Sunday, October 14, 2012

Softbank Stock Looks Compelling

What would you say if I told you that you could buy Japan’s best wireless telecom carrier (growing at 8%), coupled with the Google of Japan, for only 3.3x EBITDA?  Investment grade rated with 40% ROE’s, the firm has tripled its EPS since 2008.  Oh, and I would throw in an $11BB stake in Alibaba for FREE, plus an option to buy 70% of Sprint shares for $6.25, which are likely worth $10+ in 2 years.

This is the value proposition for Softbank today, ticker 9984 out of Tokyo, also with an ADR that trades under the ticker symbol SFTBY in the US.

This week Sprint (S) and Softbank confirmed that talks were in the works for Softbank to acquire a majority plus stake in Sprint.  Reportedly management of the Japanese conglomerate would like to pay less than $6.50 a share to acquire 70% of Sprint.  That math works out to around $6.25 per Sprint share based on rumors of a ¥1TT deal (or $12.8BB).   I’ll get to the potential deal dynamics below.

Sprint stock unsurprisingly zoomed from $5.00 to roughly $5.75 per share, while Softbank surprisingly fell 17% in one day on the news!  To put some numbers around that, Softbank shed $7.1BB in market cap for a deal that is only $12.8BB in total invested capital.  Is Softbank really overpaying by $7BB for Sprint shares?  The market thinks so.  Sprint by the way gained $2.2BB in market cap.

Put differently, the market suggests that Softbank is overpaying by $3.54 a Sprint share, meaning if the deal goes through, you effectively as a Softbank holder today are investing in Sprint at the bargain price of only $2.71.  (Math is $6.25 Sprint purchase price less $7.1BB lost market cap divided by 2BB shares of Sprint they are buying).

Even factoring in a worst case scenario for Softbank which entails buying Sprint at a full $6.50 a share, Softbank shares are a compelling long based on a sum of the parts and FCF yield analysis.  Much of the investment has to be considered too in light of the firm’s CEO and founder, the brash and charismatic Masayoshi Son.


Softbank Description
Softbank is 21% owned by Son, who founded the firm in the 1980s to distribute Microsoft software in Japan.  The firm evolved into a telecom and internet conglomerate, with Softbank’s purchase of Vodafone Japan for $17BB his entrĂ©e into the mobile space in Japan in 2006.  Son also smartly invested a 31.9% stake in the Alibaba Group in 2000, pushing its now famous found Jack Ma to start Taobao to compete with a then well-established Ebay which was making forays into China in 2002.  This is a great history of Softbank.

Much has been made of Son’s willingness to make huge acquisitions fueled by debt, and while that resonates to some wary long term investors in Softbank, the Sprint deal actually is a good one despite that fact that it is one that Softbank intends to borrow to finance.  Not only that, but the company is only 0.8x levered today (Debt/EBITDA), and would be only 1.76x levered under a fully debt financed Sprint deal.  That is still within investment grade land.  After the Vodafone deal in 2007, total debt then was ¥2.4TT Yen, which at the time implied Debt/EBITDA of 3.83x.
Here is a financial snapshot of Softbank:

One item of note here.  Capex will be much higher in FY 2013 (year ending March 2013) as Softbank builds out en masse its 900MHz base stations.  Post this, capex is expected to normalize at ¥450BB.  FCF per share works out to ¥290 this fiscal year on a ¥2395 share price using the normalized capex figures.

Sprint Deal

It’s unclear exactly how a Sprint transaction will shake out, as Softbank is reportedly attempting to buy 70% of Sprint stock by tendering for existing shares, and also by putting in fresh capital in return for new shares.  I suspect that a tender offer for $6.50 is in the cards, as well as a deal to invest a significant amount of cash for newly issued Sprint shares at current prices.  I think shareholders in Sprint perhaps are missing out on the fact that Softbank does not want to outright buy Sprint.  In fact, reportedly a number of large holders would turn down a deal for Sprint at $6.50. 

That is fine with Son, who likes to take big stakes at attractive valuations and let them ride.  In addition to Softbank’s Alibaba 32% stake, the firm also owns 42% of Yahoo Japan, the dominate provider of search in Japan and in fact powered by Google’s search technology.  Yahoo Japan shouldn’t scare investors here, they have 56% market share and have great brand equity too.  (In the 1990s, Son acquired 40% of Yahoo when it was still in the start up phase too, not a bad trade).

So, Softbank would tender for perhaps 1.0BB to 1.5BB of Sprints 3BB shares for $6.50, taking what he can get and investing cash for another 1BB share at say $6.  That means Sprint holders likely can sell 1/3 of your shares at $6.50, and keep the rest which will likely trade at current levels give or take.  (It’s hard to assume anything different, but anything is of course possible).

