Wednesday, June 26, 2013

It's Time to Worry About China

There are two ways of looking at developments on the macro-economic front.

The first is to take a top down approach and analyze as much economic data as you can get your hands on. The second is to build up a macro view by aggregating knowledge from looking at a large number of micro sources such as company earnings.

In this article I want to do the latter and look at what a few companies have been saying about current conditions in China. The issue is highly significant because the global economy is reliant on China to generate growth this year.

Government changing or is it a deeper issue?

The key question about current conditions in China is whether the slowdown is a temporary one brought about by the change in Government (as businesses/consumers wait to see the policy changes) or whether it is a deeper problem relating to structural problems in the economy. It is true that the Government has the resources to ‘buy’ its way to GDP growth closer to 8% but will it do so? Moreover will it chase 7.5%-8% growth even if it involves pumping investment into corrupt or non-competitive channels? Even at the expense of inflating a bubble in housing?

The big fear with China’s real estate market is that it is being inflated by liquidity being pumped into the economy (partly from its foreign currency reserves) which has few other mature investment vehicles with which to attract investors. This puts the government in a difficult situation. Should it buy growth at the expense of inflating a property bubble or stand and watch as the economy possibly gets weaker?

What the companies are saying

The most interesting thing about Oracle’s (NASDAQ: ORCL) recent results was the diversity in its geographic results. Its Americas results were pretty much in line with expectations while EMEA was actually slightly above its expectations'. Oracle came in with new license growth at 4% and 5% respectively in these regions.

The big surprise geographically speaking was that the Asia region was down 7% in terms of new licenses. China was cited as being weaker and, interestingly, Australia was particularly weak too. Moreover Brazil was stated as having pulled down growth in the Americas. These two countries are significant because they are commodity-heavy economies which rely on exports to China in order to grow. Since Oracle spoke to continuing ‘to see pressure in China’, I think it is more than a short term issue. The good news from Oracle's perspective is that China is not a huge part of its current sales.

Turning away from technology, I thought industrial filtration company Pall Corp (NYSE: PLL) had some interesting things to say in its recent results. I have looked at them in more depth here. Again, its big weakness in the quarter was from-you guessed it-China. It described many of the markets that it had historically sold into as being ‘down year-over-year’. Indeed its Asian sales were down 11% with China being particularly weak.

Pall’s challenges relate perfectly to the changing nature of growth in the regime. The Chinese stimulus packages will not be about pumping money into heavy industrial and infrastructural projects designed to develop its export laden manufacturing facilities and more about stimulating internal demand. Ultimately this means disruption to companies like Pall who got used to selling to the exporters.

On a broader perspective I think FedEx Corp (NYSE: FDX) gave some fascinating color on the changes in the global economy. Just a few years ago it used to generate the bulk of its profits from its express services but now the big income generator is its ground services.

Going back to 2997, its express services generated nearly 61% of operating income but that fell to around 22% in the last year. Meanwhile its ground services contributed 25% of income in 2007 but it has now risen to 70% now. This perfectly represents the changes in the global economy whereby slow growth has led customers to shift to lower priced (and slower) ground services in the face of a world with $100 oil prices.

In addition, management never fails to point out that global trade growth has been lower than global growth over the last few years. This reflects the structural changes in consumer demand from the Western consumer world which ultimately will lead to slower export growth in China.

Such issues have created operational issues at FedEx as it was geared up for international growth in its international express services. It was a growth that never came and over the last couple of years it has been restructuring and taking impairment charges as it retires unnecessary aircraft and routes. Indeed its big upside opportunity is to generate cost savings in express going forward.

The bottom line

Putting these results and commentary together paints a picture of some short term weakness plus some structural issues in China. Investing in the types of heavy industrial plays on China that worked so well in the past isn’t going to be the best option anymore and there are question marks over the viability of China’s plans to shift to a more consumer orientated economy.

It’s time to be a little cautious over China.

Tuesday, June 25, 2013

To QE or not to QE

tread carefully in writing this article because whenever anyone discusses the pseudo-religious issue of investing fundamentals and/or why markets move, he is usually met with a gale of fundamentalist abuse. In this case I’m talking about the recent falls in various asset classes, which were caused by Ben Bernanke’s recent statement . I want to look at why the market reacted the way that it did. What does this say about how readers might evaluate investing? In which stocks can we see the repercussions of these changes?

To QE or not to QE, that is the question

In short, the Federal Reserve is expected to reduce bond buying this year because the economy is in better shape. It also expects to end it in 2014, but these expectations are entirely contingent upon the economy getting better. Furthermore Bernanke stressed that he was willing to add whatever support was necessary if the economy didn’t improve. The optimistic among us would conclude that this is actually good news because it confirms that the Federal Reserve believes the economy is getting better. So why did the market sell off so aggressively?

