We have all become accustomed to putting away our money in bank accounts and various saving vehicles for safe keeping and the opportunity to earn a little interest. But what would be your response if you were told that the $1000 you deposited at the beginning of the year, hoping to earn 4-5% in interest over a 12 month period will only pay you $950 at maturity? Not the $1050 you expected but $950! A decline of 5% on your $1000 while a 5% rate of inflation wipes out your interest and takes a chunk out of your principal! Well, believe it or not, that is exactly what is happening to your savings at this very moment. Your money is being silently siphoned off by the phenomenon called inflation! Let’s clarify one thing before I move on. At the end of the 12 month period your bank statement will show that you still have $1000 and that you did in fact receive interest payments of $50, but the problem is that when you spend your $1050 you will only receive $950 of value in return. In other words, your $1050 will buy much less than it could a year earlier. But if you think this thief only targets bank accounts, think again. Inflation is quite pervasive and it envelopes just about every aspect of our lives. For instance, you might have noticed that $25 gives you a lot less gas than it did a year or two ago, or that while you spend the same amount of money at the grocery store, you come home with less and less items each time. But by now we should all be mindful of the fact that world oil supplies are shrinking and thus pushing up the prices at the pump. Or that the demand for grains and other agricultural products has gone up significantly in recent times and has caused food price increases across the board. Both statements are true, but these factors alone do not explain why your dollar is buying less and less. The answer lies in a basic understanding of inflation and what causes it.
Inflation Revealed
So what exactly is inflation? The common thought is that inflation is merely the rapid increase in the prices of goods and services, or as the text books tell us, it is the phenomenon which occurs when there is too much money chasing too few goods. While I do not have any problems with the definitions per se, I must add that the root cause is really the ever increasing supply of money. Like just about anything else, money becomes less valuable when there is too much of it floating around and as it loses value it takes more and more of it to acquire goods and services. But why do we keep increasing the supply of money? Well, the money we use to pay for the goods and services we consume has to either come from the sale of goods and services that the country produces or from simply borrowing it. In this case the US, and just about every other country in a similar situation, has been borrowing instead of producing. A lot of the production of goods has been “outsourced” to other countries over the last 20-30 years. Ironically, it was the rising wages and production costs caused by inflation that encouraged outsourcing in the first place. But the bottom line is that when a country borrows money it has to repay that money with interest, and if the country is not producing enough to pay the interest, let alone repay the principal on the loan, then it will have to borrow more to do so. Thus the cycle continues and perpetuates itself. In fact, according to the Treasury Department, as of February 2008 the US national debt was some 9 trillion dollars. And when you consider that the debt was about 5.2 trillion in 2001 it gives you an idea of the pace at which the debt, the money supply and inflation are increasing and wiping out your wealth and purchasing power in the process. That’s as simple as I can put it without delving into the important but boring intricacies. Hope you get the picture.
Staying Ahead Of The Game
I often laugh when I hear an associate or friend of mine (or anybody else for that matter) boast about the returns they are making on a bank Commercial deposit (CD), Mutual Fund, 401K or some high yielding online bank account. I had a high yielding bank account for a few years until I became aware of the fact that I was actually losing purchasing power with my money sitting there. I emptied it and deployed my money elsewhere with the aim of keeping pace with inflation. Of course I took on additional risk, but basic finance dictates that the returns be greater than the risk taken -otherwise it won’t make any sense. By that metric, my decision made a lot of sense and now I am comfortably ahead of inflation, not by much, but it is much better than having my purchasing power wiped out. The point being made here is that your savings/investments must keep pace with or stay ahead of inflation in order to preserve your wealth and purchasing power. But now that we know what to do, how do we do it? Well it wasn’t so long ago that the rule of thumb was that you should buy real estate. Well we all see that myth being blown to shreds in this environment as homeowners are waking up to find that their property is worth less than it did the day before. Well that might be a bit of a stretch but you get the point- property prices are falling and the myth of perpetually appreciating real estate has been dismissed. Note that the National Association of Realtors (NAR) told us on Feb.25 that the national median existing-home price for all housing types was $201,100 in January, down 4.6 percent from a year ago when the median was $210,900. The way you safe guard your wealth is to buy assets, or investments linked to assets, that thrive in an inflationary climate. The very things that attack you today can save you tomorrow. You can benefit from the escalating gas prices and the skyrocketing food prices even as you are forced to contend with it on a daily basis. So the next time you see the prices at the pump it won’t be as painful since the money you, and just about everyone else, are being asked to cough up will (in a certain sense) end up in your pocket.
