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.

 

Argentine inflections

Anticipating inflection points is the Holy Grail of investing: we all know that past trends, up or down, will not continue indefinitely; at some point, the curve will bend and change direction.  But when? 

When will the fundamentals of a company start to show an improvement after sustained restructuring efforts by its management?  When will financial markets start assigning to a company a stock price that is closer to its intrinsic value?  And more challenging still, when will a country abandon failed policies to save itself from chaos?

Argentina is the perfect – some may say terrible – example of a country that has followed bad economic policies for much longer than deemed possible.  Indeed, how bad these policies have been remains unrecognized abroad: not so long ago, I recall some reputed economists stating that the 2005 Argentine debt renegotiation was a model for Greece, that the Argentine economy was growing at a healthy clip.

That is nonsense, but the question remains as to why Argentina seems to defy gravity, and why it has done it for so long?  Two reasons may be given.

One is that Argentina’s growth is illusory.  Measured in US dollars, it is greatly exaggerated because of an “obese” official peso/dollar rate which stands today at 4.78.  This is to be compared with the implicit rate of around 7 when one compares the stock prices of Argentine companies on the local and New York exchanges.  In other words, the peso is overvalued by some 45%; this led the Colombian minister of finance to brag that, measured at true exchange rates, his country’s GDP had overtaken Argentina’s.

The other is that the Argentine government has picked the pockets of everyone in sight:  foreign creditors were squeezed in 2005 in a restructuring in which they lost 75% of their money; private pension funds were nationalized and their resources used to finance the public deficit; energy prices were frozen to subsidize consumer spending; official inflation calculations were fudged, defrauding everybody (and independent economists were heavily fined when their findings departed from the official ones[1]); more recently, insurance companies were forced to finance government-designated projects, foreign exchange controls were implemented to try and stop capital flight and the largest oil and gas company, YPF, was expropriated and no compensation has been paid to date.

As Mexican president Calderon said shortly after the YPF grab, anybody thinking of investing in Argentina should have his head examined. 

Despite grabbing other people’s money, Argentina is paying a very steep price for its policies. 

The refusal by Argentina to pay holders of non-restructured sovereign bonds has kept it from international financial markets since 2001.  After announcing an ambitious investment program, YPF, unable to tap these markets for billion dollar issues can only raise $100 million at a time locally; it is also unable to attract international partners to develop the vast Vaca Muerta shale oil deposits[2] because of the uneconomic pricing of hydrocarbons and pending lawsuits from Repsol[3]; electric utilities are on the verge of bankruptcy; and the ubiquitous intervention of the government in the economy has led to widespread corruption.

Starved for money and growth, Argentine companies carry low valuations.  That, plus the limited remaining number of pockets to be picked has led sophisticated investors to bet on a policy inflection point.  Eton Park, one of the most prominent US hedge funds, built a substantial stake in YPF between September 2010 and March 2012.  I estimate their average purchase price at around $40[4].  The stock closed today at $10.46.  When rumors of expropriation started to surface last April, I was tempted to buy the stock as I thought the government wouldn’t have the money to take the company over.  I just couldn’t imagine that they would just grab it, but they did.

Yet I think that we are getting close enough to an inflection point to dip a toe in Argentina.  I see three reasons for that. 

One is that having taken control of YPF, officially because its former controlling owner (Repsol) didn’t invest enough, the government now “is it”.  In other words, it must show it can succeed where others failed; it needs to attract deep-pocketed oil and gas multinationals as partners, but for that it must (1) improve hydrocarbon pricing, (2) settle with Repsol and (3) regain access to international debt markets.  This looks to me like a chicken-and-egg situation as to what comes first, a major oil joint-venture or the above three-point policy change.  Meanwhile, the clock is ticking because Argentina, once an energy exporter, is now an importer.

Second, the 2005 restructuring saga is turning sour.  Having the Navy frigate Libertad seized in a Ghanaian port is acutely embarrassing for the Argentine government and begs the question: what next? If Ghana is not safe, what more restrictive measures will the government have to apply to its movable assets?  Furthermore, the recent decision by a US judge that Argentina must pay interest on all of its external debt, including that portion which was not restructured, raises the pressure as it carries the threat of escalation in case of non-compliance.  Granted, Argentina has so far been able to delay the execution of court decisions, but it can’t expect to do so forever.  Justice may be slow but it is not dumb.

Finally and perhaps more importantly, the Argentine people are showing growing signs of opposition to the government policies.  The harsh measures taken to effectively prevent them from buying US dollars have been received , and this is understandable in a cvery badlyountry where there is little faith in the willingness of the government to pay its debts, and where real inflation is on the order of 25% p.a.  High profile corruption cases, where government members appear to have enriched themselves illegally, are especially grating when popular unemployment is high.

A large currency depreciation may be the next step, rather than better economic policies.  However this would only diminish people’s savings and living standard, which would hardly be helpful in president Kirchner’s bid to amend the Constitution in order to run for a third term.

As the above diagnosis may still be a bit optimistic - after all, Peronism in its current incarnation still has many followers - one has to look at valuation and to what extent it mitigates the risks to be undertaken.

In the case of YPF, the main risk is really that of full nationalization, a close second being delisting from the NYSE (since one buys the ADR at a 45% discount to the local share price).  Looking at its ADR stock price, YPF looks pretty cheap compared to its government-controlled peers:  Ecopetrol (Colombia) and Petrobras (Brazil):

 

	Ecopetrol	Petrobras	YPF
Market value (bn)	$115.3	$131.1	$4.1
Proven reserves (bn barrels)	1.9	12.9	1.0
Daily production (‘000 of  boe)	719	2,463	467
EV/boe of proven reserves[5]	$61.6	$15.28	$6.36
EV/boe of daily production	$162,880	$80,007	$13,615

 Of course, the above calculations are very rough and do not take into account non-upstream assets such as refineries, pipelines and other long term investments.  But they are informative nevertheless.  For example, while Ecopetrol and Petrobras have similar market values, the former has zero net debt while the latter is burdened by excessive debts.  Still, YPF looks quite cheap.

