thus reducing my interest in more tax efficient investments like municipal bonds. I also have a relatively long term horizon of over 25 years.
My next post will talk about my investment strategy.
Wednesday, June 9, 2010
Macro Thoughts
Overall I remain more bearish on the equity markets as governments around the world aggressively alter monetary and fiscal policy to manage local crises. While I believe governments should be very attentive to market efficiency, all this activity by governments potentially exasperates overall tension in the global markets. One example is inflation risk in emerging economies fueled by deflation risk in mature economies as these governments keep interest rates low to stimulate growth. The low interest rates in mature economies drives capital into higher yielding emerging economies and forces emerging economy governments to apply the brakes, thus potentially slowing growth in mature economies.
While I could list many issues that likely lead to greater fear, the main three are:
(1) Continual tapping of the brakes in the U.S economy reins in recovery potential. Tighter lending standards, slowing government stimulus, higher tax rates next year, and high consumer debt levels. The outstanding debt is like an anchor, in my mind without job growth, as any uptick in interest rates due to a brighter economic outlook provides a kick in the teeth to consumers looking to buy a house or car in the form of higher payments. Until the country reduces debt levels to where higher debt payments can be comfortably afforded, I see a tepid recovery.
(2) Potential financial death spiral in Europe. Following up on the higher overall debt levels, Europe has long relied on debt to fund their societal choices. Is Europe able to move enough money around its members to offset worries in the market, or does it become a domino effect in which one country's problems triggers higher borrowing costs in another, thus pushing it into financial peril? The high cost of insuring European debt is starting to place more pressure on the system, in my view.
(3) China slowdown. The Chinese are attempting to slow inflation and slow the boom on property prices. Can the government strike the right balance or does the government's efforts over-shoot and push the country into a Chinese-style recession (best case recession scenario is modest growth, worst case is something like catching the 1997 "Asian Flu"). Should the Chinese economy continue to slow it may trigger another Asian country's problems, which in turn causes a broader issue.
In this environment investors can plan for surprises, either in the form of unforeseen breakdowns in seemingly insignificant markets or government action. In summary, investors should plan on volatility and position themselves with flexibility to pounce on opportunities that likely appear over the next couple months.
While I could list many issues that likely lead to greater fear, the main three are:
(1) Continual tapping of the brakes in the U.S economy reins in recovery potential. Tighter lending standards, slowing government stimulus, higher tax rates next year, and high consumer debt levels. The outstanding debt is like an anchor, in my mind without job growth, as any uptick in interest rates due to a brighter economic outlook provides a kick in the teeth to consumers looking to buy a house or car in the form of higher payments. Until the country reduces debt levels to where higher debt payments can be comfortably afforded, I see a tepid recovery.
(2) Potential financial death spiral in Europe. Following up on the higher overall debt levels, Europe has long relied on debt to fund their societal choices. Is Europe able to move enough money around its members to offset worries in the market, or does it become a domino effect in which one country's problems triggers higher borrowing costs in another, thus pushing it into financial peril? The high cost of insuring European debt is starting to place more pressure on the system, in my view.
(3) China slowdown. The Chinese are attempting to slow inflation and slow the boom on property prices. Can the government strike the right balance or does the government's efforts over-shoot and push the country into a Chinese-style recession (best case recession scenario is modest growth, worst case is something like catching the 1997 "Asian Flu"). Should the Chinese economy continue to slow it may trigger another Asian country's problems, which in turn causes a broader issue.
In this environment investors can plan for surprises, either in the form of unforeseen breakdowns in seemingly insignificant markets or government action. In summary, investors should plan on volatility and position themselves with flexibility to pounce on opportunities that likely appear over the next couple months.
Wednesday, June 2, 2010
Finding some Sizzle in an Unsavory Restaurant Market
Spent some time trolling through the restaurant industry looking for ideas. First impression was - "Boy, what a tough environment." Issues include over-capacity, recent increases in minimum wages, health insurance penalties starting in 2014, high beef costs, pressure for more nutritional information, and weak demand during the recession. Not an environment where most investors want to pick. My second thought was - "Okay, who's got the most upside when the environment turns?" A hint, in my opinion, is my local Wendy's unit that is getting a makeover (taking a page from the Peter Lynch investment style).
WEN (Buy - $4.40): Wendy's/ Arby's Group
- Investment in turn-around offers potential growth drivers. Wendy's has done reasonably well pursuing the late night market and now is focused on serving breakfast at more units, a segment it has traditionally not competed. To enable this day-part expansion, management has focused resources on re-modeling units. Management plans to update 100 Wendy's and 100 Arby's company-owned units during 2010. From watching the local unit, it includes a full face-lift on the outside, which should increase traffic when completed. Finally, the advertising campaign should offer a good mix of value and premium items over the next few months.
- Clean-up goes beyond units. The company has turned-over some senior management and hired a new lead branding firm to bring the Wendy's and Arby's brands into complementary messages. Wendy's re-financed much of its debt last month, which simplified the structure and should decrease the annual interest expense by about $6 million. Stockholders also voted recently to the stock re-purchase authorization by $75 million as management believes the stock is under-valued.