The "Playbook"
However let me point out that unless you are a large sophisticated investor with money to burn, you will not be able to benefit directly from these occurrences. So since we are average Janes and Joes with average incomes and lifestyles we have to utilize the next best method in order to take advantage of the situation. In this regard, I have been looking at Mutual Funds, Exchange Traded Funds (ETF) or single company stocks that have exposure to these areas and are well placed to profit from the situation. We can proceed on the premise that hard assets and commodities have been thriving and will continue to thrive in this environment.
Before I proceed into the details of these picks and conclude this article, I want to point out two things. First, I am not recommending these securities to anyone. I am not licensed to do so, I am merely telling you what I have been doing or researching. If you feel the need to invest in any such securities go see your Financial Advisor. Secondly, if we assume the government statistics to be correct, then the inflation rate is running at 4.5%. Therefore, whatever savings you put away or whatever investment you make, you have to start by discounting the value of future earnings by 4.5%. What that means is that you will have to make roughly 9% on your investment just to preserve your purchasing power. Now think about it, how many investments do you know of that return 9%+ per year? So that should be your starting point. You need to seek out investments that can keep you ahead of the game.
That is why I have been researching and investing in things that cover basic food, metals and energy. After all, these are the things that have had the greatest price increases in recent times. I have even mentioned a few of these stocks and ETFs in recent articles and I am mentioning them again because they continue to perform well.
The "Line up"
The Power-shares Deutsche Bank Agriculture Fund (DBA): This is an ETF that trades futures on soft commodities such as corn, wheat, soybeans and sugar and should go up as the prices of these commodities continue to go up. DBA is up 55.3% over the last 12 months and 26% since January.
The I-shares S&P Commodity Index fund (GSG): The index currently tracks 24 different commodities. The index is production weighted to reflect the relative significance of those commodities to the world economy. GSG is up 39.65% over the last 12 months and 8.38% since January.
Freeport Mcmoran (FCX): FCX is one of the world's largest miners of gold, silver and copper. As of December 31, 2006, it had 2,813,089 metric tons of proven and probable recoverable ore reserves. I think FCX is one of the most efficient mining operations in this sector and will continue to benefit from the growing demand for its products. This stock is up 67% over 12 months and down 1.8% year to date.
Arcelor Mittal (MT): This Company produces and markets steel and steel products worldwide and has significant presence in emerging markets.MT is up 49% over the last year and 10% year to date.
Petroleo Braziliero (PBR): PBR is a Brazilian oil company that engages in the exploration and production of oil and oil by-products. Interestingly, PBR is the only major oil company to have made a significant new field discovery in recent times. It is up 150% over 12 months, 26% year to date &9% since I last mentioned it.
Note:
We all have to actively manage our finances in this environment otherwise we will wake up one morning and realize that we are a lot poorer than we thought. I am still working on an article regarding housing as I promised last time. It should be along shortly as I am still sourcing data. Leave a comment or question if you have one.
Wednesday, February 27, 2008
Friday, February 22, 2008
Why Agri & Commodities Will Continue To Outperform & How to Profit From It
If you are a buy and hold type investor I want to point out to you that buying and holding securities in the current market environment is not the wisest thing to do right now because of the increasing volatility in the markets. You may have noticed that it has become quite "normal" for the market to lose 300 points one week, recover 300+ points the next week only to lose 350+ points in a third week. This volatility is largely due to the fact that investors are not comfortable holding securities at this point because the prevailing thought is that there is still a lot of "unknowns" out there and that the credit situation brought on by the subprime problem is still in unfolding. And since credit is the life blood of the American consumer , and the economy as a whole, any adverse credit situation can and will be devastating to the markets. On the other hand the situation is a gold mine for traders and they have been doing well since the second quarter of 2007 when the subprime problem surfaced. However I have been finding opportunities for medium term gains in commodities, largely because there is a supply and demand imbalance which no amount of volatility can negate. Simply put, when demand outstrips supply in any asset class prices WILL go up and I have been pointing my long term oriented "clients" in this direction. Consider this statement taken from one of the newsletters that i subscribe to:
........ Global demand for Agri-Foods continues strong. Cash prices for most Agri-Foods have hit new highs in the past year. Those prices have moved so strongly that some nations are banning the export of grains. Is this the beginning of governments hoarding Agri-Foods? This supply situation is likely to only worsen as economies of China and India continue to expand. China is not yet a net importer of grains. But, in less than two years it will be one! Global competition for Agri-Food is further heightened by the move to biofuels. China is probably the only government actually discouraging ethanol production from grain. Malaysia is deeply concerned that the move to biodiesel will put palm oil in short supply. Palm oil represents about half of the world's consumption of vegetable oils. This list of shortages goes on as the world moves to a short supply situation in Agri-Food that could last a decade or more........ (Ned Schmidt, Agrifood Thoughts Newsletter)
As the incomes of citizens of emerging economies such as Brazil, Russia, India & China rise so will their caloric intake. Foodstuffs are up 22% or more, year over year, putting additional bids (demand) into grains, meats, etc. More grains (corn, wheat and soybeans) have been consumed than produced for 7 out of the last 8 years. Global grain supplies are plummeting........