So, at $5.75, while the upside to Sprint is decent over the next 2 years, in the near term I can make 75c on 1/3 of my shares perhaps, but then the other 2/3s will likely trade at current levels.  That gets me 25c of upside with a Softbank deal, but without a deal, downside of 75c a share!

See my write-up on Sprint at $2.45 when I originally purchased the name last December.  I do believe it’s ultimately an $8-10 stock in a couple of years, but the better risk reward is in Softbank right now.

Softbank Valuation
First of all, owning big companies run by tough, smart, competitive founders is usually a win.  Buying them at hugely discounted valuations is even better.  What has Microsoft done without Bill Gates?  Oracle has been phenomenal under the leadership of Larry Ellison.   Son is the Japanese version of these guys, working 19 hour days and growing up a poor Korean immigrant in a socially rigid Japanese world.  This is the kind of guy that bucks the establishment and is keenly interested in growing shareholder value, a trait surprisingly uncommon in Japanese society.

As for valuing Softbank, it’s pretty straightforward.  Some notes: Yahoo sold half of its stake in Alibaba at a $35BB valuation last May, and Dan Loeb’s reason for owning Yahoo is based on the future of Alibaba (which looks quite solid and why they only sold half), as well as Yahoo’s stake in Yahoo Japan.  He should sell his Yahoo and buy Softbank where he gets the Alibaba stake for free essentially. 
Softbank’s consolidated subsidiaries include tons of businesses, but generally can be broken down into its telecom businesses (mobile, fixed, and broadband), and its internet culture businesses (Yahoo Japan).  Then Softbank has dozens of unconsolidated subsidiaries which are accounted for under the equity method (ie the financial statements generally do not consolidate the cash, revenues, etc except under one line on both the Income Statement and Balance Sheet). 

The most important of the unconsolidated businesses are of course Alibaba, but also Renren which trades on the NYSE, Ustream, Wireless City Planning, and Zynga to name a few.  I have only given the firm credit for Alibaba and Renren (in Other Value below), and consider the others free options.  As a side note, the stake in Zynga is undisclosed.

Note figures are in BB of Yen except per share amounts or USD amounts where labeled.  I also modeled Sprint as a loser investment in my base case, dragging down the valuation by ¥232BB.  That still offers upside of 63% for Softbank holders. 

For direct comparisons sake, I modeled a $9 Sprint scenario in 2 years, which offers a double (up 105%) in the case of owning Softbank, and upside of 56% for Sprint holders (9/5.75-1).  Arguably, you could own both, however.  But if a deal falls through, you make perhaps the 17% back from Softbank immediately, or lose 13% in a Sprint investment immediately (5 / 5.75 – 1).  Again, the risk reward is skewed given the asymmetrical movements in the 2 equities post this news.

Finally, the biggest piece here is the telecom multiple.  Nippon (NTT) trades at 5.25x EBITDA, and a 9.1% FCF yield.  Slapping a 9.1% FCF yield on Softbank, and adding in the Alibaba stake would imply a ¥4000 per share value for Softbank, for upside of 67%.
As far as the downside case, I had to throw a 3x multiple on the Telecom business (half the multiple of most wireless comps and unreasonably low), and a 15% decline on the recently traded Alibaba Group value to get to a down 9% case for Softbank stock.  Seems highly unlikely to me.

Other items:
-          Softbank has offered to acquire eAccess, a rival in Japan, in a $2.2BB stock swap.  The terms of the deal include a provision that if Softbank shares drop by more than the ¥3108 base price, then eAccess shareholders can receive more shares from Softbank.  The math is that if the average price 10 trading days after October 1st is 15% below the 3108 base price, then the swap ratio gets recut in eAccess’ favor.  However, with only 2 days left the stock would have to fall impossibly low (below allowable circuit breaker rules on individual stocks) for the deal terms to change.  I also have not factored in any gains or synergies from this deal, as Softbank stock rallied over 4% on news of this takeover.
-          Much speculation as to Softbank acquiring Clearwire (CLWR) seems to have pushed that stock up dramatically too.  I wrote up Clearwire as well when it was around a buck, and at $2.32 I think the speculative fervor is a tad high.  I’d scale back.  Ultimately, I give it low odds that Softbank would recapitalize the $4.4BB of Clearwire debt (and growing) needed to avoid a restructuring, although this is pure speculation on my part.
-          Reuters reported late Friday that Softbank is in talks to borrow ¥1.8TT Yen, which is much higher than the original ¥1.0TT reported by the Wall Street Journal.  Perhaps they are looking to purchase more than 70% of Sprint, or perhaps they are merely putting in place revolving debt capacity to fund the deal as well as some refinancing of Sprint’s or Clearwire’s debt.
-          I haven’t factored in interest cost savings that the investment grade rated Softbank brings to the table for Sprint (junk rated), as well as purchasing synergies (for phones, iPhones, tower equipment, etc) that seem likely as well. 
-          Yen risk is real.  The yen is currently quite strong and could fall for a variety of reasons that any good macro analyst will tell you.  Lots of smart guys have been short JGB’s (Japanese Government Bonds) for years however waiting either the collapse in the Yen or a hike in yields.
-          If a deal is reached, Softbank shares could stay in the penalty box while Japanese investors grapple with the implications of a seemingly non-synergistic international acquisition.


