What do we do now?

This is the question that many individual and institutional investors are asking themselves nowadays. 

Bulls say that stock markets are reasonably valued by historical standards and, in any case, offer the hope of long term gains while bonds are in nosebleed territory and ready for a fall. 

Brown bears point out that central banks have distorted all asset valuations by pushing the cost of money to near zero, and that when normality returns, stocks will slip; black bears say that public finances are so weak and private businesses so frightened that economic growth is unlikely to exceed its current lethargic pace and therefore that bond yields can stay at their depressed levels for years to come.

A few charts will put the above arguments into some perspective.  Below is a chart of the S&P500 from 1982 to the present.  The red line is a linear regression of the value series while the green lines represent one and two standard deviations above and below the long term trend.

Looking at the chart, the current S&P500 isn’t cheap, but it remains within normal volatility boundaries. 

Still, even allowing for the “compression” effect due to the fact that early S&P500 values were below 400 while later ones topped 1,500, it is apparent that volatility has increased in recent years:  the biggest drop in the 1980s was 33% in 1987, followed by a 19% correction in 1990.

By contrast, we had a 42% drop in 2000-2002 and a 46% drop in 2008-2009.  As years pass by, the falls and the rebounds get steeper. 

A preliminary conclusion is that, even if stock markets are not overvalued, they are more volatile; if long term investors want to remain long, they should be ready for unsettling times.  In other words, they should carry ZERO margin loans.

The next two charts add more context to the stock markets’ past performance.  The top one graphs the yield on 10 year treasuries (GT10 Govt) and the US consumer price index (CPI) over the last 50 years.  The bottom one graphs the real yield on 10 year treasuries after deducting inflation (i.e., GT10 Govt minus CPI).

A few observations: (1) nominal and real yields as well as inflation have tapered since 1980; (2) current real and nominal yields are as low as they have ever been (except for the mid and late 70s when real yields were sharply negative as a result of an oil-driven spike in inflation); (3) nominal treasury yields have fallen faster than inflation in the last 30 years.

Unless one anticipates a Japanese-like deflation in the US, which is unlikely to happen, bond yields can’t go further down and indeed are bound to go up quite a bit.  Should they get back to the average of the past 10 years, holders of 10 year treasuries would lose 12% of their principal; their loss would deepen to 23% if yields reverted to their 1990-2013 average.

Nowhere is the risk greater than in emerging markets sovereign debt.  Yes, we have heard that Brazil, Russia and the like have better public finances, less debt relative to their GDP, etc.  But they remain economies with much promise but less robust financial, political and judicial institutions, too much poverty and immense investment needs.  Booming demand for commodities has abated lately, a clear negative for most of them.  And sometimes, these bright promises dim as fast as they arose in the first place:  the structural reforms of President F. H. Cardoso were followed by a return to government meddling and a series of scandals under President Lula, and while President Rousseff has taken a firm stand on corruption, the general economic policy remains the same.  In the span of fifteen years, Venezuela has turned from a middle of the pack emerging economy to a basket case which could explode at any moment.  Even China, which had clocked (published) economic growth rates in the 9%-10% range is now slowing down and trying to engineer a very difficult policy change.

And where do 10 year sovereign EM debt trade at?  Brazil trades at under 3.4% p.a., Colombia at 3.6% p.a., Russia at 3.2% p.a., Indonesia at 3.7% p.a., the Philippines at 3.3% p.a[1].  These rock bottom yields reflect two factors: investors/traders racing for yield (after all, these EM bonds return 60% to 80% more than US treasuries!), and their conviction that they can sell faster than the other guy when markets sell off.  Volatile stuff!

So what do we do?  Cash or stocks?  I would say some of both.  Asia may well be the future economic center of gravity of the world, but for the time being the US are.  The US also enjoy the richest domestic market (a definite advantage when the world economy stumbles along), a vast reserve of energy, and, yes, a culture and structure conducive to innovation and entrepreneurship.  Europe offers some interesting valuations, particularly in those top companies that enjoy a strong domestic base and are globally competitive.  Finally, there is Latin America, or at least parts of it…    

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[1]  All denominated in US dollars.

Apple, quick take on the latest quarterly results

Apple just published its financial results for the quarter ending March 31^st , 2013.  As expected, the gross margin has shrunk to a more reasonable 37.5% and the company expects that, in the short term, it may drop further to 36%-37%.  Net cash and equivalents stood at close to $145 billion, or almost $153/share on a fully diluted basis.

New products have been announced for the end of this year and for next.  Despite its lack of cheap iPhones and not having signed up China Mobile, Apple did rather well in China.

Significantly, its CEO Tim Cook acknowledged that the days of rocket-like growth were over but not those of product innovation.  In this context, he announced a 15% dividend increase and a more than doubling of the share repurchase program through 2015, from $45 billion to $100 billion.  Given that only $10 billion of the initial approval have been used to date, it is clear to us that the company is about to deploy a lot of fire power.

Where do we stand?  We continue to believe that the stock is undervalued, selling at a p/e of 6 times estimated 2013 earnings ($44.5/sh), adjusting for net cash holdings.  Pending the launch of new products, the price target of $600/share that we suggested last March seems realistic.  It reflects a p/e multiple of 10 times 2013 earnings and $153 in net cash.
 

Apple’s current p/e multiple of 6 compares very favorably with the Dow Jones’ and IBM’s[1] which sell at over 14 times.  While Samsung Electronics also sports a low p/e multiple of about 6.5, its free cash flows are much lower, be they measured against revenues or net profits[2].  As to gross margins, Samsung’s is below 30%, again, significantly below Apple’s.

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[1]   Adjusted for net debt.

[2]   Measuring 2012 free cash flows to net profits for the same periods and enterprise value (market capitalization + debt – cash and equivalents).

El almirante Padilla meets Captain Bligh

“Now don’t mistake me.  I'm not advising cruelty or brutality with no purpose.  My point is that cruelty with purpose is no cruelty – it’s efficiency.  Then a man will never disobey once he’s watched his mate’s backbone laid bare”. (Mutiny on the Bounty, 1962)

Until last week, Cyprus’travails looked like those of El Tite Socarras, who had been put out of the smuggling business by an overactive Colombian Navy.  By Sunday, Captain Bligh of the Royal Navy came to mind.

The weekend negotiations with the European authorities and the IMF were bruising for Cyprus, and its economic future is uncertain.  That goes for the eurozone too. 

On the positive side, the debt restructuring focused on the banks in trouble, mainly Laiki, and reverted to financial orthodoxy: insured deposits would be protected, recapitalization (of Bank of Cyprus) would involve a debt-to-equity process where losses would be assumed by shareholders, bondholders and uninsured depositors, in that order.  Laiki would be split into a good bank and a bad bank, with the former being merged into Bank of Cyprus.

Less positive was the assumption of the ECB funding of Laiki by BOC and the lack of estimates as to the extent of the losses uninsured depositors would suffer in both banks.  Laiki’s will likely lose most of their money while BOC’s may lose anywhere between 20% and 50%.

Very negative was the evisceration of the Cypriot economy.  Post crisis, its main industry, offshore banking and financial services, has been destroyed.  And it is pretty clear that this was done on purpose.  Yes, the Cypriot banking sector was hypertrophied, but isn’t Luxembourg in the same situation?  Or Switzerland?  And while it was prudent to reduce its size, did this have to be achieved overnight?

While it was legal to force uninsured depositors to take losses after junior creditors and shareholders have been wiped out, in the case of Cyprus it smacked of retribution, and of example setting Captain Bligh-style.  After all, while the Cyprus restructuring rolled on, Spain announced that the recapitalization of Bankia - which called for wiping out common shareholders, haircuts of  43% for holders of preferred shares and of 15%-40% for subordinated bondholders - would leave all depositors unscathed.

Indeed, the public flogging of Cyprus at the mast was so harsh that no country which might fear a similar fate in the future raised its voice in defense of the island.  The eurozone lives for another day, but the atmosphere on board ship is now more Bounty than Club Med.

Understandably, no country wants to quit the euro now for fear of suffering a rapid financial meltdown.  But what is the price for continued membership? 

The elaborate Euro charter, institutional design and numerous Brussels staff have been superseded by German directives; that is understandable since Germany is asked to bankroll everybody else, but is that really the European project that members had in mind?  For that matter, did Germany expect to be besieged with demands for money by its fellow Europeans when it co-founded the eurozone?

With no way to devalue their currencies, Eurozone members experiencing financial difficulties are forced to rely solely on cost cuts, which are politically difficult to enact and socially destabilizing.  A more palatable solution would be a reliance on some currency devaluation, some inflation and some fiscal/cost adjustment.  This has been the way most countries, from the Latin Americans in the 1980s to Russia in the 1990s, overcame their crises.

Mired in economic stagnation and hampered by a banking system which remains undercapitalized, Europe is gradually tackling its debt problems but is doing so on an ad hoc basis and in an increasingly destabilizing way: massive financial resources of the Union are being used up, and distressed countries are required to make adjustments which are deeper and faster than would otherwise be advisable.

Finally, it remains to be seen if smaller countries can attain and maintain the same degree of productivity as the best in class while abiding by the same EU rules: could Singapore be what it is if it were a eurozone and EU member?

For the time being, Cyprus is in the eurozone, but I wonder: longer term, wouldn’t it be better off leaving it, reverting to the lira and setting up an off-shore dollar banking zone?

El almirante Padilla, euro version

There are few musical genres that are more enchanting than the vallenatos, particularly those composed by Rafael Escalona and interpreted by Carlos Vives.  Escalona’s songs deal with everyday life in the Carribean coastal region of Colombia which stretches from Cartagena to the Guajira peninsula.  One of my favorites is El Almirante Padilla in which Escalona laments the prospects of Tite Socarras, whose contraband business has been ruined by the intervention of the Colombian Navy and who may now be forced into a new, conventional, and dull professional life.
 

Y ahora padonde irá, y ahora padonde irá?
A ganarse la vida el Tite Socarras
Y ahora padonde irá, y ahora padonde irá?
A ganarse la vida sin contrabandear
 

Change came just as suddenly to Cyprus, long accustomed to serving as a regional hub for shipping, trading and financial services.  Cyprus, planted in the middle of the Eastern Mediterranean sea, governed over centuries by various invaders, had lately morphed into the most important offshore center for Russian investments.  An EU member, it was a more reputable tax haven for corporations than more exotic venues.  It also offered a low tax refuge for thousand of European individuals, particularly British retirees.
 

In sum, its business model grated on big European authorities as much as Socarras’ contraband grated on regional authorities, and while Brussels didn’t send a frigate to deal with the irritant, the end result was the same.
 

Pobre Tite, pobre Tite...
La armada le salió lista
Hombe! que ahora esta muy triste
Lo ha perdido todo por contrabandista
 

But high living Cyprus was not in default – although it had lost access to international debt markets – and while some of its banks were essentially bust, the majority wasn’t.  Ironically, its demise was caused not by real estate speculation or other home-made disaster, but by its banks’ excessive exposure to Greece.
 

Under such circumstances, for Brussels to force its government – and for the latter to agree - to freeze bank deposits and confiscate part of them, including those that were supposedly government guaranteed is incomprehensible; not to work on a plan with Russia which is the biggest contributor to the economy of Cyprus and has the most to lose is mystifying; to force on depositors a levy equivalent to 30% of Cyprus GDP is very difficult to justify; that the Cyprus government opted to target depositors rather than bank creditors and shareholders is mind-boggling.
 

It is clear to me that the EU wanted to do away with Cyprus as a tax haven; it is extraordinary that the government of Cyprus didn’t think it was committing economic and financial suicide.  But if Cyprus’ business is ruined, its tormentors’ is also severely damaged. 
 

Yes, the economy of Cyprus is unbalanced, with a financial sector many times the size of the GDP; but is it very different from that of Hong Kong, or for that matter that of Luxembourg? 
 

Yes, when people take business risks they should be ready to pay for their mistakes; but should they now expect the EU to arbitrarily change fundamental financial rules in areas such as: government deposit insurance, the order in which losses are allocated to creditors, applying quasi bankruptcy rules in the absence of same?
 

Yes, membership to an economic and financial union carries with it obligations, but should member countries and private economic agents expect a degree of assistance and solidarity in times of crisis or that stronger members will muscle in to extract deep competitive benefits as the price for a modicum of help?
 

Don’t get me wrong, Cyprus and its banks got themselves into trouble, but they were no more guilty than Ireland, Spain, Portugal, Italy and, perhaps, France tomorrow.  Unlike others, they were too small to resist the pressure (the only exception being Ireland on the topic of corporate income tax).  
 

The latest Cyprus crisis is a reminder that the eurozone problems are a long way from being solved.  It also shows that the future of the eurozone, in its current composition, is very bleak: there is too much disparity in economic size and strength, which makes policy harmonization quasi impossible; cultural differences are too wide; finally, the eurozone is the ultimate Rorschach test: some see in it the solution to political weaknesses, others see in it an economic multiplier, a few seek enhanced geopolitical security.  In the end, whatever they want from it, no member is willing to surrender economic and financial sovereignty to a common center.
 

The eurozone may well survive this latest challenge, but in no way should investors assume that this union is comforted.  Rather, I expect each member country to more closely look after its on interests - minimizing the allocation of resources to common strategies in order to safeguard its own future – and to look for potential fellow travelers so as to enhance its security and negotiating position in case of future troubles.
 

Unos pierden porque juegan
Escalona enamorando
Pero el Tite, pobrecito
Lo ha perdido todo por el contrabando.

 

Another bite at Apple

Over the last few weeks, Apple has experienced a singular fall from grace: its stock price has got hammered as overly enthusiastic investors and speculators dumped its shares; its gross margins have become the root of all doubts; analysts have lowered their price targets; finally, famed hedge fund manager David Einhorn sued to block it from bundling several General Assembly resolutions and has publicly advocated the issuance of preferred shares as a means to unlock the value of its cash hoard. 

Is the stock now undervalued?  Is the focus on the excess cash warranted?  What is the future like for Apple?  I would respond by yes, yes and not too bad.

Once a startup which almost went belly up, Apple rose from the ashes to become THE dominant consumer tech company and attract cult-like following.  Its cash hoard is both a result of its success and culture and a portend of its future.  In that regard, it is important.

The culture at Apple is one of innovation and excellence.  Can it preserve both and thrive?  There are encouraging signs.  In a recent industry event, its CEO Tim Cook stressed that the company was built on innovation, that its pipeline was full and that Apple would resist the urge to build market share by lowering prices; as an example, he reminded us that the answer to a less expensive iMac was the iPad, not an iMac lite. Yet only extraordinary new products will move the needle of a $400 billion company.  He also dismissed Einhorn’s effort as a “distraction”, not the best of answers.

The fact is that Apple has unique strengths: huge user base, integrated device and service offering (iTunes/Aperture/iPod/iPad/iMac), great innovation, great design, and of course fabulous financials).  Yet I doubt that it can keep true to itself if it keeps growing.  A great part of its success is that it designs and builds better mouse traps than the competition.  But if it is 70% of the market, comparisons with the competition become irrelevant.  It also becomes more difficult to charge premium prices.  Finally, the laws of large numbers make it increasingly difficult to come up with innovative products that will move the needle, profit-wise.

