Quick recommendation update

As summer is approaching, it is timely to revisit some previous recommendations.

I just sold my Telecom Argentina shares for a 79% profit.  I continue to like the company’s management and its business, but the political and macroeconomic environment in which it operates (Argentina) is getting increasingly difficult.  Maybe it is the darkness before dawn, but given the gain which was to be realized and the uncertainty ahead, booking a good profit seemed appropriate.

Standard and Chartered plc, the UK international bank, has essentially been flat since our post of last August.  I maintain my negative stance: the business model, in my view, continues to be riskier than generally assessed and I am not comfortable with the bank’s corporate governance.  I am not short, I am just on the sidelines.

Finally, Apple made some important announcements, although more evolutionary than revolutionary, at its annual developers conference.  We are still awaiting the unveiling of truly eye popping devices or services.  My previous price target of $600 pending the release of new products looks a bit too high; $500-$550 is probably more appropriate.  Nevertheless, I continue to hold the stock as it looks reasonably priced at current levels and increased dividends and share buybacks are positive.

On a wing and a prayer

One of the most spectacular stages in certifying a jetliner is the wing load test.  Powerful hydraulic pistons subject the wing to ever increasing loads, bending it further upward.  Typically, it should break when the load is about 150% of its maximum expected value in flight.

Contrary to movie lore, where bolts start bursting and spars breaking, one after the other until the climatic end, the break in a wing load test is quite sudden, unpredictable with any degree of precision to the casual observer.  Yes, he will notice that stress is building as is the likelihood of a break, but the behavior of the wing at 151% will anticipate none of its destructive explosion at 152%.

Stress in society and politics tends to follow a similar pattern. In societies or countries experiencing very high financial or emotional stress, the observer can readily notice abnormal behaviors and worrisome signals, but nevertheless may conclude that train service will be more or less on time, that politicians will keep assembling and voting and people will follow more or less their usual routine.  Until, all of a sudden mayhem breaks out.

It is my belief that we are, so to speak, on a wing and a prayer in many parts of the world, certainly in Europe, and to some extent and sometimes for different reasons, in Latin America.  The extremely difficult question is whether the stress load is at 120%, 130% or 149%.

One country of concern to the investor, or should I say speculator, is Argentina.  Its economy continues to experience rising stress, its politics are poisonous and every day life is marred by the lack of security.  After the expropriation of Repsol, I decided to buy shares in YPF and Telecom Argentina (TEO) as they were very cheap and I expected the government to have to gradually return to more orthodox economic and financial policies to reach its development goals.  I also felt that international justice, while slow, was closing in.

I had thought that we were at 145% or so on the stress scale, but I now think while we may only be at 125%-130%, without an effective opposition we could go to 160% in a hurry.  Besides, the prices of these stocks had risen by 50% or so since we had bought them.  I decided to sell all of my YPF stocks and keep my TEO for the time being. 

The government seems unlikely to mend its ways and pressure to do so has not yet reached breaking point; its latest declaration in the US Appeals Court that it would not abide by its ruling if ordered to pay its debts may or may not be a ploy.  Furthermore, YPF seems to find it very difficult to implement the kind of joint ventures it needs to exploit its shale oil resources:  Exxon is MIA, Bridas may be a go but Chevron is mired in legal complications from an Ecuadorian lawsuit, and YPF’s CEO is seen courting second tier E&Ps around the globe. Even if these JVs start to operate, there is still a lot of risk attached to government meddling, as can be seen with Petrobras in Brazil.

Stress is building elsewhere too.  In Europe, with no currency devaluation possible and weak domestic and export markets, the fiscal adjustment must be borne by the population in the form of lower wages and benefits, a shrinking public sector and heavier taxation.  So far, there has been no statesman in a major country with the ability to push through any combination of these policies.  Monti tried and was bumped out; Hollande didn’t even try; Rajoy may do better than his two peers because of national cultural differences, but the jury is still out.