It’s hard to handicap the odds of this deal.  Speculation of Softbank also acquiring MetroPCS have reportedly been denied by those in the know.  That is good, I am not sure it makes sense for Softbank to go hog wild snapping up all the third tier mobile operators in the US.  In fact, Sprint’s board also kiboshed the idea of a competitive bid for MetroPCS (which Deutsche Telecom is acquiring).  

In any case, Softbank is cheap under almost any scenario, either one whereby they purchase Sprint or not.  I am sure Japanese investors do not see the value in buying the #3, money losing wireless company in the US.  Fears of an eAccess stock ratio redo probably also contributed to the sell off in Softbank.

In any case, while it may take a couple of years and some bumps along the road, Softbank with or without Sprint is a compelling long, one that could be a double with a little patience.  Good luck.

Monday, August 15, 2011

How to Invest in a Hedge Fund Via Greenlight RE, GLRE

I was up a lot last night thinking of the problems facing our markets.  We face lots of macro risks, but at least now there appears to be some reward in select stocks I am buying. 

Macro risks to keep in mind:

1) Economic concerns in the US, as slowing government spending and weak consumer spending might push the US into a recession next year.  I think odds are better than 50% we'll double dip so to speak.  Even if we don't double dip, GDP growth in the first half of this year was a meager 0.9%, and the trend is not your friend right now.

2) European banks, which hold so much European sovereign debt, that there actually could be a liquidity crisis in the next 3 months.  With French bank BNP Paribas down 24% intraday last week, liquidity fears are clearly beginning to boil over.  It was summer 2008 that stocks like MS, MER, GS, LEH were getting hit 10% - 20% per day.  Eventually the Fed let Lehman go under, but then reversed course and bailed out the entire banking system via $800BB of TARP money.  It didn't stop financials from collapsing and the equity markets to fall 37%.  Today it's the European financial system.  Leverage among these banks is as high as it was in 2007.  It got very ugly in 2008 amidst the run on the banking system.  I honestly expect that the odds of a European bank panic are close to 100%, I just don't know when.  But it is out there.

3) China.  Yes, China has been the savior to the world's economy since 2008.  Pumping capital into infrastructure projects, lending money to consumers at an astronomical pace, loading up on commodities worldwide.  But when 60% of your GDP is derived from fixed asset investments (ie infrastructure projects), there is massive downside risk to spending.  Because FAI is not recurring in nature, eventually it has to revert to normalized levels.  FAI growth was 67% in 2009, 33% in 2010, and 25% in the first half of 2011.  I read that FAI growth accounted for 8% of their 8.7% growth in GDP last year.  When will China simply reach a level of overcapacity and slow down?  It's not consumer spending driving GDP in China, its the government.

Greenlight RE
So, looking for defensive stocks makes sense to me, but also one perhaps that has some upside if the market rallies.  The one I recommend buying now is Greenlight RE, ticker GLRE.  Greenlight is technically an insurance company.  They underwrite a variety of property and casualty reinsurance, but the reality is that it's essentially an investment in a hedge fund, but one with daily liquidity despite that fact that NAV is published only quarterly.

So, why GLRE in this market?

First of all, GLRE is only 30% net long right now.  That is, their portfolio is heavily hedged.  If the market falls 20%, then GLRE's portfolio will fall far less than the market, perhaps only 5-6%.  Second, you have to understand the track record of David Einhorn who manages the money for GLRE.  Einhorn's hedge fund has racked up double digit returns in all but 3 years since 1996, when he launched Greenlight Capital.  In 2004, he started Greenlight RE, patterned somewhat after Berkshire Hathaway.  Essentially, he sells insurance policies and then invests the float in public equities.  Through the insurance premiums he collects, he essentially gets free, long-dated capital, assuming you can at least run your insurance business at a 100% combined ratio.  That is, without losses or at a breakeven level. 

Boring Insurance Stuff
So, Einhorn raised $200mm back in 2005 via an IPO and established a vehicle that essentially invests in his hedge fund called DME Advisors.  His firm writes reinsurance property & casualty policies, collects the premium and invests it hedge fund style.  So, while there are some risks to his insurance book, his biggest exposure is $66mm in cat risk (catastrophe risk ala hurricanes, etc).  This is $66 on a book of $810mm, relatively minor.  Overall though, the key is that they run the insurance business P&L neutral, or flat net income so that they can retain the premiums for investing purposes.