In this regard I have been playing the sector via shares in grain processors, fertilizer producers and exchange traded funds that track the agri food sector. I think a combination of these or just one of the ETF's will be sufficient in the way of exposure. I have been "covering" the following:
1) The Powershares Deutsche Bank Agriculture Fund (DBA): This is an ETF that trades futures on soft commodities such as corn, wheat, soybeans and sugar and should go up as the prices of these commodities continue to go up. It is now trading @ $40.59 just shy of its 52 week high but I think it has a lot further to go.
2) Potash Corp. (POT): This is a leading Canada based fertilizer,crop nutrient and animal feed producer. It trades at around $154 and should continue to grow its earnings as it deepens its involvement in the emerging economies.
3) Bunge Ltd. (BG): Bunge processes, stores and ships agricultural products. Naturally, its costs will go up as the price of the agri commodities go up, but is well placed to pass on the costs to the companies it supplies. It now trades at $109 after recently reaching a new high.
This is an out take from yet another of the services I read on a daily basis and it is intended to give a sense of the supply and demand situation with commodities (metals & oil in particular):
In virtually every corner of the commodity, natural resource and metals world supplies are constrained, capacity to produce more is not in place, it takes years or decades to develop and demand is moving higher. As the emerging world and the BRIC's (Brazil, Russia, India, and China) build the infrastructure, roads, cars, appliances, power plants, factories and homes necessary to support their emerging middle classes, enormous amounts of raw materials will be required to do so......... Oil output is falling in Venezuela, Mexico and Iran precipitously as fields are poorly maintained, underinvested in and milked for short-term gain.......Russia is flaring more natural gas than the United States uses in a year, as it has NO ability to capture or transport it from the oil fields. Consequently, shortages are set to increase in these vital areas......... OECD oil inventories are approaching 4 year lows, global oil production is about 75 million barrels a day, usage is about 85 million barrels (bio-fuels and substitutes account for the difference) Opec's production is maxed out and bio-fuels cannot expand fast enough to meet additional demand. Bio-fuels have already caused widespread FOOD shortages, environmental destruction and exploding prices....... (Ty Andros, Tedbits)
The so called hard commodities (oil, copper, gold, aluminum, etc) can be played via the shares in miners, processors or ETFs that track the particular commodity or sector.
1) Arcelor Mittal (MT): This company produces and markets steel and steel products worldwide and has significant presence in emerging markets. It presently trades @ around $76 per share. I think it could very well be a good way to play the infrastructural development taking place in emerging economies.
2) Petro Brasiliero (PBR): PBR is a Brazilian oil company that engages in the exploration and production of oil and oil by-products. Interestingly, PBR is the only major oil company to have made a significant new field discovery in recent times
(http://www.reuters.com/article/marketsNews/idLTAN2225840820080122?rpc=44) and is well placed to take advantage of the increased demand for the commodity.
3) Oil Services Holders (OIH): OIH is an ETF that tracks the shares of companies involved in the drilling, extraction and transportation of oil on contract to big oil companies. I believe this sector will benefit as global oil companies intensify efforts to recover oil from hard to reach reserves in order to meet market demand.
4) Freeport Mcmoran (FCX): FCX is one of the world's largest miners of gold, silver and copper. As of December 31, 2006, it had 2,813,089 metric tons of proven and probable recoverable ore reserves. I think FCX is one of the most efficient mining operations in this sector and will continue to benefit from the growing demand for its products.
As i mentioned in opening, the volatility in the market is quite pronounced and you may have to take profits and get back in these commodity plays a few times on the way up. As we all know these share prices will not go up in a straight line (just look at any chart).
