Stock High Blog

Hansen thoughts, yet again

aaron602@gmail.com (Fish) — Thu, 03 Jul 2008 15:10:45 GMT

Today Hansen has been smacked down to $25, so I thought I'd take a look into it and see if there is good reason for the drop. The stock is at a new 52 week low and it actually hasn't been at these levels since 2006. I already own a bundle of Hansen stock, but an opportunity is an opportunity and I'm willing to increase my position if one is presented.

First, let's do a quick summary of the company's 1Q 2008 results. Net sales increased 27.9% to $212.2 million, net income increased 42.6% to $28.8 million ($0.29 per share) from $20.2 million ($0.21 per share) in 1Q 2007. The Monster brand remains strong and the new drinks in the Monster and Java Monster lines are proceeding as planned. Plans to expand the Monster line into the U.K. are going along as expected.$159.11 million in cash with no debt. One thing that isn't pleasing to see is that cash flow decreased to $25.93 million from $48.03 million in 1Q 2007. In the 10-Q, the decrease is explained a bit more:

For the three-months ended March 31, 2008, cash provided by operating activities was reduced due to a $11.6 million increase in inventories, a $3.8 million increase in prepaid expenses and other current assets, a $3.1 million decrease in accrued compensation and a $1.0 million increase in tax benefit from exercise of stock options. The increase in inventory is attributable to the addition of new copackers, the introduction of new products and planned inventory levels to meet consumer demand.

1Q 2008 press release

So the decrease in cash flow generally seems to be due to increased levels of inventory no doubt to meet summer demand and because of the new drinks just released six or so months ago. So the cash flow production decrease seems to be more of a short-term happening rather than a longer-term trend. It's also important to remember that this is typically a relatively slow quarter for the cold beverage industry yet the profit margin still managed to increase. The company's efficiency is excellent and I don't see the decrease in cash flow production as anything much more than a short-term item necessary for a strong summer. Of course, any thoughts on this are appreciated. But given the strong earnings and sales growth, superb balance sheet, and increased efficiency, the cash flow decrease just doesn't add up to me as anything representing a faulty business or anything like that.

The company's energy drink sales increased roughly 32% and remains by far the largest segment of sales. The energy drink portion of the beverage market continues to be one of the stronger areas and I highly doubt it will slow down much through summer. Monster is an addictive, hip brand with a diversified line of drinks, and with the distribution agreement with Anheuser-Busch it certainly seems to be in a strong position. Plus, expansion into Canada and the U.K. is just starting and should start to become a more prominent part of the business.

Hansen has managed to increase the profit margin in the past couple quarters (especially in the 4Q 2007) which is impressive considering the new line of drinks and the still new distribution agreements (which actually good be a big part of the reason for increased efficiency). The balance sheet remains sparkling clean and earnings and sales continue to increase at impressive rates especially considering that the 1Q typically is a weaker quarter for the company. The one question market is cash flow, but the 4Q was such a strong quarter for cash flow production that I simply do not believe the drop off in the 1Q is much more than a short-term happening or a necessary evil to gear up for the summer.

In short, this is the way I see it. Nothing at all has dramatically changed with the business. The financials remain very strong, the new products are being well received, international expansion is just getting started, and nothing has changed with the company's long-term picture.

I look at it this way. From today's EPS of $1.60, let's assume that earnings grow at 25% annually for the next two years. This would put the EPS at $2.50 in mid-2010. This is more or less what analysts expect (analysts are expecting the EPS to be at $2.34 in fiscal 2009). Now let's assume that the market prices the stock with a P/E of 16, around today's range. Keep in mind that this is the P/E after the stock has been hammered on no news whatsoever. In any case, this would put the stock at $40, which would equal a 25% annual return over the next two years. These are extremely conservative projections in my opinion, for the next couple years I believe Hansen could easily increase earnings at 30%-35% annually. Most of the company's growth is coming from inside the U.S. on a still new distribution deal with Anheuser-Busch. Internationally there is a great deal of potential for the company and domestically there certainly isn't a shortage of potential with the new Java Monster line.

In the past couple years Hansen has typically bottomed out sometime in July. I'm very tempted to add to my position soon because there is no substance at all for the huge drop recently and today. As I write this the P/E is 15.83. This is the lowest P/E the stock has traded at since late 2003. I am not kidding, folks. Look at the company's YOY growth since the 2Q 2007:


Quarter              Earnings growth (YOY)       Profit Margin 
---------------------------------------------------------------------
2Q 2007                    35.9%                    15.65%
3Q 2007                    73.1%                    18.53%
4Q 2007                   103.1%                    18.29%
1Q 2007                    42.6%                    13.58%

This amazing growth in a sluggish economy, and you give the company a P/E of 16? This is not right. Looks like Hansen will be a larger percentage of my portfolio soon.

Courtesy of Pencils2

On Measuring Volatility

aaron602@gmail.com (Fish) — Thu, 03 Jul 2008 13:19:41 GMT

Mike at HEDGEfolios.com has a good post up today with the title of Measuring Volatility. He touches a lot of bases, but it all starts with the following statement:

“When it comes to measuring or sensing stock market volatility, I do not follow the VIX.”

Now I may have invented that silly tagline, “Your one stop VIX-centric view of the universe,” but I am the first to argue that a defaultist mind set is the wrong way to approach the investment landscape. If you follow the same indicators with the same default settings as everyone else, you are setting yourself up not just to follow the crowd, but to be a half step behind it. In order beat the crowd, what is needed is a variant perception.

Back to HEDGEfolios for a moment:

“The key element of volatility using traditional methods like the VIX rests on the reversal at extremes in a contrarian indication such as buying when the VIX exceeds 30. This is a very dangerous concept and I do not advocate for its use… I never liked that approach so I do my own thing and look at each stock, the turnover in each and how the composite of all signal changes indicates the market volatility.”

