Saturday, March 11, 2006

On Socially Responsible Investing

If a company were performing badly, but had noble cause, would you invest in it?

In a casual survey, many students surveyed at liberal arts colleges answered “Yes” enthusiastically. They explained that they wanted to help the troubled company because the world needed more of its socially responsible product or service.

Most people, understandably, find this response to be quite naive. The reasoning follows: If I buy shares of a company, the seller’s proceeds are exactly what I pay for the stock. The company doesn’t reap any of the benefit when paper representing ownership changes hands. The idea that buying a company’s stock helps them do business is simply wrong. For instance, if I were to purchase Northrop Grumman shares, the company wouldn’t benefit. Their capacity in building electronic warfare systems would be unaffected. Following this argument, the ethics of investing are of no consequence.

This logic, however, has a severe flaw. The truth is, when you buy shares of a company you are helping them do business. Your purchase of Northrop is directly helping them build weapons. The reason lies in Exit Strategy. Then Northrop offers shares to the public to finance their operations people only buy it because they believe that they will be able to sell it to someone else at some point in the futures for a capital gain. The IPO unequivocally helps a company produce its good or service. What people fail to realize is that if there were no buyers out there to purchase the stock at a time after the IPO, the company wouldn’t be able to raise any capital to fund business. The idea goes back to the concept of capital markets. If there is no market, there will likely be nobody backing a business for lack of an Exit Strategy.

Friday, March 10, 2006

That Tricky Yield Curve

It's obvious that when short-term rates are higher than long-term rates, as is the case in the U.S., that banks are in a difficult situation. This divergence in yields is how banks rake in the dough. When the yield curve is inverted the opporutnity for yield arbitrage across time dissappears.
As rates "normalize" and the risk premium for time becomes apparent in the yields, banks should see profit margins fatten substantially. It's been a popular view of B-week that banks are doomed, and frankly, by the time a critical mass of commercial media agree on an issue, it's likely no longer true. This is my view on S&L's and will be loading up the trucks (manufactured by Caterpillar) on any signs of weakness, that is Citigroup at $45.

On the regional side, IndyMac bank is another interesting story. Essentially, they are convinced that their business model is superior because of their hybrid mortgage banking/S&L model. When rates are falling their refinancing and mortgage business does exceptionally well. In a rising rate environment, they see fatter margins on interest income. Their strategy is unique in that in rising rate environments, they seek to expand their business while most banks lay-off workers. They are actively recruiting for their Pasadena HQ.

On the rates issue, there is no question that long term yields will rise. I believe the government made a savvy move in re-issuing the 30 Year Bond last month. It's cheap financing considering the likely direction of rates.

Thursday, March 09, 2006

Load up on Yahoo!

Yahoo! is the leader in one of the world's fastest growing markets and is the most visited site on the internet and most widely used portal. Sure, Google gets all the hype, but their search technology has put them in first, but the leapfrog effect is inevitable.

The company is trading at a 25% discount from a share price of $40, where I believe it belongs. Essentially, the two main elements of an investment thesis for Yahoo! are its growth potential and its extremely low valuation (only 25x earnings including their one-time capital gain from holding Google shares) and 40x earnings as evidenced by operating income (about $0.70 per share).

In terms of financial soundness, the company is supremely positioned. Current assets are over 2.8x current liabilties and debt to equity ratios are falling. Great management effectiveness ratios show that managers are responsible stewards of owners' capital. Asset turnover ratio increased almost 100 bps from 2004.

With 49% topline growth and an adjusted PE of under 40 (excluding one time charges), the recent 25% pull-back in in the valuation is compelling. We're loading up the trucks.

Jo-Ann's On Sale

Jo-Ann Stores (JAS) has come down more than 60% in the last year. Sure, management is having problems and the CEO/Chairman/President just left, but I see this as a good sign. They are conscious of the problems going on with the transition from small stores to “super-stores.” The move to super-stores is an effort to create a holistic craft shopping experience—whatever that means.

From my view, JAS is a decent company in a boring sector that is unlikely to experience any tremendous growth in the future. This is a value play in the most traditional sense: the market has pegged a price of less than the sum of the company’s parts. Let’s be conservative and say that they can never sell half of the inventory on their books. The company should fetch a value of approximately $15 a share.

I’d like to see them write-off some inventory and concentrate on what sells. I’d expect to see a jump in the share price when they announce that they’ve brought some experienced management on board. In the interim, savvy value investors like Jon Brogaard have taken a large equity stake.

