My full notes and analysis on the Wall Street Journal from the past week: January 30-February 5, 2017 (Week 5). Please Enjoy.
Donald Trump: “I love depreciation”
Trump on Depreciation
“I love depreciation,” he said in the second presidential debate last October. (link)
“Every other country lives on devaluation,…They play the devaluation market and we sit there like a bunch of dummies.”
“Mr. Trump suggested Tuesday that Japan and China are devaluing their currencies.”
“The U.S. dollar slid to its lowest level since November on Tuesday amid weak U.S. data and new indications that the Trump administration would prefer a weaker dollar.” (link)
Japan depreciation
“The Kyoto-based company (Nintendo) reported net profit of 64.7 billion yen, more than double the year-earlier level, a figure it said was boosted by the weak yen.” (link)
Mexico depreciation
“Further peso weakness could make the country even more competitive globally.”…”A weakening peso would again give them even more of a competitive edge” (link)
Banking Moral Hazard
Should we start worrying about moral hazard at banks again? I’m beginning to think the answer is yes. There’s just too much incentive for banks to game the system. Take this for example:
“Banks must pass the Fed’s stress tests in order to boost dividends or buybacks to shareholders.” (link)
Here’s what makes that simple point very worrisome:
- Banks are being incentivized to game the system in order to boost dividends or buybacks.
- They are using the same consultants who helped them avoid Basel II capital requirements before the financial crisis.
- The stress test models offer false precision: “What models cannot measure is the chance that banks all act as a herd — creating financial panics.” (link)
- The Fed is considerably intertwined with the stress tests. Should anything go wrong, they will feel responsible for bank failures and ultimately bail them out again.
Focus on What You Can Control
I always love Amazon’s approach:
“There’s always a number of things that can impact customer spending, both positively and negatively during any quarter,” said CFO Brian Olsavsky on a conference call. “What we do, is continue to focus on the things we can directly control: for us that’s price, selection, customer experience. And on those dimensions we felt we made great progress.” (link)
Exxon: Agency Costs
Exxon is unbelievably good at limiting agency costs and aligning management with long-term shareholder interests. Just check out these two examples:
Policy on Writedowns:
“Exxon hadn’t booked a decline in the value of its assets since at least 1990. This is due in part to the company’s practice of being more conservative when initially recognizing the value of new oil and gas that it discovers,” (link)
“The company’s senior leaders wanted to avoid writedowns because in accounting terms, they have the effect of making the company’s investments appear more profitable,”
“We don’t do write-downs,” former Chief Executive Rex Tillerson told trade publication Energy Intelligence in 2015. “We are not going to bail you out by writing it down. That is the message to our organization.”
Policy on Executive Stock Options:
“Half of the equity award may not be sold for 10 years from date of grant or until retirement, whichever is later, and the other half is restricted from sale for five years.” (link)
Very Low VIX = Very Low Returns
Historically speaking,
“stocks have done poorly in the year following very low VIX levels. The S&P’s annual gain has been 2.7% after the 100 lowest readings and nearly 29% after the 100 highest readings. The overall average was 8.8%.”
“A low VIX isn’t in and of itself worrisome, but the “calm before the storm” idea has some basis in history. Some of the lowest historical VIX readings preceded sharp, unexpected stock selloffs such as the 2008 financial crisis and the 1994 interest rate scare.”
Japan and the Weimar Republic
I couldn’t help but think that Japan’s monetary policy draws parallel’s to the Weimar Republic.
When the Weimar Republic went off the gold standard, there became no legal limit as to how many notes it could print. And print they did.
Meanwhile, the BOJ wants to buck a global tide of rising rates, and have announced “it would buy an unlimited-number of five- and 10-year government bonds at prices that translate to a benchmark yield of around 0.110%.” And buy they did. (link)
How long can the Rising Sun fight a Rising Tide of interest rates?
Ferrari: The Boundaries of Brand Dilution
It’s less than 2 years since Ferrari’s IPO, and the race to test the boundaries of brand dilution is on.
Historically Ferrari has established brand equity through exclusivity. Just as recently as 2013, head of Ferrari, Luca di Montezemolo, announced plans to sell fewer cars in 2013 than the 7000 it delivered in 2012.
Luca stated, ‘this is a far-sighted decision to strengthen our brand equity, from what I learned from Enzo Ferrari… We must resist people who say the competition will benefit from us making fewer cars… When others penetrate our markets, we are happy to meet this challenge.’ (link)
In 2014, the company sold 7,255 cars. That year, Luca resigned following tension with Sergio Marchionne.
By 2016, the number of cars shipped increased to 8,4000. Sergio Marchionne believes he could boost production up to 10,000 cars. (link)
At the moment, Ferrari cannot sell more than 10,000 cars a year because of emission standards. I suspect however that electric vehicles will ultimately be exempt from this number, giving Ferrari an open path to even more significant brand dilution.
Ralph Lauren: Brand Dilution
As Ferrari tests the boundaries of Brand Dilution, many fashion retailers, like Ralph Lauren, are desperately trying to recuperate brand equity after years of brand-destructive strategies.
”Ralph Lauren said it remains committed to Mr. Larsson’s restructuring plan, which has included limiting discounting, lowering inventory and reducing the number of products the company is selling.”
Know the key drivers within your industry: Coal
Key Drivers within the Coal Industry.
1) Demand and Competition from China
Chinese consumption and production policies have a huge impact on coal prices. Here’s what’s happened in just the past year:
Coal Prices Tripled: “International prices for metallurgical coal tripled in 2016 from a decade low. Rule changes in China that limited work in mines, mine retirements in Australia and U.S. production cutbacks sparked the rally. Many troubled mines were suddenly profitable.”
Coal Prices Halved: “Coal prices have tumbled by nearly half since November, after China relaxed restrictions on the number of days mines can be open…”
2) Government Regulatory Environment.
The House voted to “repeal a rule that limited companies from dumping mining waste in streams. The coal industry views the environmental rule as burdensome regulation.”
“It’s a very optimistic time now for the coal market because those regulations are being pushed back,”
3) How fast can coal miners ramp up production and re-open plants?
“…mines world-wide have already ramped up output to take advantage of the rally in prices.”
Toshiba: Learning from Other People’s Mistakes (OPM)
Warren Buffett has said that’s it’s best to learn from “other people’s mistakes” as much as possible. Well I think there’s much to learn from Toshiba’s perilous venture into nuclear energy.
Toshiba’s nuclear ambitions made for a great investment story. They planned to leverage Westinghouse’s nuclear reactor design to reduce costs by cranking out many “cookie-cutter” power plants. This low cost strategy, combined booming demand, would lead many investors towards an optimistic view of the company.
At first things started out well:
“Southern chose Westinghouse’s design for the first new nuclear plant to be built in the U.S. in 30 years, and the next month Scana also chose the AP1000 for a plant in South Carolina.” (link)
But eventually the twin pillars of Toshiba’s plan, low cost and booming demand, eventually dissolved leaving them with losses that could approach $6 billion. How did this happen?
Their misery stemmed from two major sources:
- Replicating Errors: Any error in their cookie cutter power plant design was replicated throughout all the power plants they were building. Leading to very costly mistakes. (link)
- Stagnation: The nuclear industry has stagnated or declined in most every country but China. Largely as a result of Fukushima and political headwinds. This lead to increasingly ferocious competition.
We should learn to watch out for:
- Very large tail risk (Fukushima)
- Political risk
- Execution risk (Difficulties of Implementing the strategy)
- Investing outside of your circle of competence.
- I would not have seen the risks of replicating design errors in the reactor design.
Other major issues from this story:
- Toshiba exposed themselves to unlimited losses: The deal restricted Westinghouse’s ability to “seek further increases in the contract price,” Southern said—meaning that if the nuclear plant couldn’t be completed in a timely manner, Toshiba would shoulder the costs.
- Toshiba had a high profile accounting scandal in 2015 (link): Warren Buffett says, “In the world of business, bad news often surfaces serially: you see a cockroach in your kitchen; as the days go by, you meet his relatives,”
This Week in Human Misjudgment: Pavlovian Association
Currently lots of human misjudgment centered around anybody involved with Trump. For example:
“Uber Technologies Inc.’s chief executive, Travis Kalanick, said he is stepping down from President Donald Trump’s economic advisory council, saying that his participation has been misunderstood as an endorsement of the new administration’s policies.” (link)
“The announcement “follows criticism of the ride-hailing firm over perceptions that it supports the Trump Administration, with some celebrities and others using social media to call for people to delete Uber’s smartphone app.”
Under-estimating risk:
Be wary of trading strategies. Many often underestimate the risk involved. Here’s one example of where it may be occurring:
“It really came down to the leverage,” said Mr. Skalak on why he switched from stocks to futures. On a good day, Mr. Skalak said he can make $600 to $1,000. He pulls out of the market if his daily losses approach $400, a policy he adopted after some steep losses.” (link)
First: His strategy is likely dependent on being able to pull out of the market in a calm and orderly fashion. During market panics however, liquidity can dry up and severe fluctuations can wipe out years of profits like it did to the Carry Trade back in 2008.
“These rare and unexpected changes in the market, such as the sudden devaluation of a currency, can wipe out years of accumulated gains. Thus, higher interest rates in the lent currency may be the payoff for bearing the risk of a peso event. But determining the effect of an unlikely future event is something of an experimental nightmare.” (link)
The carry trade is often described as “picking up pennies in front of a truck,”
Second: This trader sough out a strategy where he could apply a great deal of leverage, but here’s a few warnings against leverage:
Currency Swaps & Interest Rates
Very insightful article into the relationship of currency swap and interest rates.
Foreign bond investors measure investment attractiveness by the hedged yield differential. Therefore, to understand the demand for bonds from foreign investors, you have to know both the yield differential and the cost of hedging currency risk with currency swaps.
Example: (link)
“At the end of January, a 10-year U.S. bond yielded around 2 percentage points more than its German equivalent and 2.4 percentage points more than a Japanese bond.”
“But if investors fully hedged themselves against currency exposure, the pickup in yield would disappear completely. After that cost, a U.S. 10-year bond would offer a yield 0.06 percentage point lower than a domestic equivalent for an investor with euros, and 0.7 percentage point lower for a Japanese investor.”
“The relative attractiveness hasn’t increased as much as the nominal difference in yields suggests,” added Mr. Inkinen.
“Hedging an investment mutes its impact on the exchange rate, but if Japanese and European investors want to benefit from higher yields on bonds elsewhere in the world—particularly U.S. Treasurys—they would have to buy more bonds unhedged against currency risk.”
Market Developments
- Bullish Oil Bets Climb to Record (link): ” Long positions exceeded shorts by such a degree that it’s the largest net bullish position in 10 years of data from the CFTC.”
- Strong demand for Italian commercial real estate (link): Investing in Italy “is a way to move up the risk curve and deliver returns promised to investors,”
- Investment Grade Bond mania: “Investment-grade companies have sold $146 billion of bonds this year, the most for any comparable period on record going back to 1995,”
- Systemic Risk in China’s lending environment (link): The default “rippled through the world’s largest internet investment marketplace, hitting investors who hadn’t even bought the securities.”…Individuals seeking higher returns invest in these unregulated securities with a few swipes on their phone.
- WeWork is just a duration mismatch? hmm… (link): WeWork’s “business model is to sign long-term leases with landlords, but take short-term rents from its own tenants, meaning that revenue is volatile and losses could pile up in a recession.”
- Businesses are struggling to charge more (link): The Fed noted earlier this month that “increases in input costs were more widespread than increases in final good prices” – an indication that businesses are struggling to charge more.”
- The Facebook IPO still haunts the Nasdaq (link): “…since the glitch-filled IPO of Facebook Inc. on the exchange in 2012, NYSE has landed the majority of the dollar volume raised in tech IPOs valued at $1 billion or more,”
Oh Mon Dieu…
Think about this the next time you examine your daily habits.
“EA said its mobile game “Star Wars: Heroes of the Galaxy” was a significant driver of digital sales, with fans now spending an average of 155 minutes a day playing it.”
In the course of a year, that equates to 16 hours per day for 59 days straight of doing nothing but playing this video game. Over the course of 60 years, that’s 9.7 years.
Statistic of the Week
“Americans now lose $500 million a year to street crime but $8 billion a year in ATM fees.”