Volatility is a wide-ranging concept. It can be defined, measured and applied to over 10,000 stocks and ETFs in many different ways. To think that best way to harness information about volatility is to buy when the VIX hits X is ludicrous.

Consider that the concept of volatility can be applied not just to price, but to volume, options prices, market breadth data, etc. Volatility is a characteristic of every slice of the almost infinite flow of data that is associated with the markets.

It’s not just what you measure, it’s how you measure it. Volatility can look forward when it is in the form of a forecast or a derivation, such as implied volatility. When volatility looks backward, the opportunities to get creative are even richer. There is historical volatility, average true range, Bollinger bands, Chaikin volatility, relative volatility, and a variety of ways in which to index volatility.

Continued on On Measuring Volatility

Things I stuffed up - edition one - Interest rate risk versus credit risk

aaron602@gmail.com (Fish) — Thu, 03 Jul 2008 11:22:03 GMT

Anybody that trades stocks makes mistakes. I have made plenty. I would prefer sweep those under the carpet but a little bit of healthy self-flagellation is good for the spirit. Besides I hope it will make me a better investor. Besides I just posted that I purchased Ambac - something that could (easily) wind up as the next mistake. So you should know just how much I stuff up.

So this is the first of (almost certainly) many posts detailing things I stuffed up.

The list for the first choice is long. How about these?

(a) Believing that regional banks of Credit Agricole (which are very good) would offset the losses at the investment bank (which is very bad). Stock is down from 36 to 12.

(b) Believing that the mortgage insurers would blow up this cycle but the bond insurers would probably be OK. Ambac is down 90 to 1ish and is no longer writing much business. MTG (which was my favourite short) is down from 60 to 6 but is writing plenty of business. Got the wrong shorts… and didn’t short the bond insurers…

(c) Believing that the (seemingly extreme) valuation difference between News Corp and other media stocks would solve itself by New Corp’s stock price rising. It didn’t as a stock price comparison of Viacom, Time Warner and News Corp will attest. (It was a wash – all the stocks lost a little.)

(d) Buying Origin Energy at under $2 and selling it at about $4 on the basis that the utility parts of the business were fully recognised. I sold it despite loving the management. It is currently under hostile takeover at $15.60 – and the Aussie dollar in which it is priced has almost doubled. I didn’t recognise just how good the gas assets were. This was non-trivial as the fund I worked for owned almost 5% of the company – and left more half a billion dollars on the table and it was my fault.

Against this it should be pretty hard to tell what the worst intellectual error I made in the past five years is. But I have a candidate. I thought that the interest rate risk in US banks would blow up before the credit risk.

Background

The US has a very unusual mortgage market. Most mortgages have the peculiar term of being fixed rate when rates are rising – but being refinanceable if rates fall. This means that customers pay more for their mortgages than most jurisdictions – but that all the interest rate risks fall on the financial sector.

For instance in most markets the difference between central bank fund rate and the average mortgage rate is less (often much less) than 200bps. In the US it is unusual to get a conventional mortgage at under 6 percent – and the feds fund rate is 200bps. Mortgage margins in the US are more than double most countries.

For this however the system as a whole takes an awful lot of interest rate risk. If short rates were to go to say 8 percent there would be 5-7 trillion in mortgages that yield less than that. Individual institutions might say they were hedged – but the system as a whole cannot be hedged.

I spent an awful lot of time looking for banks and other institutions that were particularly levered to interest rate risk. WestAmerica Bancorp (an otherwise pristine bank) stood out. If you look at the balance sheet I linked in my previous post you will see that it contains $1.5 billion in fixed rate securities financed floating. That number is very significant compared to pre-tax income of 120 million or tangible book value of about 270 million. And WABC is by no means the largest offender.

My back of the envelope calculation was that the system had about 400 billion of pre-tax profits. That included all brokers, all banks, all insurance companies, fund managers – the works.

The US system had 7 trillion of interest rate miss-match. Almost half the profits of the entire US financial system could disappear in a 200bps rise in rates across the yield curve. And they would have disappeared without a penny of credit losses. A lot of institutions would lose their profits entirely. They would in my view all try to hedge simultaneously guaranteeing the dynamic hedging strategies that were in place did not work.

And I thought with Alan Greenspan setting the tone of the Fed the stuff up on inflation and hence interest rates was inevitable. Greenspan never saw a problem he could not fix by pumping more liquidity into the system. I thought Helicopter Ben was even more likely to use a little inflation to get the US out of its mess. Indeed that is where the “helicopter” moniker comes from – a speech to that effect. So essentially whilst I thought that credit problems were sort of inevitable – the US would inflate their way out – and hence the real manifestation would be an interest-rate-risk debacle.

So I spent a couple of years getting completely obsessed about interest rate risk. It led to some OK shorts (eg Fannie and Freddie) but meant I underestimated the credit story.

The credit risk I thought had been passed pretty heavily to the non-bank sector. It existed in the Europeans (I sort of knew about UBS). It existed in the investment banks (including Citigroup). It existed in some regional banks (I knew about Bank United). But I was stunned it wound up quite so bad at Fifth Third. Just stunned.

I thus covered a Fifth Third short many years ago. (Ooops.) I was short a bunch of interest rate risk sensitive banks (such as North Fork which was purchased by Capital One) and I didn’t short MBIA and Ambac. Indeed I was tempted to go long (but fortunately I did not). I made money on a few interest rate shorts – but altogether it was not a profitable activity.

A few years ago the short end of the yield curve was at about 1%. The long end in the 4s and quasi-government guaranteed mortgages were in the high 5s. Borrowing short to buy Fannie Mae backed mortgages was the seeming no-lose trade. Everyone was on it. It didn’t even carry much credit risk because everyone knew the government backed Fannie.

However it carried – and still carries – massive interest rate risk. Everyone seemed to ignore that. My usual reaction – if everyone is doing something then it will probably lose you money. I would rather be on the other side.

Still I remain convinced that this is a theme that will play out. Warren Buffett says inflation is heating up – and he doesn’t stretch the duration of his assets.