Generally given the natural disasters this year (tsunami's in Japan, fires in Australia), most expect pricing on the insurance side to firm up, which should bode well for 2012.  Pricing has been horrible the last 18 months as there were few natural disasters and capital levels in the insurance industry got pretty high.  Net net, looking at the numbers below, you can see that in 2010 & 2011 to date, they incurred only small losses on the insurance side despite the weak environment, but positive insurance net income in 2008 and 2009.

Combined Ratio96.50%96.50%102.80%102.10%

Most importantly, the company books reserves for future losses in a fairly conservative manner.  When you see banks or insurers taking write-downs, you really can't ignore them.  They are the result of under-reserving for future bad loans or future insurance losses.  It's bad underwriting and speaks to poor management.  At GLRE, they have had reduced loss reserves in later years, meaning they actually slightly over-estimated future losses on the balance sheet, and increased net income later to adjust for this. 

Loss reservesChg in NI

This is good, clearly the insurance business at Greenlight isn't very likely to hurt you, and in fact could help you some.

The Meat
The important side of the business is Einhorn managing the float, or your money if you buy the stock.  While he has only beat the market by 10% cumulatively since 2005, he does so with far less risk.  He runs a long-short equity book, typically 50-100% gross long, vs 25-75% gross short.  I am generallizing here, as he modifies his net long exposure to fit within his view of the market.  In 2008, he was actually only down 17.6%, vs the market down 37%.  Then in 2009, he was up 32% while the market returned only 27%.  I have seen him speak several times and met him once, and can tell you first hand: this guy is lightyears better than almost anyone in the business.

Here is what Einhorn said from GLRE's quarterly call last week:

"The Greenlight Re investment portfolio ended the month [July] approximately 87% long and 62% short, down from 93% long and 70% short at the end of the second quarter. We believe there are quite a few stocks and sectors such as REITs that are trading at all time highs, are overvalued and we are short some of them. It is our belief that the global economic situation has deteriorated so far this year and is in worse shape than we thought it would be at this point in the cycle.

Given these concerns in addition to consolidating our long and short positions and our highest conviction investments in maintaining a modest debt long position, we continue to hold a significant position in gold, some sovereign CDS, options on higher interest rates and a few currency positions and hedges. We reduced exposures because we believe the opportunity set had become less attractive. Though we don’t usually comment on mid-month performance given the recent market volatility, we believe it's important to provide some additional commentary.

In recent days, the market has suffered a very large decline. Our conservatively positioned portfolios held up reasonably well with gains in the short portfolio and gold almost offsetting losses in our long portfolio. We have taken the opportunity of falling prices to cover some shorts and make modest long investments. As of now our quarter-to-date performance is approximately flat. We are approximately 86% long and 53% short.

Bullish Case
Lots to like here:  1) NAV (or rather Book Value per share) is flat since June 30th, while the market is getting crushed.  Yes GLRE itself has gotten crushed, but that just means you can now buy it at a mere 7% premium to NAV.  It was as high as a 40% premium to NAV at the peak.  The stock has traded from $28 just a few months ago, to $21.75 today.  Book value has fallen from $21.39 to $19.82 in that time. 

2) Exposure is light, and he has a big position in physical gold, which is performing well.

3) He owns credit default swaps (CDS) on European sovereigns, which are blowing out.  In the event of a complete liquidity meltdown, he will make money as interest rates skyrocket.  If there is a default, he will make tons of money.  I wish I could buy European sovereign CDS in my PA. 

4) with the stock at 1.07x book value and with losses expected to mitigate on the insurance side, its pretty cheap.  The stock has historically traded around 1.25x book.

As far as his long positions, his top 5 are:

Month of August Returns
Top 5-2.16%

These are names I like, and in fact have 3 in my own portfolio.

So, the S&P is down 7.5%, his top longs are only down 2.2%.  Pretty solid.  But what I like best about GLRE is that I don't think its a carefully followed name.  Case in point:  they publish their returns on their portfolio every month, so in theory you shouldn't be that surprised when they report quarterly earnings.  In May however, the stock fell 7% after reporting negative earnings.  While the monthly numbers were published on their website well in advance, a 4% hit to BV/share caused an abnormally large 7% decline in the stock.  Strange.

This month, I am hopeful that traders are panic selling a stock whose BV/share (or NAV as I call it too) is roughly flat since June 30th.  In a bull market, this stock likely could trade at 1.3 to 1.4x book, or approximately $26-28 a share.  In fact it was $28 earlier this year.  Further, if the bull market re-asserts itself and book grows as it has historically, then a $22 book could translate into upside of $29-30 a share.

The stock IS correlated to the markets.  It's one to buy on a dip, as it has lately.  Einhorn controls risk in bear markets, but it is almost impossible to make money when risk aversion translates into unbridled selling.   This was the case in 2008.  But if markets fall another 20%, I would expect GLRE's portfolio to perhaps fall 5-10%, given his net long position of 30% today.  Worst case, the stock falls to a book value multiple, and book value itself falls say 8% to $18.25.  From $21.75 to $18.25, down $3.50 a share or down 16%. 