NOTE: Of course there are quite a few more companies and ETFs which will be beneficiaries of this ongoing global commodities bull market, but in my estimation the companies I have listed will stand to do better than most by virtue of the fact that they are better prepared and have global coverage in terms of their markets and raw material sources. You will also note that, on a dollar basis, these companies and ETFs seem a bit pricey but I would like to point to the fact that on a valuation basis they are quite attractively priced especially when you consider that demand is strong and growing and that these companies operate on a relatively low fixed cost basis.
I would also like to point out that even though all the indicators are pointing to a bull market in commodities which may last for years, the threat of an outright recession is real. Constantly rising prices in a shrinking or recessionary economy can lead to demand destruction where demand for the product falls because the market simply cannot afford it. It is not far fetched that such a scenario could play out in the not so distant future and we ought to be mindful of it. Furthermore, I am not one of those who believes that the worlds emerging economies have "decoupled" from the US economy and that a recession in the US would have very little impact on them. On the contrary I still believe thatThe US is a major market for just about all emerging economies and while they are increasingly trading among themselves i do not think these economies can keep growing at the pace they are now growing if US demand for their products slows or shrinks. Therefore if the US recession turns out to be severe and protracted it will cause a global slowdown and, by extension, a fall off in demand for commodities.
Where next? If history is enough to go by, then the first to fall in a recession will usually be the first to rise in a recovery- or at least the strongest among them-. I am therefore in the process of assembling a list of housing, housing related and financial companies that I think will be good to start accumulating. It will be ready in two weeks. These picks however will have a three to five year time frame. In the mean time ride out the recession and the jittery markets with the commodity plays.
........ Global demand for Agri-Foods continues strong. Cash prices for most Agri-Foods have hit new highs in the past year. Those prices have moved so strongly that some nations are banning the export of grains. Is this the beginning of governments hoarding Agri-Foods? This supply situation is likely to only worsen as economies of China and India continue to expand. China is not yet a net importer of grains. But, in less than two years it will be one! Global competition for Agri-Food is further heightened by the move to biofuels. China is probably the only government actually discouraging ethanol production from grain. Malaysia is deeply concerned that the move to biodiesel will put palm oil in short supply. Palm oil represents about half of the world's consumption of vegetable oils. This list of shortages goes on as the world moves to a short supply situation in Agri-Food that could last a decade or more........ (Ned Schmidt, Agrifood Thoughts Newsletter)
As the incomes of citizens of emerging economies such as Brazil, Russia, India & China rise so will their caloric intake. Foodstuffs are up 22% or more, year over year, putting additional bids (demand) into grains, meats, etc. More grains (corn, wheat and soybeans) have been consumed than produced for 7 out of the last 8 years. Global grain supplies are plummeting........
In this regard I have been playing the sector via shares in grain processors, fertilizer producers and exchange traded funds that track the agri food sector. I think a combination of these or just one of the ETF's will be sufficient in the way of exposure. I have been "covering" the following:
1) The Powershares Deutsche Bank Agriculture Fund (DBA): This is an ETF that trades futures on soft commodities such as corn, wheat, soybeans and sugar and should go up as the prices of these commodities continue to go up. It is now trading @ $40.59 just shy of its 52 week high but I think it has a lot further to go.
2) Potash Corp. (POT): This is a leading Canada based fertilizer,crop nutrient and animal feed producer. It trades at around $154 and should continue to grow its earnings as it deepens its involvement in the emerging economies.
3) Bunge Ltd. (BG): Bunge processes, stores and ships agricultural products. Naturally, its costs will go up as the price of the agri commodities go up, but is well placed to pass on the costs to the companies it supplies. It now trades at $109 after recently reaching a new high.
This is an out take from yet another of the services I read on a daily basis and it is intended to give a sense of the supply and demand situation with commodities (metals & oil in particular):
In virtually every corner of the commodity, natural resource and metals world supplies are constrained, capacity to produce more is not in place, it takes years or decades to develop and demand is moving higher. As the emerging world and the BRIC's (Brazil, Russia, India, and China) build the infrastructure, roads, cars, appliances, power plants, factories and homes necessary to support their emerging middle classes, enormous amounts of raw materials will be required to do so......... Oil output is falling in Venezuela, Mexico and Iran precipitously as fields are poorly maintained, underinvested in and milked for short-term gain.......Russia is flaring more natural gas than the United States uses in a year, as it has NO ability to capture or transport it from the oil fields. Consequently, shortages are set to increase in these vital areas......... OECD oil inventories are approaching 4 year lows, global oil production is about 75 million barrels a day, usage is about 85 million barrels (bio-fuels and substitutes account for the difference) Opec's production is maxed out and bio-fuels cannot expand fast enough to meet additional demand. Bio-fuels have already caused widespread FOOD shortages, environmental destruction and exploding prices....... (Ty Andros, Tedbits)
The so called hard commodities (oil, copper, gold, aluminum, etc) can be played via the shares in miners, processors or ETFs that track the particular commodity or sector.