There are good people who think inflation is highly unlikely. Paul Krugman (who I admire) suggests that Bernanke should ignore the inflation naysayers. Mish writes for ever on how inflation is not likely – see here and here for examples.

I will get back to this shortcoming one day soon.

Courtesy of Bronte Capital

Starbucks to close 600 stores; Chipotle sees opportunity

aaron602@gmail.com (Fish) — Thu, 03 Jul 2008 00:15:30 GMT

This is old news by now, but curious to see what people think:

Starbucks Corp. announced that it will close 600 "underperforming" stores in all major U.S. markets.

Approximately 70 percent of the stores opened since the beginning of fiscal 2006, Starbucks said in a statement.

The Seattle coffee giant said that it will also open fewer than 200 new stores in the U.S. in its fiscal 2009 year. Starbucks operates about 7,000 stores itself and licenses another 4,100 in the U.S.

"We recognize that it is necessary to make decisions that will strengthen the U.S. store portfolio and enable us to enter into fiscal 2009 focused on enhancing operating efficiency, improving customer satisfaction and ensuring long-term value for our partners, customers and shareholders," said CEO Howard Schultz.

Starbucks (NASDAQ:SBUX) said pre-tax charges related to the closings will be about $200 million in asset write-offs that will be recognized in the third quarter of 2008. In the fourth quarter of 2008 and for the first half of fiscal 2009, the company said it expects up to $140 million in lease-related costs. Severance costs are expected to be about $8 million.

Long-term this is probably what had to be done to ensure brand and service quality. This process of closing stores and laying off workers will take a decent amount of time and I'm not expecting the share price to do a whole lot probably for another year or so. It's a bummer that the company chose to do this in the start of the summer season which often is a great time for beverage sales (although Starbucks has a more rounded offering of drinks so it isn't quite as big a deal).

I will be looking to add to my position over the next 1-2 years depending on how this transition goes and as we find out what else Schultz and company have in mind. Starbucks has tremendous brand power, and right now the world economy is going through a somewhat difficult time. Schultz understands this business more than anyone else so I have a lot of confidence in the decisions he makes.

On a related note I found this article interesting:

(June 30, 2008) With consumer confidence at a 16-year low, fewer families dining out and oil prices spiking above $130 a barrel, the time seems right for restaurant companies to retrench, not grow.

But executives at such chains as Chipotle Mexican Grill, Bruegger’s Bagels, BJ’s Restaurants and Buffalo Wild Wings nonetheless view 2008 as a great time to roll out new restaurants.

Compelled by the opportunity to take business from competitors and capitalize on more favorable leasing conditions for tenants, including stable or decreased rents, chains that have continued to post revenue and same-store sales gains despite the economic downturn are laying the foundation for long-term growth.

Chipotle is leading the charge with projections of 130 to 140 new units this year, for a total of more than 830 units. Buffalo Wild Wings also is flying high, planning about 75 new locations for a total of roughly 568 restaurants.

“Our sales model and restaurant performance have been very, very strong, and this is a great time for us to be more aggressive,” said Rex Jones, chief development officer at Chipotle. “We look at this as a long-term [opportunity].”

Both Chipotle and Buffalo Wild Wings I own so I find this very interesting and can see why it is very smart to take advantage of the slow economy and build new stores when the competition is low. Both companies have excellent balance sheets so they're able to take advantage of times like these. Chipotle, Buffalo Wild Wings, Netflix, Middleby, and quite a few other companies look so compelling right now at the levels they're trading at. Now that I just got some cash available with bargains everywhere, it's going to be hard to either wait and see or pick one of them right now.

Courtesy of Pencils2

Getting Tougher to Push Financials Lower from Here?

aaron602@gmail.com (Fish) — Wed, 02 Jul 2008 14:53:53 GMT

Halfway through today’s session, my screen is once again filled with red, as the indices look as if they are poised to take a run at yesterday’s lows.

From a sector perspective, the picture is considerably muddier, as two recent laggards, financials (XLF) and consumer discretionary (XLY), are clinging to positive territory as I type this. As I see it, one or the other of these sectors will have to continue to deteriorate if the markets are going to continue lower from current levels.

Given that the financials are already down 53% from their May 2007 highs (see chart below), it is important to keep in mind that the easy money has already been made on the short side. A wide variety of financial sub-sectors (mortgage companies, bond insurers, money center banks, regional banks, investment banks/brokers, etc.) have already made multiple trips to the woodshed – and while some individual issues may still be quite vulnerable going forward, there is a limit to the amount of blood that can be squeezed from a broad-based ETF or index.

Continued on Getting Tougher to Push Financials Lower from Here

GIGs and Ambac

aaron602@gmail.com (Fish) — Tue, 01 Jul 2008 23:19:21 GMT

Warning: Wonkish. Read only if you are interested in Ambac.

The Whitney Tilson post I wrote up on the weekend goes through the issues of GICs and MBIA. The story is that when a municipality raises a bond it doesn’t need all of it straight away. So the bond insurers (using their contacts with the municipalities) sold “guaranteed investment contracts”. These contracts were invested in primarily high-grade instruments (but not Treasuries). A guaranteed return was offered to the municipality. Withdrawal was usually limited to term giving MBIA several opportunities for profit by structuring investments to match total maturity schedules.

The problem for MBIA was that the GICs could be accelerated in the event of a ratings downgrade – either that or the company could be forced to post collateral. The collateral requirements are causing MBIA difficulties.

Ambac has also written GICs and they too can be accelerated. Here is the disclosure in the last annual filing. Note the section bolded by me which says that Ambac has “de-emphasized” this business for reasons primarily related to liquidity needs.

It is clearly a problem in the event of “well defined credit events” (which I presume is a ratings trigger). As to whether this ratings trigger is an issue for the stock: I report – you decide. As to whether these are ultimately parent company liabilities? I will leave that for another post. But if you want to know any earlier than that - read the statutory statements of the insurance subsidiaries.