 YPF faces two specific challenges: as an oil champion under government control, it is in the quasi permanent threat of having its management and strategies politicized; it also faces a very onerous investment program.  Another, less politically risky way of playing the “Argentine inflection point”, is Telecom Argentina (TEO).

The controlling shareholder is a holding that includes Telecom Italia and the well regarded Wertheim group from Argentina.  TEO is well managed and has strong financials.  It is the second largest telecom company in Argentina after Claro (controlled by Carlos Slim’s America Movil).  Its investment needs are more modest than YPF’s on a relative basis. It has a lower profile than YPF.  Finally, its ADRs enjoy a similar discount to local shares.  On a per mobile subscriber basis, it is worth less than one tenth of America Movil.

As history shows, populist governments rarely act in an economically rational way; when they control rich countries, and when they resort to reprehensible policies, they can endure far longer than orthodox thinkers imagine.  But even they cannot repel the laws of gravity forever.  They usually don’t see the light or change their ways; their rule generally ends when they can no longer afford handouts and resort to heavy handed policies to stay in power.

I have started to build small positions in YPF and Telecom Argentina.

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[1]   It is ironic that one of them was the former minister of finance who had presided over the heavy-handed foreign debt renegotiation.

[2]   Which YPF estimates to hold 23 billion barrels of oil resources.

[3]   The Spanish company whose controlling shareholding of YPF was seized by the Argentine government this year.

[4]   Based on the average prices during the periods in which Eton Park reported building its stake.

[5]  EV: Enterprise value, i.e. market capitalization – cash and equivalents + debts.  For YPF we have used the official exchange rate to convert debt amounts to US dollars since most of these are dollar denominated to begin with.

 

 

 

YPF

The recent announcement by the Argentine government that it would seize control of both YPF and YPF Gas came as a surprise to many.  Rumors that the move was imminent had been discounted as out of sync with an increasingly progressive Latin America and globalized economic relations.

Yet it did occur, and it was preceded by a seemingly concerted action on the part of some provinces to cancel YPF’s concessions.  As of yet, there is no detail as to how such government control will be instrumented nor how much YPF intends to pay for it. 

Readers may remember that when Bolivia expropriated foreign oil and gas companies, it paid nothing for the assets it took; the expropriation decree specifically stated that only the foreign oil companies that accepted the government action and agreed to stay on and cooperate would receive some share of future revenues to be negotiated.

In retrospect, the Argentine government action was not totally surprising.  After all, in 2005, Argentina basically reneged on its external debt by imposing a 75% haircut.  It also took over some $25 billion of domestic private pension funds and recently appropriated the foreign exchange reserves held by the Central Bank.  Nationalization is within a country’s rights (whether it is a good choice or not) provided that proper compensation is paid.  I do not know what the government will decide in this respect, but if it depends on international pressure, it may be little.

Indeed, the reactions from fellow Latin countries have been mixed and in some regards, surprising.  Quite naturally, “fellow travelers” such as Bolivia and Venezuela applauded the move; the Uruguayan president was on the whole sympathetic without endorsing the decision; his Chilean homologue was non-committal (which is surprising since Chile suffered from the Argentina decision, a few years ago, to renege on its obligations to supply it with natural gas).  Perhaps more unexpected was the reaction from the Mexican president who declared that, after such a move, any foreign investor contemplating putting money in Argentina would need to have his head examined.  Just as startling was the comment by Haroldo Lima, Head of ANP (the Brazilian National Petroleum Agency) that the move was excellent news for Latin America.

What to make of all this?  One conclusion is that bad habits die hard.  This is clearly the case with Argentina, and oil continues to provoke irrational reactions in many quarters.  Another, more controversial perhaps, is that with some notable exceptions, Latin America’s seeming economic miracle has had more to do with huge demand for its raw materials than with profound and durable internal reforms.  I am thinking about Brazil in particular where President Cardoso’s reforms have not been pursued and, in several instances, have been partially reversed.

Chile continues to have the most transparent economy and rule-book, but after some 30 years, it shows some signs of free market fatigue that bear watching.  Peru has achieved the fastest and most consistent growth in large part thanks to its mining industry; but it has also diversified and President Humala has so far surprised the skeptics, me included.

The two most interesting success stories are Mexico and Colombia. 

Having boosted its economy thanks to maquiladoras on the border with the US in the 1980s, Mexico’s industry then suffered from the competition from China.  But the trend has reversed in recent years as the US and Mexican economies integrated ever more.  Indeed, as Argentina nationalized YPF, Mexico may be about to open Pemex to minority investors.

Colombia’s recovery started when President Uribe regained control over the security of the country.  It was then sustained by a large domestic market, the country’s position between North and South America and by intelligent development and monetary policies. 

In a sense, I think that Colombia, barring unforeseen setbacks, is in the third inning of a virtuous economic and political cycle while Chile is late in the sixth.  I am not sure where I would put Brazil (fourth, eighth?) and Peru (second, seventh?).  Mexico is probably in the fifth.

In sum, political and cultural factors continue to be greatly underweighted in assessing sovereign risk and this YPF episode is a vivid example of that.  But the YPF crisis also helps highlight some countries which have been misjudged in my view.