1) Arcelor Mittal (MT): This company produces and markets steel and steel products worldwide and has significant presence in emerging markets. It presently trades @ around $76 per share. I think it could very well be a good way to play the infrastructural development taking place in emerging economies.
2) Petro Brasiliero (PBR): PBR is a Brazilian oil company that engages in the exploration and production of oil and oil by-products. Interestingly, PBR is the only major oil company to have made a significant new field discovery in recent times
(http://www.reuters.com/article/marketsNews/idLTAN2225840820080122?rpc=44) and is well placed to take advantage of the increased demand for the commodity.
3) Oil Services Holders (OIH): OIH is an ETF that tracks the shares of companies involved in the drilling, extraction and transportation of oil on contract to big oil companies. I believe this sector will benefit as global oil companies intensify efforts to recover oil from hard to reach reserves in order to meet market demand.
4) Freeport Mcmoran (FCX): FCX is one of the world's largest miners of gold, silver and copper. As of December 31, 2006, it had 2,813,089 metric tons of proven and probable recoverable ore reserves. I think FCX is one of the most efficient mining operations in this sector and will continue to benefit from the growing demand for its products.
As i mentioned in opening, the volatility in the market is quite pronounced and you may have to take profits and get back in these commodity plays a few times on the way up. As we all know these share prices will not go up in a straight line (just look at any chart).
NOTE: Of course there are quite a few more companies and ETFs which will be beneficiaries of this ongoing global commodities bull market, but in my estimation the companies I have listed will stand to do better than most by virtue of the fact that they are better prepared and have global coverage in terms of their markets and raw material sources. You will also note that, on a dollar basis, these companies and ETFs seem a bit pricey but I would like to point to the fact that on a valuation basis they are quite attractively priced especially when you consider that demand is strong and growing and that these companies operate on a relatively low fixed cost basis.
I would also like to point out that even though all the indicators are pointing to a bull market in commodities which may last for years, the threat of an outright recession is real. Constantly rising prices in a shrinking or recessionary economy can lead to demand destruction where demand for the product falls because the market simply cannot afford it. It is not far fetched that such a scenario could play out in the not so distant future and we ought to be mindful of it. Furthermore, I am not one of those who believes that the worlds emerging economies have "decoupled" from the US economy and that a recession in the US would have very little impact on them. On the contrary I still believe thatThe US is a major market for just about all emerging economies and while they are increasingly trading among themselves i do not think these economies can keep growing at the pace they are now growing if US demand for their products slows or shrinks. Therefore if the US recession turns out to be severe and protracted it will cause a global slowdown and, by extension, a fall off in demand for commodities.
Where next? If history is enough to go by, then the first to fall in a recession will usually be the first to rise in a recovery- or at least the strongest among them-. I am therefore in the process of assembling a list of housing, housing related and financial companies that I think will be good to start accumulating. It will be ready in two weeks. These picks however will have a three to five year time frame. In the mean time ride out the recession and the jittery markets with the commodity plays.
Monday, February 11, 2008
More Downside for Moody's
Moody’s, like Standard and Poor’s, has found itself at the center of what could very well be the next shoe to drop as the subprime issue continues to unfold. As things are now, Moody’s is still considering a likely downgrade of the beleaguered bond insurers and so called monolines, Ambac and MBIA and if such a downgrade were to take place it would likely set off a chain reaction of bond downgrades which would threaten the financial system as a whole. There is therefore little wonder why there is a concerted effort between the New York state insurance commissioner and eight banks to come up with a rescue package for one or both of the bond insurers. The fact is that if Moody’s does issue a downgrade their ratings criteria and methods will be questioned even more than they are being questioned now. And if they don’t downgrade even more questions will be raised. After all, from all indications and by using just about every possible valuation metric, MBIA and Ambac are virtually insolvent having guaranteed bonds valued at many times their capital base. How could a firm like Moody’s miss this?
