Friday, November 30, 2012

Are Rating Agencies Pointless?

The ratings agencies have had their reputations damaged in recent years and I confess I have a certain amount of sympathy for them. They get pilloried and lambasted by the finance industry who has found someone to conveniently blame for their idiotic investment decisions during the sub-prime debacle. On the other hand, they get little credit when their work turns out to be accurate.  Every profitable investment decision is, of course, the sole creation of the investment professional looking at it. Let me be clear, I am not saying they didn’t make mistakes, they did, but they are not responsible for pushing buttons at trading desks.

With that said I thought it would be interesting to look back at what stocks Standard & Poor’s had on positive and negative outlook and see how they performed in terms of stock performance. I know they are analyzing the debt situation so they really should be judged on that basis but, like I said, this is a bit of fun.

The Results are in!

I went back to the start of the year to see what S&P had on positive and negative outlook and then tabulated performance. I’ve tried to be fair and pick a random sample of 16 stocks each and matched them up in terms of sector.

Unfortunately the ‘negative outlook’ stocks have outperformed the ‘positive outlook’ stocks although both underperformed the S&P 500 which is up 13.2% in the comparable period. This doesn’t speak volumes for using S&P ratings to pick stocks!. I happen to think that it is a useful analysis because bond outlooks usually reflect the same factors that equities do.

Now before readers start preparing hate letters to Standard & Poor’s, I want to discuss some of the stocks here and give some opinions as to what is going on.

Negative Outlooks

Frankly I can understand the call on R.R. Donnelley (NASDAQ: RRD). The stock's debt dwarfs the market cap and there is little growth in the business whilst plenty of downside risk. Printing always will be a highly cyclical activity. When the going is good the presses are rolling but when it’s bad the printers are lumbered with underutilized capacity. Moreover there is a huge secular challenge for traditional printers as more and more media moves online. It’s hard to see what it can do about it. The yield is huge but will it be paid?

I can understand the negative call on United Technologies (probably due to defense cutbacks) but Abbott Labs is quite puzzling, it’s one of the stronger health care names out there.  Elsewhere, I was surprised to see Walgreen (NYSE: WAG) on negative outlook. Okay nobody liked the Express Scripts deal but its debt is not huge in relation to its cash flow and the business is not going bust anytime soon. Despite believing that it will be tough to get back as many customers as it hopes, I think the stock is cheap and the sector has plenty of upside catalysts.

Positive Outlooks

I don’t get the positive call on Advanced Micro Devices (NYSE: AMD). This is a business with declining earnings and revenues which is a distant second to Intel in many markets. In addition the semiconductor market is cyclical and while most industry commentators were predicting an upturn this year (which didn’t happen) this is not an industry with a huge amount of earnings visibility and AMD is not even a strong player in it.

I like Roper Industries (NYSE: ROP) and think it deserves a positive outlook. The company is acquisitive and in consequence usually has some debt, but it is seeing gross margin expansion in its mix of niche markets. Cash flow generation is very strong and it is a leading player on all of its end markets.  Margins are high and return on equity is usually good so this is not a business that typically has high maintenance capex requirements.

Coca-Cola and United Health Group were good judgments but I think the call on Oracle (NASDAQ: ORCL) was a good one that might not have resonated with many at the time. The company has a significant amount of cash on the balance sheet, but going into the New Year it had given a nasty trading statement and was faced with the obvious need to make acquisitions to buy itself into the cloud space and fight back against SAP. It wasn’t obvious in January that Oracle would have such a good year and S&P deserves some credit.

The Bottom Line

Overall this analysis did not produce a good performance and it suggests that S&P are no better than most at predicting end markets. Don't rely on the ratings agencies to make your investment decisions!

The other point that keeps going through my head is that it is fine to value an asset, but in the end it is the underlying direction in the trend of that asset that truly matters. Investors may think it is all a matter of just buying low valuations and selling high, but actually they need to be aware of the basis on which that valuation lies. For example, Spain and Ireland used to think they had solid debt situations and strong banking sectors thanks to their booming housing markets. Enough said.

Thursday, November 29, 2012

Why the Oil Boom is Over

Long term investors make long term decisions and none should have longer time frames than those in the commodity markets. In this article I want to focus on energy and look at some of the developing trends within the oil market. Essentially, if you are going to buy an oil related company, you are betting on oil prices.

Oil Demand Varies With Pricing

One of the biggest and most pervasive of myths surrounding oil demand is that somehow it is price inelastic. In other words no matter how much the price goes up the demand will remain the same. This idea is simply not true and here is the evidence to prove it.