Financial Services Liquidity. The principal uses of liquidity by Financial Services subsidiaries are payment of investment and payment agreement obligations, net obligations under interest rate, total return and currency swaps, operating expenses and income taxes. Management believes that its Financial Services liquidity needs can be funded from its operating cash flow, the maturity and sale of its invested assets and from time to time, by inter-company loans and repurchase agreement transactions. The principal sources of this segment’s liquidity are proceeds from issuance of investment agreements, net investment income, maturities or sales of securities from its investment portfolio and net receipts from interest rate, currency and total return swaps. The investment objectives with respect to the investment agreement business are preservation of capital by maintaining a minimum average quality rating of AA on invested assets, maximize the net interest rate spread as compared to investment agreements issued and to maintain a liquid floating rate investment portfolio, which includes short term investments, to minimize interest rate and liquidity risk. As of December 31, 2007, the investment agreement business floating rate investment portfolio approximates $6.3 billion or 84% of the investment portfolio related to the investment agreement business. Recently, Ambac decided to de-emphasize the Financial Services businesses. Ambac’s decision to decrease outstanding exposure to the financial services businesses was primarily due to the different liquidity needs of the business compared to the Financial Guarantee business, rating agency views relating to non-core businesses and to allow management to enhance its focus on the financial guarantee business. Ambac believes that this decision should not materially impact the Financial Services business liquidity.

Investment agreements subject Ambac to liquidity risk associated with unanticipated withdrawals of principal as allowed by the terms of the investment agreements. These unanticipated withdrawals could require Ambac to sell investment securities at a loss to the extent other funding sources are unavailable. Ambac utilizes several tools to manage liquidity risk including regular surveillance of the investment agreements for unscheduled withdrawals. In general, Ambac has characterized the portfolio of investment agreements into two broad categories, contingent and fixed withdrawal. As of December 31, 2007, approximately $4.5 billion relates to contingent withdrawal investment agreements. Contingent withdrawal transactions include contractual provisions that allow the investor to withdraw principal and require minimal notice to Ambac. The vast majority of these investment agreements can only be drawn in the event that well-defined, observable events have occurred, primarily credit events. As of December 31, 2007, approximately $3.3 billion relates to fixed withdrawal investment agreements, of which $1.8 billion include provisions where under certain circumstances our counterparty has the ability to withdraw funds during 2008.

Disclosure: I have just purchased a fair size holding in Ambac and a smaller holding in MBIA. I think it is possible (even likely) that both companies go to zero - but I do not think that they do so rapidly. Ambac in particular is trading at out-of-the-money option value only. My expectation of return is high - but I can't eat my expected return and it is entirely possible I will lose 100 percent of my investment. I will sell a fair bit of the position on any big rally. I do not want too many "told you so" emails if I stuff this one up. But then I will not gloat that much if I get it right.

Courtesy of Bronte Capital

Fearogram Maps Recent VIX Complacency

aaron602@gmail.com (Fish) — Tue, 01 Jul 2008 13:42:46 GMT

There has been so much talk about complacency in the VIX that I thought I should dust off the old fearogram and see just how complacent the VIX has been as of late.

For those who are new to the concept of the fearogram (a term I hatched last October), it is essentially a chart of the daily change in the VIX vs. the daily change in the SPX. (For more background on the fearogram concept, try previous posts with the fearogram label.)

The chart below plots a best fit diagonal black line which represents a ratio of the daily percentage change in the VIX to the daily percentage change in the SPX for every trading day going back to 1990. Essentially, the larger the distance between individual data points and the fearogram best fit line, the more extreme the level of fear or complacency. For data points above and to the right of the best fit line, the VIX is increasing out of proportion to the drop in the SPX, indicating more fear. For data points below and to the left of the best fit line, the relatively muted reaction of the VIX suggests more complacency. Data points that hug the best fit line are indicative of a VIX that is consistent with typical historical relationships between the VIX and the SPX.

Continued on Fearogram Maps Recent VIX Complacency

Corn, Wheat Fall After Increased Production

aaron602@gmail.com (Fish) — Tue, 01 Jul 2008 13:40:22 GMT

Corn, Wheat Fall After U.S. Farmers Planted More Than Expected

June 30 (Bloomberg) -- Corn fell the maximum permitted by the Chicago Board of Trade and wheat dropped the most in 13 weeks after the government said U.S. farmers planted more of both crops than previously expected.

Corn was sowed on 87.3 million acres, up 1.9 percent from a March forecast, and spring-wheat planting jumped 6.8 percent to 14.197 million acres, the U.S. Department of Agriculture said in a report today. Corn prices doubled in the past year to a record on June 27, and wheat jumped 13 percent this month after reaching a record in February. The U.S. is the world's largest corn grower and wheat exporter.

...

Corn futures for December delivery fell the CBOT's 30-cent limit, or 3.8 percent, to $7.57 a bushel, the biggest percentage drop since Jan. 23. The most-active contract reached a record $7.9925 on June 27. Corn is still up 26 percent this month, the biggest monthly gain since June 1988.

This is an interesting, although in hindsight not surprising, thing to see. Record prices are bound to attract farmers to plant more of those respective crops, and in this case it was corn and wheat. Most of that corn will probably go to the inefficient, costly, terribly executed ethanol program, and a lot of the wheat will most likely be exported given the shortage of food in quite a few countries. I wouldn't expect corn prices to drop much more, given the nature of the crop (it's a crop that farmers have to rotate every year or two in order to keep the soil in quality shape) it just isn't sustainable and I don't think prices are falling too much more over the next year or so. It's unlikely that the federal ethanol program will be terminated anytime soon (unfortunately), so demand and production will most likely continue to rise. The question is if the corn growers can keep rotating their crops in order to keep the soil at a sustainable level. E10 is a far better way to go because it can be used on the majority of vehicles today and doesn't require any special treatment as does E85. If only the market could figure out such things...