It might be smart to buy half a position now, and wait for a pullback to buy more.

Compared to a bull case of $30/share or up 38%, the risk reward is certainly skewed to the upside.  I also think that there will be early warning signals to get a read on earnings.  Their website provides monthly investment returns.  Weakness there coupled with strength in the stock would be a clear sell signal (as was the case earlier this year). Alternatively, decent monthlies lately against a beaten up stock should equate to a buy.

Finally, if you are a buy and hold guy, this stock is probably perfect for you.  You get one of the best hedge fund managers in the business for a smidgen above book value.  He manages risk far better than a mutual fund.  Sure he charges a hefty 2% & 20% to manage the GRLE book, but his returns net of fees are also fantastic.  Plus, he can short stocks, European sovereigns, go long in an appropriate way.  Mutual funds are all pigeon-holed into one strategy, and run either 95% or 100% long without any short positions.

Since 2005, book per share has grown over 80% cumulatively or 11% per year compounded.  If that happened over the next 6 years, I would not complain, nor would I be surprised.

Monday, August 1, 2011

The Debt Ceiling Deal, A Drop in the Bucket at Best

Last night our government reached an early agreement on spending cuts in order to raise the debt ceiling.  I assume most people, even non-financial industry types, have been keenly aware of the debate going on between Republicans (via John Boehner) and Obama.  I am not terribly surprised that a deal was reached.  We have raised the debt ceiling 70 times in 50 years.  It's hardly a ceiling. 

But net net, pressure was as high as its ever been on Washington to stop dickering around.  Threats by the ratings agencies to downgrade Treasuries was also a big factor.  So, last night Obama and the Republicans agreed on a $2.5 Trillion dollar deficit reduction bill over the next ten years.  The problem is, this is akin to resolving who will pay the bar tab on the Titanic.  This fiscal ship that is our US government is still sinking.

Not Enough
Understand that with $1.4 Trillion dollar annual deficits, our 10 year total deficit forecast is forecast to be $13 Trillion.  These aren't my numbers by the way, they are government numbers, and way understated.  They always are.  $13 Trillion will likely end up being 25% higher, figure $15-$17TT as a realistic deficit number.  We have millions of baby boomers retiring starting in 2015, and their increased need for Social Security and Medicare will be tremendous.  Even at a low $13 Trillion deficit over the next decade, it doesn't take a genius to realize that $2.5 Trillion in cuts is still far from what we need to balance our budgets and get us back toward fiscal soundness.  $10TT of cuts anyone???  Don't sell your gold yet.

The question is, how will our government finance these deficits?  That is $11+ Trillion in additional bonds our country has to sell, in addition to our current maturities that will roll off.  While China gave up on large UST purchases back in 2009, now the Russians are looking to diversify into other currencies and securities as well.  The reality is that our US Treasury and Government will be forced to continue to print money to fund deficits for as far as the eye can see.  I am not sure that there really is another $10 Trillion of capital in the world willing to add to our existing $14.3 TT of debt.  I mean, the entire world's economy is only $60 TT, and we expect them to lend our government $23TT by 2021?  That's a lot for an economy that is now under 25% of world's GDP.

Some Perspective on the Size of Our National Obligations
So, if we have $11 TT in deficits over the next decade, where will we end up in terms of Debt-to-GDP?  Well, assuming a 2% economic growth rate, we'll get pretty close to 140% Debt-to-GDP by 2021.  That is pretty close to Greece today, and about guarantees our future insolvency.  But if you actually include the present value of our entitlement programs too, we are well beyond insolvent today.  I have seen total government liability estimates ranging from $50 Trillion, to $200 Trillion dollars.  These are inconceivable numbers.  To fund $200 TT of obligations with a $15 Trillion economy is impossible unless you taxed 100% of people's income for 18 years!  (in case you're wondering, you cannot tax government receipts, so its $200 TT divided by the sum of corporate income plus personal income which is closer to $11 TT).  Or put differently, if we raised tax rates to an astonishing 50% of income on everyone, it would take us almost 40 years just to fund what we owe today!  Consider too that today around half of our citizens pay no income taxes at all.

I think this first "scare" is a canary in the coal mine.  We will have many more similar debates in Washington over the next decade, and it's going to be far uglier.  Eventually the debate has to extend to Medicare, Medicaid and Social Security.  If nothing is done, then in 20 years, 100% of our tax receipts will be needed just to cover these 3 programs.  That would leave zero dollars for education, defense, infrastructure, or anything else.  This isn't our kids problem anymore, it's ours.