I think the answer is that a new generation of investors is now conditioned to think that asset classes move in tandem with liquidity provision by central banks. ‘Oh look the Federal Reserve is doing more quantitative easing! buy, buy, buy!’ or ‘the latest PMI numbers were crumby but hang on, that means the Federal Reserve will be forced to do more QE!! Buy!’

And lest anyone think this is only a national game, consider the European Central Bank (ECB): ‘What’s that? The Europeans are now writing off hundreds of billions of debt from countries like Greece and also buying their debt in order to keep them solvent? Sounds like QE to me! Buy, Buy, buy!’

How it started and why it has gone on

In truth this all started in 2008 when we all realized (bar some Austrian School enthusiasts) that the global economy would have been toast without massive injections of liquidity from central banks. In a sense we have all lost a certain amount of confidence in the global economy and are more focused on the immediacy of QE as a catalyst for positive equity market returns.

The pattern has been set, and the die has been cast. I guarantee you that after the speech made by Bernanke (and the market falls) the only topic of discussion among young ‘hot-shot’ investors will be over liquidity injections in the marketplace because that is what has guided the returns that they are judged on.

Will it always be like this?

The tricky bit now will be to ascertain whether investors can rid themselves of the notion that markets only move based on QE injections.  If so then good old fashion notions like evaluations and maybe even the equity risk premium could make a comeback. You may say Warren Buffett is a discounted cash flow dreamer, but he’s not the only one. Frankly I have no idea if this will be the case or not but I observe that this type of investment conditioning can go on a lot longer than people think.

What are the stocks to look for?

The key thing in the short to mid-term is to look at the sector/company results for those that are the key markers of the effects of QE.  Within housing, the idea is that as QE is scaled back, the stimulus behind the housing recovery will be reduced.  A key beneficiary of housing would be something like Home Depot (NYSE: HD).

It recently said that it was seeing a broad based recovery in the housing market and since last summer has noted that its growth prospects were diverging from correlation with GDP. The key thing to look for here is whether Home Depot starts to report any deterioration in its market conditions. My view is that it will not because scaling back QE is unlikely to have an immediate effect on housing sentiment.

Another key area will be banking, namely Wells Fargo (NYSE: WFC) and Capital One
Financial (NYSE: COF). The interesting thing about Wells Fargo is that its net interest margin has been falling partly thanks to low interest rates.




So surely rising rates would potentially be a good thing? The answer lies in whether you think the economy is improving and whether loan demand will improve or not. If so then Wells Fargo should be able to make more money anyway. This line of argument highlights the fact that the quality of its loan book and its future prospects are tied to the direction of the economy. If Bernanke is right then Wells Fargo will see increased loan demand. Again it’s something to look out for.

It’s a similar situation with Capital One. It is regarded as a more conservative type of lender and, so far, it has not reported strong loan growth. Indeed, it expects $12 billion of run-off in 2013 and a further $8.5 billion in 2014, and despite a decent automotive market in the U.S. it recently reported a $500 million drop in auto loan origination. As Capital tends to be more conservative, it is useful to follow its commentary closely because it is unlikely to adjust its lending criteria in order to chase business.

Another area worth following closely is the utilities sector, which could be represented by an ETF like the Utilities Select Spider (NYSEMKT: XLU). I think this ETF will be a very useful gauge of interest rate sentiment and/or whether the economy is going to slow down or not. Utilities do tend to be interest rate sensitive (thanks to their tendency to carry debt and pay high dividend yields), and the sector has sold off sharply in recent weeks as the market anticipated Bernanke’s statement.




^TNX data by YCharts

Again it is worth watching this ETF’s movement in order to see what sentiment is over interest rates.

The bottom line

In conclusion, I think the investing fixation with QE will continue for a while yet, and we can expect the Federal Reserve to carry on doing exactly what it has been doing before. If the economy gets weaker (and you will see it in the stocks discussed above) then the rhetoric will turn back into more liquidity provision but, if the economy continues to do well then, and only then, will the QE fixation abate. However we might be headed for some more volatility as this QE obsession continues.

Saturday, June 22, 2013

What Miss Utah Really Should Have Said...

I would have voted for Miss Utah. Not only did I find her the most attractive but she also gave a pretty coherent answer to a question which appeared to be come pre-loaded with a rather poorly thought out line of argument.

It gets worse. Most of the press following the famous question and answer session in the Miss USA pageant hasn’t managed to give a better answer to the question despite having ample time to think about the subject matter. Miss Utah was given about a second to respond. In this article I want to explain why and discuss a few stocks that are set to benefit from what the question/answer says about society.

A silly question deserves...

Let’s start with the question.

"A recent report shows that in 40 percent of American families with children, women are the primary earners yet they continue to earn less than men. What does this say about society?"