Courtesy of Pencils2

Wachovia and negative amortisation

aaron602@gmail.com (Fish) — Mon, 30 Jun 2008 18:38:57 GMT

There is a press story here about how Wachovia is ceasing to orginate mortgages with negative amortisation features.

The headline:

SAN FRANCISCO (MarketWatch) -- Wachovia Corp. said on Monday that it won't offer mortgages with negative amortization features anymore, one of the main types of home loans offered by Golden West, the mortgage giant the bank acquired for $24 billion roughly two years ago.

This is a race: whose head is further in the sand, Wachovia or Barclays?

I wrote here how Fifth Third does not originate neg-am mortgages. Fifth Third (who have now contacted me) have not written such mortgages for years. The IR guy can't actually confirm that they ever wrote them.

Why are Fifth Third and Wachovia even mentioned in the same breath when it comes to difficult (multi) regional banks?

Search me.

Courtesy of Bronte Capital

Don Fishback on Complacency in the VIX/VXO During Selloffs

aaron602@gmail.com (Fish) — Mon, 30 Jun 2008 14:26:17 GMT

When someone follows the VXO more closely than the VIX, it is usually because they have been doing it for a decade or more and found no reason to switch when the CBOE changed how the VIX was calculated back in 2003. For all practical purposes, the differences between the VIX and the VXO are not meaningful enough for most investors to warrant monitoring both volatility indices.

With that preamble out of the way, I am pleased to report on some interesting research on the VXO by Don Fishback, who is indeed an experienced hand when it comes to options and volatility. Looking at instances going back to 1986 in which the OEX (the S&P 100 index, which is the underlying for the VXO) declined 10% and the VXO remained under 30, Fishback concludes:

“Bottom line is that when the market falls 10% off of a recent high, and VXO stays below 30%, what was bad gets worse. In every prior instance where VXO failed to climb to above 30%, the market continued lower. The MINIMUM additional downside is another 10%.”

Granted, these conclusions cover only six data points that fit the statistical profile noted above, but the correlation between the level of the VXO when the 10% OEX decline is met and the extent of the subsequent decline over all 14 data points in the study is also worth pondering. Read the full article at 10% Declines and VXO Less than 30% and consider checking out another take on Don’s work by my blogging alter ego at Daily Options Report.

Continued on Don Fishback on Complacency in the VIX/VXO During Selloffs

Bond insurer - has airport to sell

aaron602@gmail.com (Fish) — Sun, 29 Jun 2008 22:35:32 GMT

I wrote about Sydney Airport here. Funnily enough various news source aggregators (such as Wikio) filed the article about a financial crash landing with real airplane crashes. Bronte Capital must have got a few perplexed visitors.

That said – my original post is pretty convincing on the notion that if air traffic in Sydney falls over any sustained period the airport will default.

I have no idea how sharply air-traffic will fall here. Air traffic is one of the most consistent of all variables. It just rises. The reason of course is that the cost of flying in real terms has fallen for decades. When I was a kid people who flew from Sydney to London were regarded with some awe – they were the “jet set”. Now they are “cattle class”. To fly to London cost AUD2000 and average household income was about AUD10000. It costs less in nominal terms to fly to London now...

But if the recent trend in oil prices is permanent and continuing the era of ever-rising air-traffic volumes is over. We will again refer to people who fly long-haul as the jet-set.

There is some listed subordinate debt in Sydney Airport – the so called SKIES (see my last post). Beyond that are a AUD3.7 billion of medium term notes of which AUD2.9 billion is drawn and AUD884 million of inflation indexed bonds with two maturities (2020 and 2030). My sting: all these instruments are insured by Ambac and MBIA.

I see the advert: Bond insurer – selling airport in glitzy long-haul destination.

If oil goes to $400 they will take a loss on this. But otherwise it should be fine.

Courtesy of Bronte Capital

What to buy next...

aaron602@gmail.com (Fish) — Sun, 29 Jun 2008 22:32:30 GMT

Lately I've been going bargain hunting after these wild couple of days. As I've written before, I've more or less narrowed my choices down to Yamana Gold, Hurco, and Middleby.

I'm inclined to go with Middleby, the boring oven manufacturer (among other things). The market didn't like the company's most recent results, but it certainly doesn't justify the stock getting hit down to a new 52 week low below $45. The company is a leader in commercial ovens and owns the top brands in the market, international expansion is picking up, and the company has a dedicated management team. New, efficient ovens are picking up steam amid higher energy costs, and barring a severe slowdown in the near future (which I don't expect to happen), the company's business should not halt too much. Margins are holding relatively steady considering today's environment. One thing I don't like is the company's high debt level due to using debt to finance acquisitions, but the company has managed debt well over the past several years and cash flow production has been rising each year for the past four years (and this year is off to a good start when compared to last year). So, considering how much the stock has been hit even though nothing has changed with the core business, I see Middleby as my likely next purchase within the next couple weeks.

Hurco is very tempting and the stock is in a similar situation to Middleby, but over the past two quarters the company has experienced negative cash flow production which I haven't gotten a good explanation for. The balance sheet is very clean, which certainly is a plus in a hostile economic environment. The company is a good hedge to a lower dollar and has great opportunity in Asia (although, come to think of it, Middleby also has a lot of opportunity there). So Hurco certainly has a lot of pluses and if I did have more cash I probably would open a position at these prices. But, cash is limited, and for now I need to pick one company.

Yamana Gold is one of the better gold businesses out there today and I'm glad I already have a bit invested in them. I see gold as a very good hedge in inflationary times and poor economic times in general, which is one of the main reasons I've considered adding to my position. Yamana is a top notch gold producer and is a very well managed company, all pluses. But, gold has jumped a large amount over the past few days, so taking that into account and also the fact that I don't feel I know quite enough about the business just yet, I'm passing on Yamana for now. If the share price took a dive to the $14 area, though, it'd be very tempting to add to my position.