And how do you reduce healthcare benefits and Social Security from elderly and indigent people?  I don't know.  But at some point, you either cut entitlements, or risk default and dollar devaluation.   Debt monetization inevitably leads to hyperinflation, an economic depression, and mass unemployment.  The savings of our population would be decimated.  Imagine 20-25% unemployment and the stock market down 60% and you start to see that perhaps cutting entitlements is the lesser of 2 terrible evils. 

Economic Numbers Last Week
Amidst the "good" news of a debt ceiling agreement, last Friday we got a glimpse of what GDP looked like in Q1 and Q2.  It was ugly.  Q1 GDP growth was a dismal 0.36%, and Q2 GDP growth was a meager 1.3%. Both were far below economists' expectations.  No surprise that the US market fell 4.2% last week.  This chart below shows that in almost every instance when GDP fell below 2.0% since 1945, it signaled a recession. 

The horizontal line above is at the 2% level and the shaded areas are recessions.  I think what raises the recession probability for me is the fact that a big component of GDP, government spending, is now poised to fall.  While the details on our debt ceiling agreement haven't really been worked out, I can only assume that we'll see around $250BB in cuts to government spending over the next 12 months.  That is a 1.5% drag on GDP.  In Q2, when GDP was up 1.3%, government spending actually increased 2.2%, around $325BB annualized.  If government spending had been down $250BB, then GDP would have been in negative territory. 

The really bad news?  The stock market has fallen on average 26% during the last 11 recessions.  Today we will likely get a relief rally, but I am cautious and would lighten any risky stocks you hold.  I am hiding in cash, gold, international big caps, IG corporate bonds and dividend yielding stocks.  Good luck.

Friday, June 17, 2011

Why Greece Matters to the World Financial Markets

Greece is a mess.  Since the first crisis over their fiscal situation began 18 months ago, Greece has hobbled along, trying to avoid a default.  Last year, in May 2010, Greece accepted a 110BB Euro bailout package to refinance existing maturities of bonds, as well as to fund its yawning deficits.  The bailout required austerity measures on the Greeks however, including huge spending cuts.  Government wages were cut 15%, pensions curtailed and public services reduced.  The economic hit has been meaningful, with GDP down 3-5% likely in 2011.  And, only one year later, Greece again is on the brink of default.  I wonder when people will realize that you cannot solve a debt crisis with more debt. 

Greece joined the Euro currency in 2000.  This enabled Greeks (the government as well as businesses) to borrow at extremely low interest rates.  The following decade was marked by a huge credit binge, one that took GDP from roughly 100BB Euros, to a peak of 230BB Euros in 2008.  When the liquidity crisis hit in 2008, Greece's economy got hurt badly, while at the same time its debt problems began to come to the fore.

While Greece reported sub 3% deficits for years, and total debt less than 60% of GDP, as required by the Maastrict Treaty (to be a member of the Euro), the reality was far worse. Thanks to unreported government expenditures in military spending, as well as in healthcare spending, real annual deficits were well north of 5% of GDP.  And, in 2009, the Greek's number fudging was revealed, causing concerns about it's debt levels, and sparking the first sell off in Greek bonds.  As a side note, Goldman Sachs had been designing currency swaps that enabled Greece to avoid reporting a cool $1BB of Greek public debt.  At the same time, they began buying credit default swaps on Greece.  That is, shorting their debt.  Nice.  I am amazed the regulators had nothing to say about that.

By 2009, Greek deficits spiked to an unwieldy 13% of GDP, far far north of the 3% required by Euroland.  And, Greek government debt had accumulated to a hefty 300+BB Euros, which amounted to 127% of GDP.  Typically, the tipping point is around 140-150% of Debt to GDP.  Greece was basically on the verge of insolvency.  At this level of debt, interest rates tend to skyrocket as investors demand far larger returns to invest in riskier bonds.  And they have.  Today we are seeing extremely high rates on Greek debt.  The 2 year Greek note yields 29%.  And Greek 10 year notes are around 18%.  According to the WSJ, the CDS market implies a 75% chance of default on Greek debt.  Personally, I think its higher.

What the Europeans, and the rest of the world, fear is contagion.  This is why this mess is rattling markets everywhere.  I know, how can an economy the size of Mississippi (no offense Mississippians), scare investors from Asia to the US?  Well, the problem is that 150BB Euros of Greek debt is held internationally, mostly by big banks in Europe.  French banks alone hold 57BB Euros of this debt, German banks 34BB Euros.  What if you are a counterparty to, say, Credit Agricole in France?

Specifically, Credit Agricole has 71BB Euros of Tier 1 equity capital, against 1.6 TRILLION of assets.  That is, its 21x levered - or $21 bucks of debt for every $1 in equity!  Ridiculously high.  Further, they own 22BB euros of Greek debt.  If that debt becomes worth 50c on the dollar, then that's a 15% hit to their equity, 11BB euros.  So if Greece defaults, then Credit Agricole would likely have to raise outside capital, which would dilute their equity further.  Stock sells off.  In fact, Moody's downgraded 3 French banks this week, citing Greek loan exposure on their balance sheets.