Note that European oil demand has fallen in recent years and is currently significantly below where it was 17 years ago. The situation is not quite the same in the Americas, but if we break out North America from the number its demand is running pretty close to 2000 levels.

The bulls would have you believe that this is merely a reflection of the ongoing shift in manufacturing production to the Far East, and investors should focus on overall demand. There is some truth in this, but I don’t think it is reflective of the big picture. Nor does it explain the fact that growth has been good in the US and Europe over the last 17 years, and if you add forecast demand in the US and Europe for 2013 it is only 6% above what it was in 1996. This does not suggest that demand is inelastic.

The evidence is that China in particular has seen a rapid escalation in demand in line with its strong economic growth. This fact is even more relevant when we understand how inefficiently China has been using energy.

Here is a graph of the composition of growth in oil demand.

There are some fascinating developments here. First, note how strong Asia/Pacific has been; but as the first chart demonstrated, things are somewhat tailing off. Second, Europe has really managed to reduce oil demand in face of high prices. Third, the Middle East and former Soviet Union have started to be large contributors to demand growth in recent years.

The third point is the key to understanding the dynamics. The growth in demand has been greatest in the regions that subsidize oil prices. Asia/Pacific and the US are also contributors to this trend because, they too, subsidize oil, but few places in the world pay less for gasoline then the Middle East or the former Soviet Union.

The lesson is clear. Demand is not price inelastic, and if you subsidize it more oil will be used.

Road Hogs

There is no more emotive topic in energy usage than that of gasoline. It makes up over 25% of global oil demand and the statistics are simply amazing with regards to who uses what.

You can draw your own conclusions here, but I think the idea that the US necessarily has to use 4.2x as much gasoline as the whole of Western Europe is not a tenable one. As for blaming China gasoline demand for high oil prices, this graph says otherwise.

Where Next With Oil?

I can’t make this anything more than a cursory analysis that tries to highlight the key points.  I haven’t gotten into the supply side or the geopolitics of many of the suppliers (oil is overwhelmingly produced by the Government sector) but increasingly we are seeing developments like shale gas or LNG, which suggests that oil is not that critical an energy demand resource as many previously thought it was. Throw in productivity enhancements (fuel efficient engines, solar powered cars etc.) and demand can be reduced.

If you are going to invest long term in a Chevron (NYSE: CVX) or an Exxon Mobil (NYSE: XOM) you need to appreciate that their evaluations will be based on the long term value in their proven and probable reserves. The price of this depends on the continued willingness of governments to subsidize oil demand (particularly gasoline) and/or to allow for the growth of alternative energy sources. For example the country that is believed to have the largest shale gas reserves in Europe (France) appears to be the most reticent to allow fracking, yet the President claims to be ‘pro-growth.’ Plus ca change?

On the other hand, China is doing anything it can to maintain growth but move away from gasoline usage. This is not great news for a company like Harley Davidson (NYSE: HOG), which would dearly love to make significant inroads into China. Instead I think Harley should look at the second chart and go for growth in the Middle East (the brand is loved there) and other emerging parts of the world.

Just as oil exploration companies would suffer if there were political changes, so would oil services companies. Therefore any investment in oil services company Halliburton (NYSE: HAL) might not quite see as favorable an outcome as when Dick Cheney was in office.  If you are buying an oil services company you are usually making an investment in a company with a high correlation to spot prices.

Where Next Without Oil?

In my opinion, the next decade for oil prices will not be as favorable as the last. Shale gas has changed the way people think and it’s time for the US and others to gradually wean its populace of gasoline subsidies. Moreover, the Chinese look set to become more energy efficient in the future and may well revolutionize the way the world thinks about electric cars powered by LED based systems.

Not only are the Chinese investing in electric cars but also in high speed railways. It is not often that Warren Buffett is cited as a growth visionary but I think he was right to buy Burlington Northern. Obama has been somewhat thwarted in his pursuit of extensive high speed rail lines, but the free market has been voting for rail. For example, FedEx (NYSE: FDX) was very clear recently that its customers are prefer using slower, cheaper (non express) delivery methods at the moment. This inevitably involves using more railways and fewer airplanes. This is not a disaster for FedEx but it will have to reorganize its investment priorities.

Perhaps it’s time for the US consumer to do something similar and start traveling inter-city by train rather than by car or plane? That is one way to reduce gasoline demand.