Are we at 110%, 120%, 130% in Western Europe?  Again, tough to say.  My guess is we are over 100% which really means that we are somewhat beyond the maximum “normal” stress level.  I think that stress is bound to rise for two reasons: either governments do too little and lose control over their autonomy or they try to do the right thing and will trigger massive pushback from pressure groups and maybe the population at large.  I still like companies in basic sectors which are effectively restructuring, such as retailers Carrefour in France and Tesco in the UK.  I also see strong restructuring talent at Vivendi (France).

As for the US, I am embarrassed by Washington, but I take solace in two factors: we are below 100% and there is a broader realization in the population that we need to cut government spending just like households cut their own.  The debate, in my view, will be how to devise a program that will be viewed as allocating the sacrifices fairly.

What is unclear is the margin of safety that we have as investors.  The actions of the Fed continue to distort all asset values, from real estate to bonds and stocks.  Traditional benchmarks such as p/e multiples, bond yields and the like imply that bonds are expensive and stocks are reasonably priced.  But with a slow growing economy and corporate profits at an historically high level, it doesn’t take much imagination to see stock prices falling 10% or even 20%.  So the important question is, should this happen, would the stocks that I hold still be attractively valued based on long-term fundamentals?  And since we are in a “what if” frame of mind, how about a Warren Buffett test that I find compelling:  would I hold the same stocks if I knew that their shares would not be publicly traded for the next three to five years?

2102 revisited: stock commentaries

We reviewed a few stocks this year.  So far, our take has been mostly right.  Our current scorecard is provided at the top of each section.

YPF (+33%) and Telecom Argentina (+16%)

Last April we noted that the nationalization of YPF and the expropriation of its then controlling shareholder, the Spanish multinational Repsol, was part of a long standing pattern of misbehaving by the Kirchner governments. 

Last month, with surprise developments affecting its unrestructured sovereign debt (impounding of the frigate Libertad in Ghana, adverse New York court judgment), with massive street demonstrations against the Kirchner government and the evident difficulties that YPF had in closing joint-venture deals with the likes of Chevron and others, we surmised that change may soon become inevitable and we started to invest in Argentina, just a little.  We thought that YPF would be a good start, with Telecom Argentina as a less speculative second choice.  At the time, their ADR prices were $10.46 and $9.82 respectively.

Today, they are $13.90 and $11.41.  While Repsol’s legal pressure is continuing, the Spanish government has made it known that it was in regular contact with its Argentine homologue and that a resolution of the dispute was likely.  After initial difficulties, YPF was able to raise substantial sums by issuing bonds on the local market; ironically, the repressive financial controls made YPF bonds the best deal in town.  It also helped that the government could force its Social Security system to buy half of the company’s debt offerings.

Negotiations seem to be continuing with Chevron and now Bridas, and they are very difficult: how could it be otherwise given the Repsol expropriation precedent and the unrealistic energy pricing system?  In the end, I think that Argentina has no choice but to pay Repsol for its stake in YPF and to adopt economically sensible oil and gas prices.  After all, its shale deposits are among the richest in the world, it will control and benefit their exploitation and it doesn’t want to be too dependent on Bolivia and Brazil for its energy needs.

Even though it gears to become the energy national champion (by taking control of Metrogas and with its expected bid for Petrobras Argentina),YPF continues to be priced for disaster (see peer comparisons in our September post). I do believe that the current strategy consisting in copying the Brazilian energy model is wrong and terribly costly; but even then, if the Repsol dispute is settled, as I expect it will, the YPF stock should rise very appreciably.

Telecom Argentina is well managed, profitable and carries a large net cash position.  Price controls and high inflation have squeezed its profit margin, but it too is priced for disaster.  Its stock may not pop up as much as YPF’s, but it is offers lower risks.

The other big risk factor for US investors is the continued listing of these companies’ ADRs in New York, as this provides liquidity and attractive economics given the overvaluation of the Argentine peso.  One would think that, unable to tap international bond markets, Argentina would be anxious to maintain access to international equity markets. 