Now lets say the team manages do bail out the bond insurers, I do not think it would be business as usual for the likes of Moody’s. The confidence once reposed in a Moody's triple A rating has been badly shaken and has started to manifest itself in the company’s stock price. In its most recent report the company reported a 54% drop in earnings and signaled a weaker 2008:
The severity and protracted nature of current credit market dislocations confirms that the challenges of 2007 will persist well into 2008," Moody's Chief Executive Raymond McDaniel said. "It is going to be a challenging year, both inside and outside the U.S."
In addition to this we are told that Moody’s, as well as other ratings agencies will probably have to deal with increased regulatory scrutiny going forward. The regulators could very well start taking a look at the relationship between these ratings agencies and the issuers they work with. This could cut deeply into profits especially in light of the fact that a significant part of Moody’s earnings comes from companies issuing bonds as the WSJ told us last Thursday:
Regulators are probing whether the three companies were too cozy with investment banks. A slew of self-imposed overhauls have been denounced by New York state's attorney general, Andrew Cuomo, as "too little, too late."
Moody’s, having been around for so long, has become engrained in the global financial system and has taken on the aura of a sacred cow, so in many investors minds it is hard to imagine the global markets without a Moody’s, just like many never thought we would see the end of Arthur Andersen. I am not suggesting that Moody’s will go broke and disappear but I believe that it will be significantly weakened in the medium term and will have to undergo an intense period of restructuring in order to continue. In the meantime the stock price is likely to head lower as bond investors and issuers go elsewhere in search of a less troubled rating agency and outside the glare of the regulators. I expect Moody’s to pull out all the stops to stem the decline in the stock price. In fact they have already started by announcing a stock buy back and new self imposed regulations as announced in the earnings conference call. But I do not think it will be enough especially since we are learning, thanks to Bill Ackman, what MBIA and Ambac had on their books, all of which is turning out to be some of the worst quality structured products, yet these firms continued to carry a triple A credit rating. http://www.yousendit.com/transfer.php?action=batch_download&batch_id=Mmd0UXVuQzMzeUxIRG Even if MBIA and Ambac had no subprime exposure, the very fact that they had liabilities that were way in excess of their capital makes one wonder why Moody’s and others continued to assign the triple A credit rating. The bottom line is that the unfolding situation has severely tarnished the Moody’s shield, the stock has fallen more than 50% year to date and from all indications it will continue to suffer as the situation persists and more of the mess is brought to light. I have been short MCO since October 2007and have covered only 40% of the position so far.
Now lets say the team manages do bail out the bond insurers, I do not think it would be business as usual for the likes of Moody’s. The confidence once reposed in a Moody's triple A rating has been badly shaken and has started to manifest itself in the company’s stock price. In its most recent report the company reported a 54% drop in earnings and signaled a weaker 2008:
The severity and protracted nature of current credit market dislocations confirms that the challenges of 2007 will persist well into 2008," Moody's Chief Executive Raymond McDaniel said. "It is going to be a challenging year, both inside and outside the U.S."
In addition to this we are told that Moody’s, as well as other ratings agencies will probably have to deal with increased regulatory scrutiny going forward. The regulators could very well start taking a look at the relationship between these ratings agencies and the issuers they work with. This could cut deeply into profits especially in light of the fact that a significant part of Moody’s earnings comes from companies issuing bonds as the WSJ told us last Thursday:
Regulators are probing whether the three companies were too cozy with investment banks. A slew of self-imposed overhauls have been denounced by New York state's attorney general, Andrew Cuomo, as "too little, too late."
Moody’s, having been around for so long, has become engrained in the global financial system and has taken on the aura of a sacred cow, so in many investors minds it is hard to imagine the global markets without a Moody’s, just like many never thought we would see the end of Arthur Andersen. I am not suggesting that Moody’s will go broke and disappear but I believe that it will be significantly weakened in the medium term and will have to undergo an intense period of restructuring in order to continue. In the meantime the stock price is likely to head lower as bond investors and issuers go elsewhere in search of a less troubled rating agency and outside the glare of the regulators. I expect Moody’s to pull out all the stops to stem the decline in the stock price. In fact they have already started by announcing a stock buy back and new self imposed regulations as announced in the earnings conference call. But I do not think it will be enough especially since we are learning, thanks to Bill Ackman, what MBIA and Ambac had on their books, all of which is turning out to be some of the worst quality structured products, yet these firms continued to carry a triple A credit rating. http://www.yousendit.com/transfer.php?action=batch_download&batch_id=Mmd0UXVuQzMzeUxIRG Even if MBIA and Ambac had no subprime exposure, the very fact that they had liabilities that were way in excess of their capital makes one wonder why Moody’s and others continued to assign the triple A credit rating. The bottom line is that the unfolding situation has severely tarnished the Moody’s shield, the stock has fallen more than 50% year to date and from all indications it will continue to suffer as the situation persists and more of the mess is brought to light. I have been short MCO since October 2007and have covered only 40% of the position so far.