It gets worse.  Credit Ag also has 1.5 Trillion of debt in the form of depositors, bonds, and loans from other banks.  What happens when these 1.5 Trillion of lenders/depositors get scared as the stock craters?  They obviously rush to withdraw their money as fast as possible.  A meaningful % of their 500BB euros of depositors, 150BB euros of overnight/interbank loans could get called.  That 60-70BB of capital would get eaten up very very quickly.  Literally overnight.  It's exactly what happened to Lehman Brothers in September 2008. 

Admittedly this is a bit dramatic, but the contagion could spread because US investors in money market accounts have huge exposure to European banks.  According to Fitch, 44% of assets at the ten biggest money market funds are invested in overnight loans to European banks.  You likely have unknowingly lent money to Credit Agricole (or BNP Paribas or SocGen).  And if it goes down, then your seemingly "riskless" money market account takes a hit.  If US investors start pulling money out of their money market accounts, then the run on the entire financial system would begin again, just as it did in the Fall of 2008.

The worst off is obviously Greece itself.  Or rather, their banks which hold 200BB euros of their own debt.  Greek citizens are depositors at big Greek financial institutions too, and a default could jeopardize the entire Greek financial system.  I merely point this out, not to frighten anyone, but to point out that the world's financial system is built on too much leverage.  The holders of debt of an overlevered economy (Greece), are overlevered banks in Europe & Greece.  And investors in European banks are money market investors all over the world.  That is you and me.  (well not me actually, just you.) 

Part of the solution to the problem seems to be to get the solvent countries to provide enough in loans to keep Greece from defaulting.  It's perhaps the only way to avoid another panic, this time starting in Europe and spreading worldwide.  But a loan package to get them through 2011, will just have to be upped again in 2012 and 2013, etc.  It can't go on forever, eventually Greece has to restructure. 

To sum up:  you have 150BB Euros of Greek public debt owned in Euroland, that is worth 25-50c on the dollar.  Net net that is a 100BB Euros of losses that have to be borne among European banks.  Sure Greece itself gets smoked, but to some extent, they dug their own debt hole.  They can dig themselves out of it.  So, really, 100BB Euro's of losses is quite manageable given time to reserve for it, to announce some capital raises among banks to offset losses, and to create an orderly restructuring of Greek debt.  I mean, the US housing bubble caused 1.2 TRILLION in bank losses.  So why all the fuss over $140BB (USD) of Greek losses.  Greece alone is very fixable.

The bigger contagion problem extends beyond Greece.  If you let Greece default, then likely you kick them out of the Euro currency.  Ok.  But what about the other PIIGS?  Portugal, Italy, Ireland, and Spain?  And Belgium is also under mountains of debt, 330BB Euros about the same as Greece.  While Greece carried "only" 120% Debt to GDP 3 years ago when the problem first came to light, now its around 152%.  The PIGS (and Belgium) today are at:

Country     Public Debt (Euros)      Debt/GDP
Belgium         330MM                         100%
Portugal         200MM                           83%
Ireland           100MM                          100%
Italy              1900MM                         120%
Greece           330MM                          142%
Spain              650MM                          70%
  TOTAL       3510MM

This is very scary.  3.5TT Euros of debt.  If these bonds end up restructuring, the Euro then completely unravels.  Recoveries on this debt would be 25-50% best case.  That is at least a 1.7TT Euro hit to banks and holders of this debt worldwide.  That is $2.4 TRILLION dollars of potential losses, at least. This is much bigger than the housing losses in the US, which almost brought down the entire system.

Of course a big part of the explanation was that housing losses were shifted from the private sector to the public's balance sheet.  This debt has not gone away.  We avoided a total meltdown by having US and European governments bail the banks out.  What happens when the governments of Europe and the US need bailing out?  As I pointed out from the Credit Agricole examples, banks holding this debt will potentially face a Lehman style outcome. 

Greece is perhaps the canary in the coal mine.  It's going to avoid a restructuring this year it seems, but what happens in 2-4 years, when not only Greece, but all of the PIIGS have a debt crisis?

The EU authorities apparently are close to putting together a second Greek bailout.  The IMF has pledged money today, Germany is backing down on its tough "reprofiling" talks.  (They wanted to extend maturities out by 7 years).  While Greece has 30BB euros of maturities in 2011, and another 30BB in 2012, the European leaders have no other choice it seems but to try to keep it together. 

The prospect of more government cuts is causing more rioting in Greece right now however.  The headlines look identical to a year ago with tear gas being fired upon demonstrators in Athens.  Since unemployment has spiked to 16%, more cuts just accelerates their death spiral economically speaking.  This causes GDP to fall more, and Greece's Debt/GDP ratio to worsen.