Cracking the Oil Code

Background Information
Being the lifeblood of the world’s industrialized economies, crude oil is the most actively traded commodity. The world consumes roughly 80 million barrels of crude oil per day and uses petroleum products for a multitude of applications, including transportation, heating, and plastic production. Because oil is such an essential input in the production process, its price is closely followed and reported daily by the financial press. Also, most of the world’s heaviest consumers of petroleum rely on imports from Middle Eastern oil-producing nations. Since the formation of an international petroleum cartel, the Organization of Petroleum Exporting Countries (“OPEC”), the political importance of oil has escalated. In an effort to insulate the American economy from oil shocks, the U.S. government began stockpiling emergency oil reserves in 1977 as a national security policy.
The question of whether the price of oil is high or low based on market fundamentals is a contentious debate. Currently, oil is trading at about $60 per barrel in 2005 dollars, a relatively high price compared to historical averages. Many justify this price and remain bullish, adhering to the idea that the supply of petroleum is fixed and that increased demand from developing countries will drive the price higher as they accelerate growth. Others dismiss the current price as being irrational and the result of increased speculative activity by large alternative investment funds. This paper seeks to explain what determines the price of oil.Several different types of crude oil are produced and receive different market prices. For instance, North Sea crude, generally known as Brent crude, commands about a $1 premium to the OPEC Basket Price, which includes various blends of Dubai, Saharan, and Venezuelan crudes. The price quoted on the New York Mercantile Exchange, however, is for light-sweet, or West Texas Intermediate (“WTI”) crude. WTI is the most easily and widely refined crude in U.S. refineries, making it the most frequently quoted type of oil in the world. Light-sweet WTI crude on the NYMEX trades at about a $2 premium to the OPEC Basket Crude. Changes in the price of crude oil have large affects on the U.S. economy and are difficult to explain and predict. The quoted price of crude oil on the NYMEX represents the cost of one 42-gallon barrel of crude oil before transaction and transportation costs.

The Independent Variables, Functional Form, and Expected Signs of Coefficients
While it is clear that many variables affect the price of crude oil, determining the correct variables for an equation is difficult because there are several ways to measure a single phenomenon. Below are the independent variables and a detailed explanation of why each was chosen and what it means:
-Industrial Production Index: As the world’s economies grow, industrial production expands and global demand for oil increases. Because the United States economy consumes roughly 25% of the world’s crude oil, and meticulous monthly data is collected by the government, the Industrial Production Index was chosen to explain demand for oil in developed countries. The Industrial Production Index measures the monthly physical output of the manufacturing, mining, gas, and electricity industries. Other ways of measuring output, such as real GDP, are inferior to the Industrial Production Index for this model because real GDP measures output in the service and technology sectors, which consume less petroleum than heavy industries. Theory suggests that the relationship between industrial output and crude prices should be linear. Increases in industrial output should mean that oil demand has increased and that the price should rise. A positive (+) sign is expected.
-Non-OECD Consumption of Petroleum: This variable is a measure of oil consumption in the developing world. As the developing world industrializes, the world economy’s demand for petroleum accelerates. Both China and India are two of the fastest growing nations and consume large amounts of oil. Almost all literature concerning the price of oil cites Chinese demand as a driver of prices. The relationship between non-OECD consumption and the price of oil should be linear as well. As the consumption of a non-renewable resource increases, price should rise, so the expected sign of this coefficient is positive (+).
-Change in Crude Stocks: Changes in the commercial stocks of crude oil are an important driver behind changes in price. Quantities of crude oil stocks are stocks of oil held at refineries, in pipelines, in bulk terminals, or any quantities in transit to the aforementioned destinations. If this variable were the absolute level of crude stocks, an inverse function form would be theoretically accurate, because the impact of the stock levels on price would diminish as they increased. Because it is the change in stocks, only linear is appropriate. An increase in crude stocks should ease the market’s fear of a shortage, so the expected sign of this coefficient is negative (-).
-Change in U.S. Field Production: A disruption in U.S. field production should have a large impact on prices. Because the U.S. consumes more petroleum than it produces, it is forced to import crude oil from abroad. As more oil is produced in the United States, fears of a shortage will diminish and the price should fall. The relationship between changes in field production and the price of oil should be linear. The expected sign of this coefficient is negative (-).
-Change in OPEC Output: By restricting output, OPEC has been able to raise the price of oil. OPEC’s share of world oil production has decreased since the 1970’s because new oil fields have come on-line and market power has eroded; nevertheless, OPEC’s pricing power still exists. Theory suggests that the relationship between changes in OPEC output and the price of oil is linear. The expected sign of this coefficient is negative (-) because as OPEC increases output, the price of oil should fall.

NYMEX = -263.354 + 2.894 INDPROD + 0.061 NONOECD - 0.176 STOCKS
(11.600) (0.794) (-2.210)
+ 0.212 FIELDPROD + 0.062 OPEC
(0.9053) (0.676)
N = 42 Adjusted-R2 = 0.8795 DW = 1.400

INDPROD = the Industrial Production Index

OPEC = the percentage change in OPEC output

NONOECD = the percentage change in Non-OECD Consumption

STOCKS = the percentage change in commercial stocks

FIELDPROD = the percentage change in U.S. production

Abercrombie is Too Cheap

Abercrombie is trading at just 15x earnings. Most of the recent drop is due to the company failing to meet same-store-sales expectations. Analysts were looking for a whopping 13% month-on-month growth in sales, but they came in at around 6%, which is particularly robust in my opinion. What analysts forget is that February saw some of the coldest weather in recent history in the East. It doesn't take a genius to figure out that spring apparel doesn't sell when NYC is having a blizzard. The same-store-sales shortfall is likely an aberration.

The company is a proven brand creation machine. After hugely successful Hollister they are pushing forward with Reuhl, which is geared toward the twenty-something age group. I have no doubts that they will continue pushing forward solid brands, just as they did with Abercrombie Kids.

The market is currently holding a 20% off sale. Fair value is somewhere in the $68-$72 range. The market has been pessimistic in the entire retail sector. Urban Outfitters met expectations with morning but is off about 15%. It’s time to load up on ANF.

See chart: