For whom does the (Chilean) bell toll?

There are few more emblematic legal constructs in emerging market finance than the Chilean DL600.  What Michael Phelps is to swimming, the Decree Law 600 is to foreign direct investments: both defined an era and both set very high bars for their successors.

It is thus very significant that former president Michelle Bachelet, now the leading candidate to return to that office, proposed to eliminate the DL600.  Apparently, this would be part of a set of new policies, such as raising corporate income taxes, to generate more public revenues to finance greater social expenditures.

I have observed for a few years now that a sort of frugality fatigue is setting in Chile.  Chile was the first, and for decades, the only Latin American country to embrace an economic model based on budgetary equilibrium, personal financial responsibility and free enterprise.  The first signs lassitude started to appear after twenty years of effort.

One important area of friction has been the private pension system.  Another more recent has been education.  In my view, a major factor in the sentiment shift has been the change in regional politics.  Center-left moderates such as F. H. Cardoso in Brazil (1995-2003) and R. Lagos in Chile (2000-2006) and center-right A. Uribe in Colombia (2002-2010) have been replaced by N. and C. Kirchner in Argentina (2003- present), H. Chavez and N. Maduro in Venezuela (1999- present); these new populist regimes have actively promoted government interventionism, budgetary laxity and public sector expansion.  Even Brazil, under presidents Lula (2003-2011) and Rousseff  (2004-present), has returned to greater government activism in economic affairs.  Virtue is difficult enough to preserve, but all the more so when temptation is all around.

The DL600 was promulgated in 1974 by the military junta (probably another feature which doesn’t endear it to President Bachelet) and has been a landmark piece of legislation. Besides its symbolic importance which cannot be underestimated, its success stems from its unique features:

·        Foreign investments instrumented via DL600 are approved via a contract between the investor and the State.  The strength of a contract is that its terms cannot be amended except by mutual consent of the parties.  No such protection exist under general legislation;

·        The DL600 guarantees a fixed corporate income tax rate of 42%[1] for a period of 10 years, extendable for a total of 20 years; it also fixes the mining royalty tax for 10 years;

·        Other guarantees include non-discrimination vis-à-vis local companies, access to foreign exchange and freedom to remit dividends and capital (after one year), freezing of the accounting for such items as depreciation and accumulated losses.

In a country where mining is the single biggest economic activity (and thus where capital investments are both very large and long-term), the assurance that the conditions under which one invests will not change is very valuable.  The success of DL600 can be measured by three numbers: $51 billion of foreign direct investments in 10 years in a country with a GDP of $164 billion[2].

It is debatable whether Chile would get tangible financial benefits from abolishing DL600.  If anything, it would signal that a Bachelet-led government would want to preserve the right to change FDI taxation, a rather worrying sign.  It would also reduce some of the competitive edge that Chile has had compared to such rivals as Peru.  Finally, it would send a not so subtle signal that budgetary discipline would be under greater threat since the government would open the way to higher taxation.

Perhaps it takes a foreign perspective to fully appreciate the value of the DL600.  From mine, I found that while other countries often presented more favorable terms for FDI, Chile generally won thanks to the stability of its institutional framework.  DL600, if abrogated, will be missed.

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[1]  This compares with an effective tax rate of 35% assuming (1) all net profits are paid out in the form of dividends and (2) the foreign investor chooses not to avail himself of the terms of the Decree Law 600.

[2]  It is important to remember that by far the biggest mining entity in Chile is state-owned CODELCO whose investments are thus considered local and outside the DL600.

 

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.

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.