The Problem With Capital One Financial (COF)
I originally posted this article at www.seekingalpha.com a month ago
On Wednesday, January 16, 2008, Fitch affirmed its previous A- ratings on Capital One Financial (COF), citing the company’s strong business and solid liquidity. The stock closed the day up 3% from its previous day's $42 close. The Fitch report presented a fairly stable picture of the company and handed a bit of hope to the bulls.
However, I want to take a look at the language in the report, and a few other facts, and show why I think this presents a rather bearish case for the company. Fitch had this to say about the company’s situation: Credit deterioration beyond current expectations with a corresponding hit to segment profitability, particularly in US Card, an absence of earnings and asset quality improvement in the auto segment, decreased liquidity, or weakening risk-adjusted capitalization could trigger negative rating actions (and earnings potential).
I would like to substitute that word “could” in the report with “will”. If we take a look at the business segments mentioned we will see that the credit card and auto loan segments are the areas in which the latest round of the subprime situation has manifested itself. There have been recently published reports of increased credit card delinquencies and auto loan defaults. And get this- Capital One is one of the leading subprime credit card issuers with a reputation of extending credit to less than suitable borrowers. As far as the part about decreased liquidity is concerned, we all know that reasonably priced financing is hard to come by with the confidence in the credit markets so seriously shaken and most lenders taking a wait and see approach or seeking capital injections to beef up their own balance sheets.
The fact is that the worsening macroeconomic conditions will only impact negatively on the business segments mentioned and you can add to that the personal, student and mortgage loan businesses which Capital one also operates. But just in case we are too far gone with the pessimism, Fitch wants us to know that all is not lost and that stabilization of segment credit metrics, improvement in the UK credit card portfolio, and a turnaround in the auto business with the development of consistent segment profitability, could provide positive rating momentum.
Interpreted to mean they are hoping that not withstanding the mess in the credit markets, the economy and an increasingly burdened consumer, improvements in the auto business will save profitability. We know better. Just last Thursday the company announced that its full year profit would come in 21% lower than forecast citing, among other things, mounting consumer loan losses. I think it only gets worse from here on. I also get the feeling that there is a lot of crisis management taking place. Evidence of this lies in the fact that the company basically had their bank, Capital One National Association, through a holding company; take over the Auto Finance portfolio on the basis that it will allow: the auto business to leverage the bank's deposit funding. This change will make COF less reliant on the capital markets, which is a positive development, given the uncertain environment.
It seems to me that they are seeing early signs of trouble in the Auto loans business and are taking preemptive steps. This could be seen as good management if it were not for the fact that the auto loan business will not be the only segment that will need propping up. Furthermore in its most recent sec filing COF stated that their balance sheet position is very strong with some 29 billion in available liquidity. But I would like to point out that this “liquidity” consists of: unencumbered and highly liquid investment securities, unused committed conduit capacity, and available borrowing capacity from the Federal Home Loan Banks.
OK. I have a few questions here. What exactly are these highly liquid investment securities? Are they of the subprime variety? How long will they remain “highly liquid” in this credit environment? Just how committed is this unused conduit capacity in this increasingly recessionary economy? And when they speak about borrowing from Federal Home Loan Banks are they referring to the Macs- meaning Fannie (FNM) and Freddie (FRE)? The same Fannie and Freddie with the ailing balance sheets? The present situation does not look so good for COF. They are trying to deal with the problems but their methods are suspect (shifting auto finance to its bank). And their contingencies are questionable at best.