The report in question appears to be the Pew Research Center Report on “Breadwinner Moms”.  Of course ‘families’ includes single parent families and this is the clue to understanding this report.

In the context of this question there are three conclusions from the report and they are graphically represented here. All data is sourced from the report. The first two data sets relate to the % of households with children under 18.




A few notes.

  • From 1960 to 2011, the percentage of married women earning more than their husbands rose from 3% to 15%. This implies that women’s relative position –for whatever reason- is better.

  • The percentage of single mothers as the primary breadwinner has risen dramatically.

  • The percentage of never married single moms has exploded to 44% from 4%. This is not about increases in divorce rates ,although that surely helps too.

Frankly only the most fervent equalist can expect a single parent to have the earnings potential of a married or single person. The evidence is that married women are doing relatively better so anyone reading the Pew report and then focusing on why women aren’t earning as much as men, is engaging in rather a pointless exercise. It is surely far better just to try and stop, or rather not incentivize, women  getting into single parenthood.

The gender pay gap is a myth

Aside from this observation, there is another line of argument which sees the male/female pay gap to be a complete myth anyway and even a Dept of Labor report on the matter argues

“this study leads to the unambiguous conclusion that the differences in the compensation of men and women are the result of a multitude of factors and that the raw wage gap should not be used as the basis to justify corrective action. Indeed, there may be nothing to correct. The differences in raw wages may be almost entirely the result of the individual choices being made by both male and female workers”


Sounds reasonable to me.

The real answer

It strikes me that the real answer to the question of what it ‘says about society’ would be point out that the gender pay gap doesn’t actually exist. Married women are relatively better than they were before and something has been happening in order to make single parenthood more socially acceptable and economically viable.

But back to investing

If the trend continues towards single parenthood, increased divorce rates, according to many commentators, this implies more poverty, more crime and more social discord. Meanwhile married woman’s relative purchasing power seems to be increasing. Given these trends, which stocks could benefit?

I think something like Whole Foods Market (NASDAQ: WFM) could be a long term winner. I never cease to be amazed that its management has argued that the 80/20 rule seems to apply in its business. In other words 20% of its customers can generate 80% of its revenues. Therefore the way to think of this business is as having the potential to convert a relatively small number of wealthy married women into long term customers. Investors shouldn’t underestimate the cultural significance of this fact. Let’s recall that the other great movement in retail over the last few years has been trading down.

Of course trading down is also a consequence of these trends in society. Granted the recession and the difficulty in recovering lost jobs didn’t help but the trend towards single parenthood and welfare dependent parentage is likely to benefit the dollar stores like Dollar Tree (NASDAQ: DLTR). In my opinion this is the best performing dollar store right now. In fact it is the only one that has managed to grow discretionary sales more than consumables recently.

While it is certainly true that same store sales growth is slowing at the dollar stores at the moment, they still have good long term prospects from new store rollouts. Dollar Tree plans to increase square footage by 7.3% this year so even if same store sales come in at low single digits, it will have top line growth. My one concern would be that its forward PE of 15.3x doesn’t leave much room for error.

In tandem with the idea of increased poverty and crime, investors should look to how retail companies might fight shrinkage. In other words stop in store theft. One play on thse theme could be Verint Systems (NASDAQ: VRNT). Indeed I note that in its recent results it discussed a $4million order with a bog box retailer for its video surveillance systems. Although video intelligence only makes up a mid teens percentage of revenues, Verint also sells other intelligence solutions that help fight money laundering and fraud. Some of which may well be being committed by staff.

Last but not least, I would suggest looking at Allergan (NYSE: AGN) and PetSmart (NASDAQ: PETM).  Increasing numbers of wealthier married woman should be inclined to spend on cosmetic surgery and Allergan’s Botox is the global leader. Indeed I note that despite the slowdown in Europe, Allergan reported strong growth in Europe. Or is the recession reducing the number of alpha males out there and leading more hypergamous women to take up cosmetic surgery? Add in the growth prospects from increasing medical use of Botox (migraine, spasticity, bladder etc) and long term prospects look assured.

As for Petsmart, the argument is that more single parents, later marriages and increased divorce rates will lead people to take on pets (and spend money on them) as a way to supplant an emotional attachment that is missing in their lives. At least that’s how the industry sees it.

Here is the data on U.S. pet expenditures from the American Pet Products Association.




Its recession resistant numbers speak for themselves. There is a long term secular trend here and I think companies like PetSmart are benefiting from it.

The bottom line

Unfortunately Miss Utah didn’t have time to give a thought out answer to the question. But in any case the question was a lot dumber than she was made out to be.

Thanks to readers for sticking with a long article. I hope there are some interesting investment ideas here plus an attempt to tell the truth about what the data really says about society, rather than try and correlate it to some pre-supposed feminist dogma.