Anyway, there are a ton of other bargains out there, such as Tata Motors, Hansen, Village Super Market, so it really is hard to choose which to add to. My portfolio has been hit very hard, so at this point I'll probably patiently average down with my current holdings and keep my eye on a few other businesses that I don't currently own. Along with Hurco, the railroad industry is one I'm very attracted to and would definitely consider investing if they take a hit.

Courtesy of Pencils2

Gold Stocks, Silver, Copper, and the Dow

aaron602@gmail.com (Fish) — Sun, 29 Jun 2008 14:59:38 GMT

Above is a weekly chart showing GDX, the gold stocks ETF. What I wanted to point out is that gold stocks experienced a very nice bounce off a major area of support. I now feel that the short term trend for gold stocks has moved from neutral to up, so I decided to go long this sector, and will remain long until the short term trend changes.

The next chart is a weekly chart of silver, which also rallied this past week:

Ever since silver corrected from the $21.00 an ounce area, I have been slowly and steadily buying more and more silver coins, which allows me to dollar cost average. In both charts posted so far, I feel that the long term trend is up, so this means that dollar cost averaging is a strategy that has a high probability of paying off. Buying or selling in the direction of the long term trend always puts the odds in your favour.

In addition to feeling bullish on gold stocks and silver, I feel that copper is looking very strong right now. Unlike oil or gold, copper rarely gets any mention in the media, but is something that can make you a lot of money nonetheless.

If copper can decisively break above the $4.00 a pound resistance area, then I think there is the potential for an explosive move higher. In my previous post, I mentioned an ETF that follows the price of copper.

Also in my previous post, the theme that commodities will likely outperform stocks was mentioned. I think that this trend will begin intensifying in the coming weeks. Part of the reason for this belief lies in how ugly the Dow Jones charts look (monthly, weekly, or daily.)

The above chart shows the Japanese Yen on the top panel and the Dow Jones Industrial Average on the bottom panel. For the last month, I thought that the Yen would start rallying and this would take stocks down. However, for the most part, the Yen has fallen along with the Dow. The way I see this is that if the Dow can't even rally with the help of a falling Yen, then we are in serious trouble when the Yen eventually does turn around.

If the Yen begins rallying, it will start unwinding the so called carry trade, and cause stocks to plummet. The Yen appears to be bouncing now off its 200 day moving average, so this is a chart I will keep my eye on next week, as things may get very interesting.

Courtesy of Gold Stock Prophet

Whitney Tilson on MBIA

aaron602@gmail.com (Fish) — Sun, 29 Jun 2008 11:32:41 GMT

There is a great Whitney Tilson post on MBIA on Seeking Alpha.

To me the key difference between the AA guarantors and the AAA guarantors was that by-and-large the new players in this industry (such as ACA Capital Holdings) had to post lots of collateral in the event of problems - accelerating liquidity concerns and hence bankruptcy. The AAA guarantors by-and-large had to pay when the liability fell due.

This is a huge difference. I have argued several times (see here and here) that the price of various bits of paper in the secondary market is irrational. However I have no idea what the rational price is. Nor does anyone else - not the shorts, not the longs - not anyone.

If you have to mark to market the books of financial institutions they are almost all insolvent. There is an enormous amount of paper that is 20 bid, 90 offered, price you could actually get something closer to 20. If you have to collateralise based on actual values you could get in a trade now (or sell illiquid assets to buy liquid ones for use as eligible collateral) you are stuffed. Simply stuffed.

But if you can sit it out then you are possibly OK. The reason - the defaults might be much lower than currently anticipated in market pricing. Regular readers will know my view is that defaults will be lower than current market prices. I just don't know how much lower and hence I don't know what the end-game is for somone who is levered to this stuff but does not need to post collateral.

ACA Capital Holdings had contracts that demanded it posted collateral and that smashed them up - simply smashed them. Their website is indicative of what happened to the company. But the case for Ambac and MBIA was that by-and-large they did not have to post collateral and hence had hope.

However we now know that MBIA in particular has large collateral requirements. I know of a few more contracts that potentially involve collateral at MBIA. Cumulatively they matter a great deal.

If you are thinking about the bond insurers as a buy (and I am) the collateral requirements are the critical issue. If you don't have collateral requirements then the end points are all that matter. If the things you have insured default at a (much) lower rate than the market currently thinks (something that is possible) then you will make money.

For now you have the hope of much lower end-point defaults. Hope means the stocks have value. Option value only - but as the end outcome is a long way away and a lot of things can happen there should be quite a lot of option value. [One possibility for instance - there is a lot of inflation over say ten years which reduces the real value of the liabilities or increases the nominal value of the assets that back them. That could be a blessing to a bond insurer.]

If you have collateral requirements then end-point solvency is not all that matters. You need to be continuously solvent and on current market prices you are not solvent right now. Whitney Tilson's article is the first widely available and easy to follow discussion of the collateral requirements of MBIA. And this is the critical issue for the stock. Read it.

Now please please contact me if you have done a similar run through Ambac. I have not - but I knew of far less that was collateralised at Ambac than MBIA. And that matters. Its why I sometimes think I want to punt on Ambac. [Indeed I have at various times - but have hedged the position shorting Ambac debt and made good profits by sheer luck. Those were not super speculative positions. Buying Ambac common without shorting the debt is a massively speculative position.]

John

A note - the saga of MBIA saying for years that they had few collateral requirements and then revealing billions of dollars worth of them tells you about trusting management. I can't just ring up Ambac management and ask them about collateral requirements. If you had done that with MBIA you got creamed.

Indeed some very fine fund managers got creamed doing precisely that.

Ronald Regan was right: "trust but verify".

=======================

Post script: I do not agree with everything that Whitney Tilson writes in his Seeking Alpha article. I strongly disagree with his assertion that MBIA has an obligation to downstream the $900 million sitting in the parent company. The buyers of guarantees from MBIA purchased them backed by stated regulatory assets of MBIA's insurance subsidiary not the MBIA parent company. I see no reason why MBIA parent company should increase those regulatory assets unless they are contractually obliged to do so.