JP Morgan Chase (+19%)

In May, I commented on the London Whale travails of JP Morgan which had pushed its stock price down to $36.96 on the day of my post.  I advised prudence, cautioned that the loss on its derivatives could well exceed the initial estimate of $2 billion (it did) but took the view that buying below $36 would result in a profitable trade.  The stock price spent two months below that level, bottoming at $30.70.  Today it is $42.81.

The bank management was extensively reshuffled.  Yet markets have responded without enthusiasm.  Although the stock price should appreciate further next year, my view of the company has evolved.  I have come to the conclusion, partly through personal experience and partly through industry review, that the bank has grown too big and diversified to provide superior customer products and services and to be effectively controlled. 

Warren Buffett once said that he wanted to invest in businesses that even fools couldn’t sink, because sooner or later fools would be in charge.  JP Morgan’s top management is very smart, even if it may suffer from some hubris; but I wouldn’t want to own the stock if fools were at the helm.  Admittedly, this is a remote possibility in the case of JPM.

Standard Chartered plc (-6%)

Last August, I wrote about Standard Chartered plc.  I expressed disbelief with their decision to continue doing business with Iran through their US facilities despite clear prohibition imposed by their host country.  I questioned the bank’s decision-making and the oversight exercised by its Board of Directors.  I also felt that its market value failed to reflect the inherent risks of its business model.  I elected to pass and wait for another day to invest.  The stock price then was 1,418.5p; today it is 1,497p.

Since then, little has changed. Of its twenty-one Directors, only two new have joined the Board following disclosure of the Iran saga.  No top or senior manager has paid the price for this fiasco.  The bank settled the outstanding charges with the US federal authorities for $327 million.   However, its latest quarterly results were satisfactory and, had I bought the stock back then, I would have made a 6% gain to-date.  I remain a skeptic but I admit that I may have been wrong.

 

Apple (+26%) and Research in Motion (+87%)

Last September, I argued that Apple was not a cheap stock despite its modest p/e multiple, the reason being that such multiple resulted from a very high gross margin.  I noted that reverting to 2006 gross margin levels would push the p/e above 23, even after deducting Apple’s large cash balances from its market value.  I also expressed some doubt that Apple could maintain its growth rate and gross margins by targeting emerging markets such as China.  Interestingly, Apple’s latest quarterly results showed a small drop in margins which the company put on the concurrent launches of new products.  The stock price, which was $691 on the day of our initial writing, has now fallen to $510. 

Irrespective of its fundamentals, Apple, once buoyed by client adoration and investor exuberance, seems to have lost some of its magic:  Steve Jobs passed away; it stumbled with its handling of Google Maps and Youtube; it continues to rankle with its refusal to support Adobe Flash; Apple TV remains an undefined possibility.  That said, relative to its peers, it remains a unique company; it is just very difficult to keep beating extraordinary expectations and to have to add $50 to $70 billion a year to justify current market valuation.   

On September 28^th, I argued that Research in Motion, the maker of the Blackberry, was a buy as it was priced for extinction, which didn’t seem likely. Today, a consensus has emerged that its new Blackberry 10 will come to market early next year.  Carriers and large corporate clients are testing it.  Besides its reported merits, the BB10I is benefitting from telephone carriers wanting to break the Apple/Android duopoly.  On the other hand, RIMM is faced with patent litigation from Nokia and has a very steep hill to climb in Europe and North America to regain market share. 

How will RIMM look like in two years, will it have succeeded in regaining critical mass, I don’t know.  But it has a sporting chance thanks to a meaningful client base (80 million), strong technology and good finances.  Back on 9/28/12 the stock price was $7.50.  Today, even at $14.05, its stock price continues to discount a somber future.

We should remind ourselves that extrapolating in a straight line is always dangerous; that was true when I wrote about these stocks back then and that is true now.  Market valuations are right most of the time, but when consensus reaches 90% or more, it is usually worth our while to investigate.