- Valuation implies low expectations, which company should meet in ST. At an EV/TTM Adj. EBITDA of under 7x the stock appears reasonable when compared to MCD of about 10x. Most analysts have a Hold rating, offering upgrade opportunities. Finally, the company is just returning to profitability and the amount of operating leverage in the re-modeled units may offer upside surprises should sales tick-up. All-in-all, assuming management executes, the stock should start to move up in the second half of the year and offer multiple years of sustained growth.
Note: My time line for all stock picks is 1-5 years, unless otherwise noted.
WEN (Buy - $4.40): Wendy's/ Arby's Group
- Investment in turn-around offers potential growth drivers. Wendy's has done reasonably well pursuing the late night market and now is focused on serving breakfast at more units, a segment it has traditionally not competed. To enable this day-part expansion, management has focused resources on re-modeling units. Management plans to update 100 Wendy's and 100 Arby's company-owned units during 2010. From watching the local unit, it includes a full face-lift on the outside, which should increase traffic when completed. Finally, the advertising campaign should offer a good mix of value and premium items over the next few months.
- Clean-up goes beyond units. The company has turned-over some senior management and hired a new lead branding firm to bring the Wendy's and Arby's brands into complementary messages. Wendy's re-financed much of its debt last month, which simplified the structure and should decrease the annual interest expense by about $6 million. Stockholders also voted recently to the stock re-purchase authorization by $75 million as management believes the stock is under-valued.
- Valuation implies low expectations, which company should meet in ST. At an EV/TTM Adj. EBITDA of under 7x the stock appears reasonable when compared to MCD of about 10x. Most analysts have a Hold rating, offering upgrade opportunities. Finally, the company is just returning to profitability and the amount of operating leverage in the re-modeled units may offer upside surprises should sales tick-up. All-in-all, assuming management executes, the stock should start to move up in the second half of the year and offer multiple years of sustained growth.
Note: My time line for all stock picks is 1-5 years, unless otherwise noted.
Tuesday, June 1, 2010
Buy AMD ($8.30) - Advanced Micro Devices
- Demand outlook improving for the company. Gartner predicts 22% growth in the sale PC units in 2010, driven by consumers who consider a PC more of a necessity and businesses that are upgrading after delaying purchases during the recession and starting the adoption of Windows 7. Gartner expects this growth cycle to extend through 2011 into 2012. Furthermore, AMD is expected to pick-up market share in the notebook market because the company has revealed the number of computer models incorporating AMD's Vision technology has tripled from one year ago. (http://www.digitimes.com/news/a20100513PD210.html) These two trends should add a tail-wind to AMD's stock.
- Historical results somewhat muddy, but investment choices clear. In December 2009 the company deconsolidated Global Foundries' results and began accounting for the business using the equity method, resulting in a short-term less clear view of the trends in the business. Furthermore, a couple years of losses and one-time expenses have made the business unattractive. That said, the most recent quarter highlighted a post-accounting change of a less leveraged balance sheet and stronger returns. Looking forward, recent commentary by Global Foundries, which supplies and is partially owned by AMD, illustrates investments in new production to meet near-term and longer-term demand growth. (http://albany.bizjournals.com/albany/stories/2010/05/31/daily1.html?ana=yfcpc)
- Investors buying now are ahead of the curve. 22 out of 31 opinions are Hold or Sell, offering significant potential for upgrades and estimate raises. Revenue and EPS estimates for 2010 and 2011 vary widely, from $6.2B to $7.8B for 2011 revenue and from $0.10 to $0.85 for 2011 EPS, suggesting a low level of conviction by the market. At the intra-day price of $8.30, AMD is trading at under 10x the high EPS estimate for 2011, or 14x the mean of $0.60. The valuation using the mean EPS is not cheap, but I'm betting the improving demand outlook and wide dispersion of estimates drive the consensus 2011 estimate up over the next year.
- Historical results somewhat muddy, but investment choices clear. In December 2009 the company deconsolidated Global Foundries' results and began accounting for the business using the equity method, resulting in a short-term less clear view of the trends in the business. Furthermore, a couple years of losses and one-time expenses have made the business unattractive. That said, the most recent quarter highlighted a post-accounting change of a less leveraged balance sheet and stronger returns. Looking forward, recent commentary by Global Foundries, which supplies and is partially owned by AMD, illustrates investments in new production to meet near-term and longer-term demand growth. (http://albany.bizjournals.com/albany/stories/2010/05/31/daily1.html?ana=yfcpc)
- Investors buying now are ahead of the curve. 22 out of 31 opinions are Hold or Sell, offering significant potential for upgrades and estimate raises. Revenue and EPS estimates for 2010 and 2011 vary widely, from $6.2B to $7.8B for 2011 revenue and from $0.10 to $0.85 for 2011 EPS, suggesting a low level of conviction by the market. At the intra-day price of $8.30, AMD is trading at under 10x the high EPS estimate for 2011, or 14x the mean of $0.60. The valuation using the mean EPS is not cheap, but I'm betting the improving demand outlook and wide dispersion of estimates drive the consensus 2011 estimate up over the next year.
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