I expect a little more light to be shed on the COF situation at their earnings conference call later this month when the questions start coming in. If the answers to some of these questions do not hold water (and I suspect they won’t) the downgrades will be fast and furious and the stock price will falter further. Of course, the Fed will probably dish out a 50 basis point cut at the end of the month and throw a lifeline to COF and the entire financial sector. I expect an initial positive reaction in the stock price and then, when the situation is reassessed, we should continue on our downward march. The Fed will not be able to help everybody. The reason why capital is so hard to get these days is not due to a lack of money; there is plenty of money in the system. The problem is a lack of confidence in the system - and a lot of uncertainty about what lies on the balance sheets (and in the SIVs) of financial companies like COF.
On Wednesday, January 16, 2008, Fitch affirmed its previous A- ratings on Capital One Financial (COF), citing the company’s strong business and solid liquidity. The stock closed the day up 3% from its previous day's $42 close. The Fitch report presented a fairly stable picture of the company and handed a bit of hope to the bulls.
However, I want to take a look at the language in the report, and a few other facts, and show why I think this presents a rather bearish case for the company. Fitch had this to say about the company’s situation: Credit deterioration beyond current expectations with a corresponding hit to segment profitability, particularly in US Card, an absence of earnings and asset quality improvement in the auto segment, decreased liquidity, or weakening risk-adjusted capitalization could trigger negative rating actions (and earnings potential).
I would like to substitute that word “could” in the report with “will”. If we take a look at the business segments mentioned we will see that the credit card and auto loan segments are the areas in which the latest round of the subprime situation has manifested itself. There have been recently published reports of increased credit card delinquencies and auto loan defaults. And get this- Capital One is one of the leading subprime credit card issuers with a reputation of extending credit to less than suitable borrowers. As far as the part about decreased liquidity is concerned, we all know that reasonably priced financing is hard to come by with the confidence in the credit markets so seriously shaken and most lenders taking a wait and see approach or seeking capital injections to beef up their own balance sheets.
The fact is that the worsening macroeconomic conditions will only impact negatively on the business segments mentioned and you can add to that the personal, student and mortgage loan businesses which Capital one also operates. But just in case we are too far gone with the pessimism, Fitch wants us to know that all is not lost and that stabilization of segment credit metrics, improvement in the UK credit card portfolio, and a turnaround in the auto business with the development of consistent segment profitability, could provide positive rating momentum.
Interpreted to mean they are hoping that not withstanding the mess in the credit markets, the economy and an increasingly burdened consumer, improvements in the auto business will save profitability. We know better. Just last Thursday the company announced that its full year profit would come in 21% lower than forecast citing, among other things, mounting consumer loan losses. I think it only gets worse from here on. I also get the feeling that there is a lot of crisis management taking place. Evidence of this lies in the fact that the company basically had their bank, Capital One National Association, through a holding company; take over the Auto Finance portfolio on the basis that it will allow: the auto business to leverage the bank's deposit funding. This change will make COF less reliant on the capital markets, which is a positive development, given the uncertain environment.
It seems to me that they are seeing early signs of trouble in the Auto loans business and are taking preemptive steps. This could be seen as good management if it were not for the fact that the auto loan business will not be the only segment that will need propping up. Furthermore in its most recent sec filing COF stated that their balance sheet position is very strong with some 29 billion in available liquidity. But I would like to point out that this “liquidity” consists of: unencumbered and highly liquid investment securities, unused committed conduit capacity, and available borrowing capacity from the Federal Home Loan Banks.
OK. I have a few questions here. What exactly are these highly liquid investment securities? Are they of the subprime variety? How long will they remain “highly liquid” in this credit environment? Just how committed is this unused conduit capacity in this increasingly recessionary economy? And when they speak about borrowing from Federal Home Loan Banks are they referring to the Macs- meaning Fannie (FNM) and Freddie (FRE)? The same Fannie and Freddie with the ailing balance sheets? The present situation does not look so good for COF. They are trying to deal with the problems but their methods are suspect (shifting auto finance to its bank). And their contingencies are questionable at best.
I expect a little more light to be shed on the COF situation at their earnings conference call later this month when the questions start coming in. If the answers to some of these questions do not hold water (and I suspect they won’t) the downgrades will be fast and furious and the stock price will falter further. Of course, the Fed will probably dish out a 50 basis point cut at the end of the month and throw a lifeline to COF and the entire financial sector. I expect an initial positive reaction in the stock price and then, when the situation is reassessed, we should continue on our downward march. The Fed will not be able to help everybody. The reason why capital is so hard to get these days is not due to a lack of money; there is plenty of money in the system. The problem is a lack of confidence in the system - and a lot of uncertainty about what lies on the balance sheets (and in the SIVs) of financial companies like COF.
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