One strategy would be to keep up growing by branching out in related or contiguous sectors, without cheapening the offerings.  There are precedents; think of LVMH, the large luxury company which runs the gamut from champagne, haute couture, perfumes to high-end accessories.  Yet there are important differences; while fashion is akin to technology in that it must come up with new models at least once a year, LVMH products are all brand names that guarantee a certain market permanence as long as high quality is maintained.  Another is culture:  LVMH has always been a conglomerate while Apple’s success stems in large part from its unique culture which in turns makes large or numerous acquisitions difficult.

Because it is unlikely to become a serial acquirer, Apple has no need to keep its mountain of cash.  But there is another, more important reason, why it should distribute it to its shareholders; it needs to avoid the complacency that sunk the likes of Sony.  Without flirting with danger, Apple must be a company (especially in the technology sector) where all the staff realize that the good life is not assured unless they keep coming up with winners, and that, in the words of Andy Grove, “only the paranoids survive”.  The simplest way to deal with the excess cash is to buy back the stock.

Is Apple undervalued?  I think it is.  If it slowly shrinks its cash pile and tries to keep growing by expanding its global market share by offering less expensive products, I think it is a short to medium-term trade, with an exit price in the low $600.  If it takes a more aggressive path by buying back its stock at a faster pace and if it signals that it will accept shrinking as the price of remaining focused on bringing to market a few products of superlative innovation and design, then I would think that Apple is at least a medium to long-term trade with a much higher price target.

 

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?

Third visit to Apple

Back in September 14, 2012, we argued that Apple was not such an attractive investment because its high stock price was the product of very high gross margins.  We doubted that the company could keep its expansion pace by targeting emerging markets which, while offering much promise, could likely not afford the same high device prices practiced in the US and other mature economies.  We estimated that, should these margins shrink, the implied stock valuation would look rather high: 18.2 times net profits, after subtracting the cash and investments from the market capitalization.

Where are we now?  Since then, most analysts and commentators have discovered the importance of gross margins and Apple has released quarterly financials showing its margins are under pressure.  The growth pace of unit sales has decreased and instead of blowing estimates, the company is missing some or just beating others.  In short, Apple appears to have become a “normal” company, no longer managed by its mythical founder, albeit one with annual sales on the order of $180 billion, and cash and liquid investments of $137 billion.

The question is this: while it looked (to me at least) richly value at $692 per share, what to make of its current price of $450?

If I take key analysts’ estimates for 2013 as a starting base but lower the gross margin from 40% to 30%, I get a net profit of $30/share and a free cash flow (cash flow after capex) of $36/share.  At the current share price, Apple sells at a p/e of 15 times 2013 net profits.  However, given the huge liquidity held by the company, it seems more meaningful to calculate a p/e multiple after subtracting cash and near cash from the company market value (we must also adjust downward the 2013 year-end liquidity for the lower projected income resulting from the lower gross margin).   This adjusted p/e comes to 9.7 times.

We ran another parallel calculation based on free cash flow.  We got a multiple of 12.6 times market value and 8.1 times market value adjusted for net cash.

From market darling, Apple has become market black sheep.  As it was overly own, it is reasonable to expect continued selling until investors feel, if not comfortable, at least ‘safe”.  In other words, the pendulum of emotions which swung wide one way is likely to swing wide the other.  We could get to $400; some now predict a price in the $300 range.  Who knows.

It is true that keeping up innovating and dazzling customers is very difficult.  One can think of the fashion industry which must come up with four new looks every year.  Except that Apple has over 500 million customers, offers both hardware and software products, most of which can be described as aspirational, and has all the cash it needs to carry out almost any strategy.  Finally, one common feature of great companies is great culture.  In this regard, it seems to me that Apple started well but recently stumbled, taking shareholders for granted and displaying some grating hubris.

Pulling it all together, my view is that, even after reducing expected gross margins to more sustainable levels, a free cash flow yield of 12.3% (the inverse of 8.1) is an interesting investment proposition, even if the stock price falls further.  I bought some shares today.