Of course Whitney (talking his book) has a different view. I have a suggestion: next time Whitney invests in a stock that goes to zero he should pour more of his clients' money in just to make the creditors happy. (He argues that MBIA should do this with shareholder capital and its insurance subsidiary). If Whitney acts as irrationally as he is demanding the management of MBIA act then I am sure the creditors of his bankrupt investment would thank him.

For once - and perhaps the first time - I find myself strongly agreeing with Tom Brown of Bankstocks.com. [I can't tell you how many times I have thought Tom is speaking nonsense.]

Courtesy of Bronte Capital

NDX Drops 4% and IBD Bag Indicator is Yellow...

aaron602@gmail.com (Fish) — Fri, 27 Jun 2008 11:41:10 GMT

Earlier this month I talked a little bit about the mean reverting bounce associated with a 3% one day drop in the SPX in VIX Spikes and SPX Drops Are Not Necessarily Two Sides of the Same Coin.

Yesterday, we had a 4% drop in the NASDAQ-100 (NDX) and, not surprisingly, the 33 year historical record of 4% drops in the NDX suggests that a bounce is again likely to follow yesterday’s pain. What I found particularly interesting is that the bounce following a 4% NDX drop has a lifespan of only a month or so before any incremental gains revert back to the historical norm. In fact, the maximum post-bounce advantage peaks at about ten trading days, then slowly starts to erode. Looking at data from all 108 of those 4% drops, average performance begins to drop after the tenth day and is decidedly bearish during the period of 2-6 months after that 4% drop.

Part of the reason for this statistical bull trap is the relatively high number of 4% drops in the NDX that occurred during the 2000-2003 period (accounting for 75% of all 4% drops during the 33 year period under study), which lends a bearish cast to the data.

Continued on NDX Drops 4% and IBD Bag Indicator is Yellow...

Drink deeply of the poison: another look at Fifth Third Bank

aaron602@gmail.com (Fish) — Fri, 27 Jun 2008 10:02:19 GMT

Fifth Third was a well run bank with a cult following. Now it is up on hard times. I have looked at it numerous times with an eye to buying it - but never purchased. I blogged about that here.

I was so blinded by the past glories of the company that I couldn't even make money shorting it.

The true believers however really drank the Kool-Aid. In 2000 it was priced it at 7 times tangible book plus excess capital.

So now I am back having a look at Fifth Third. Investor Relations didn't return my email (which is disappointing) but so far I have positives and negatives.

The biggest negative is location. It is big in tough states - having three of its state concentrations in three of the worst five states for property forclosure.

The second bigggest problem is an huge error of judgement on behalf of the management. They spent a large part of 2007 drinking the Kool-Aid themselves repurchasing $1.1 billion in shares at seemingly low prices during 2007 only to issue a billion in converts at even lower prices in 2008. They paid an average price above $40 a share and issued around $10.

There is a phrase for that. Its called believing your body odour is purfume.

But at the moment I want to accentuate the positive. There is plenty of positive - and some of it reflects well on management.

This post focuses on the origination of mortgages with negative amortisatisation features and high loan to valuation ratios.

Fifth Third and Negative Amortisation loans

The 2007 annual report includes the following paragraph:

The Bancorp does not originate mortgage loans that permit customers to defer principal payments or make payments that are less than the accruing interest

That tends to cheer you up in this environment.

The 2006 annual report was slightly different:

The Bancorp does not currently originate mortgage loans that permit principal payment deferral or payments that are less than the accruing interest.

The "does not currrenlty" line also appears in the 2005 annual report.

So sometime they stopped originating that sort of loan - and they did it years before the credit crisis broke. In other-words management did not lose their minds as all about them lost theirs.

High loan to valuation mortgages

Another indication of quality management was that they slowed origination of high loan to valuation mortgages much earlier than most of their competitors. They have a category for mortgages with a loan to valuation ratio above 80 percent and no mortgage insurance. Mortage originations for this were as follows:

2004 1286 million
2005 1245 million
2006 679 million
2007 265 million

The company slowed its origination in this category from mid 2005 and slowed it dramatically before the credit crisis hit. That reflects very well on management. Very well indeed.

So given this - I could drink the Kool-Aid. If you dear reader see good reasons to stop me please let me know. I write this blog at least in part for the comments and emails - and I don't get enough of them.

Meanwhile: memo to IR - its good to return phone calls and emails.

John

Courtesy of Bronte Capital

Citigroup thinks Barclays needs more

aaron602@gmail.com (Fish) — Fri, 27 Jun 2008 09:52:14 GMT

Well you don't say:

June 27 (Bloomberg) -- Barclays Plc, Britain's fourth-biggest bank, may need an additional 9 billion pounds ($17.9 billion) to absorb credit-related writedowns and bring its capital in line with U.K. peers, Citigroup Inc. said.
The London-based bank will raise 4.5 billion pounds in a share sale announced earlier this week, lifting its core-equity Tier 1 capital ratio to 5.8 percent from slightly below 5 percent, said London-based analysts led by Tom Rayner in a research note today. That will lag behind Royal Bank of Scotland Group Plc and make Barclays Europe's ninth weakest bank in terms of capital, said Rayner, who has a ``sell'' rating on the stock.
``With credit market conditions continuing to deteriorate globally, we believe it is simply a matter of time before further significant writedowns are taken,'' Rayner said.
Barclays spokesman Alistair Smith couldn't immediately be reached for comment.

Sack Bob Diamond. Sack him now.

Courtesy of Bronte Capital

New 2008 Low in the DJIA, Yet VIX Shows Complacency

aaron602@gmail.com (Fish) — Thu, 26 Jun 2008 19:50:33 GMT

I have received a number of questions and comments in which readers have expressed surprise about the relative complacency in the VIX (currently at 23.51 as I type this) while the DJIA is in the process of making a new low for the year.

One important and often overlooked element of a VIX spike is surprise. Similar to Nassim Taleb’s idea that a black swan cannot be anticipated, if all of the Bob Janjuah’s of the world predict an impending market crash, the media runs with the story, and investors rush out to snap up portfolio protection…then it becomes much less likely that people will panic and the market will crash if stocks start to turn down. Put another way, where there is a safety net, there is a lot less fear.

Another point worth noting is that the DJIA is not representative of the broader markets, as reiterated by Adam at Daily Options Report today in Lookout Below? The Russell 2000 and NASDAQ-100 indices, for instance, are showing considerably more resiliency in the recent downtrend.

Turning to the VIX:SDS ratio, which I unveiled last August in Fear vs. Volatility (follow the links for some background and explanatory notes), I use this indicator to evaluate the amount of fear and complacency in the market relative to market movements. The size and direction of the gap between the current ratio and the 100 day SMA or the 10 day SMA and the 100 day SMA provide some useful information about the incremental sentiment involved in market moves.

Continued on New 2008 Low in the DJIA, YEt VIX Shows Complacency

The Associates-Sandy Weill's greatest miss

aaron602@gmail.com (Fish) — Wed, 25 Jun 2008 22:37:44 GMT

People seem to have decided that the merger of Citigroup and Travellors was a failure - indeed the great failure of Sandy Weill's vision.

That may be true - but given that JPMorgan is buying Bear Stearns Citigroup effectively buying Salomon Brothers might just be "prescient".

Anyway - everyone appears to have forgotten the most awful Citigroup acquisition of all time - The Associates.

The Associates (or more correctly Associates First Capital) was the financial arm of Gulf and Western. It was later purchased by Ford - and then spun to Ford shareholders in 1998.

Less than two years later Citigroup purchased it for stock and wound up giving away one sixth of Citigroup.

Yes that is right - long term shareholders of Ford who did not sell out now own a large amount of Citigroup - and that is worth more than the residual Ford holding.

You make your money in the stock market often in odd ways.

--

The history of the Associates is here.

--

Associates had two main businesses - a leading US subprime mortgage business and a Japanese consumer lending business.

It was the Japanese consumer lending business that most attracted Weill. The press release announcing the merger is headlined about Citigroup growing its overseas consumer finance business. To quote:

"This transaction, which will be accretive to Citigroup earnings by at least $.10 per share in the first year of combined operation, accelerates our consumer financial services expansion globally," said Sanford I. Weill, Chairman and Chief Executive Officer of Citigroup. "In one step, we catapult our international earnings in these rapidly growing segments by more than 40%. We are particularly excited about The Associates' strong presence in Japan, where it is the fifth largest consumer finance company, and in Europe, where it has more than 700,000 customers.

The Japanese consumer lending business however has almost been regulated out of existence - it is unprofitable (having once had an 80% ROE) and Citigroup is trying to close it. They are by repute having difficulty doing so.

In the end the Associates was probably worth less than zero.

Warren Buffett complains endlessly about having given away 1.6 percent of Berkshire for the essentially worthless Dexter Shoe business. I have never heard the top brass of Citi make the same complaint about the Associates - but I have heard it from upper-level Asian Citigroup executives.

That is the true legacy of Sandy Weill.

Courtesy of Bronte Capital

A slight difference in statements: Chart Industries and Energy World Corporation

aaron602@gmail.com (Fish) — Wed, 25 Jun 2008 22:35:53 GMT

I wrote previously about the strange Energy World Corporation (EWC). See “Getting oil on my shirt”.

Some follow up is warranted – as I left the question as to who had the technology open. But I think we can decide pretty quickly who is telling the truth. Here are some direct quotes from EWC and Chart Industries.

This is from the last EWC annual report:

The Company has placed contracts with Chart Energy and Chemicals Inc (Chart) for four 500,000 tonnes per annum liquefaction plants and associated major equipments. As subcontracts to Chart the motor-driven MR compressors will be supplied by Siemens AG, Germany. These contracts which are within the original capital budgets, and programmed equipment deliveries will permit the production and delivery of LNG from our gasfield in Sengkang during the second half of 2009. Once installed and operating the trains will have the capability of producing 2 million tonnes of LNG per annum.

This is the Chart Industries press release:

Chart Industries to Supply Four LNG Liquefaction Trains in Indonesia for Energy World Corporation Equipment orders exceed $100 million

CLEVELAND, July 2 [2007] /PRNewswire-FirstCall/ -- Chart Industries, Inc. (Nasdaq: GTLS) announced that its wholly-owned subsidiary, Chart Energy & Chemicals, Inc. ("Chart E&C"), has been awarded significant orders totaling in excess of $100 million from Energy World Corporation Limited ("EWC") to supply Cold Boxes, Brazed Aluminum Heat Exchangers, Air Cooled Heat Exchangers and ancillary equipment for four 500,000 tons per year Liquefied Natural Gas ("LNG") Liquefaction Trains to be installed by EWC in Southeast Asia. The trains are intended to provide LNG to meet the growing demand for LNG in Indonesia, the Philippines, China and Japan as the economies in these regions grow. The first two trains are scheduled to come on stream in the second quarter 2009.

Do you notice any difference between these statements?

Well – there is some difference between an “LNG Plant and associated major equipment” (as per the EWC statement) and “Cold Boxes, Brazed Aluminum Heat Exchangers, Air Cooled Heat Exchangers and ancillary equipment” as per the Chart release.

For a start nobody has mentioned purification (essential because otherwise the carbon dioxide that exists in all gas freezes in the cold-boxes and blocks the equipment), storage tanks, port facilities, pipelines to the gas field or anything else. The storage tanks are particularly expensive.

John

As an afterword: Funnily enough there is no point using Google to find anything put out by EWC. They format all their releases as PICTURES not as text – which makes them impossible for Google’s bots to dictate. I had to retype…

Further EWC doesn’t maintain a website – something that is unusual for a multi-billion dollar company.

Courtesy of Bronte Capital