Greece should drop out of the Euro voluntarily.  Restructure their bonds in a pre-arranged fashion.  Offer a deal to give holders say 25c on the dollar.  I still have not quite understood the Greek's rationale behind staying in the Euro.  To stay in requires years of austerity, government budget cutting, and raising taxes.  It can only result in a decade long depression, just to keep a common currency with your neighbors.  Using the Euro does keep Greek inflation in check, but with a strong currency, Greece's economy will struggle to grow exports and compete with more productive, efficient countries (like Germany). 

If Greece reduces debt by 75%, and goes back to using Drachma's instead of Euros, then the value of that Drachma will be awful.  Horribly awful in fact, especially against any G7 currency.  The cost of imports into Greece (think oil) will skyrocket, causing inflationary problems.  But the benefits of inflation and restructuring are that it will fix their current account deficit problem, as well as their fiscal budgetary problems.  The pain will be severe for 1-2 years, but then the bad debts are wiped away, Greece has a devalued currency, helping exports, which in turn helps the unemployment problem.  To me, a decade of deflation and depression to maintain a currency whose benefits mostly go to Germany makes zero sense.

Risk aversion will be paramount for the time when Greece actually does default.  I think its out there, but I cannot even guess if it will be next year or 2014.  Euro puts are potentially a decent trade, but you have to get the timing right.  135 strike Sept Puts on FXE cost 7.50.  So you need a 127.50 Euro price to break even by September, with current exchange rates around 142.  Seems expensive to me. 

Clearly financials holding PIIGS sovereign debt will also suffer in Europe, as banks there are like banks here loaded with crummy mortgages.  Hard to find places to hide, but I still like gold, big cap defensive names, shorter duration corporate bonds and cash.  Good luck.

Monday, June 6, 2011

The "Sell in May" Phenomenon

I am not sure why this is true, but it is.  If you had invested your money in the Dow Jones every year since 1950, but only during the months of November through April, you would have made 7.4% on an annualized basis.  The May thru October returns of the Dow since 1950?  Only up 0.4% per year.  So, here we are and it's June, and the question comes up again.  Should we have sold in May?

The truth is, there do seem to be valid seasonal anomolies that contribute to the "sell in May" theory.  Vacations in the summer and lack of newsflow impact returns in the summer.  Also, pension contributions, tax refunds, year end bonuses, all occur during the November thru April timeframe.  So seasonally speaking its a tough few months until we get to November 1st.

So, this year, on top of the normal seasonality, we have a market that has run up 18% since September 1st last year.  There is a fancy statistics phrase I love that describes the weather, and also the stock market: serial autocorrelation.  That is, if its unusually hot on Monday, then its much more likely to be similarly hot on Tuesday, and even Wednesday.  The market is the same way.  Returns are correlated to the returns of the day before.  It's not a random walk.  Given that we are down for 5 weeks in a row, its more likely that we will continue down for the next 5 weeks.  Knowing also that liquidity is a big driver of the market, you can ride the momentum a bit, that is until there is "game changing" news. 

Last summer the market sold off 16% from peak to trough, beginning its decline in April and ending around September 1st.  The announcement of QE2 at that time was the catalyst (ie the game changing news) that ended the downdraft.  We might need a QE3 announcement to break out of our current weakness, but all indications are that QE3 won't happen for at least 3-6 months.  I suspect that continued economic weakness (on top of more fiscal deficits), will ultimately give the Fed an excuse to restart easing.  Or force them to.

So that is the somewhat weak technical picture.  The fundamentals aren't so great either. 
 - Unemployment ticked back up to 9.1% in May.
 - The manufacturers ISM index fell by the most in May since 1984. 
 - Consumer confidence fell to 60.8 from 66, a pretty meaningful decline.
 - GDP was revised to 1.8% growth for the first quarter of this year, down from 3.1% growth in Q4 2010.
 - Housing continues to worsen, see prior blog on that.
 - Leading Economic Indicators, designed to forecast economic activity 6-9 months out, declined in April by 0.3%, the first decline in the past 12 months.
 - S&P earnings estimates for 2011 are hitting new highs.  ie, with economic weakness, it makes it less likely that earnings will be able to match or exceed expectations.

This chart from the BLS below shows the employment problem in our country.  While the unemployment rate is seemingly improved, if one adds in the "discouraged workers" (the ones that have given up looking for a job), then really we are pretty close to the lows. 

This chart specifically shows that labor force participate rate through May this year.  Only 58.4% of our population is working, pretty close to the bottom and way down from almost 64% in 2007.  On the whole, we aren't creating new jobs in this country.  We are bouncing along the bottom, and that is despite massive stimulus in the past 2 years.  It's a little frightening to ponder what happens to this when the government reigns in its spending in an attempt to fix our deficit problems.  (hint there are 2.2mm employees that work directly for the federal government, countless others indirectly).

So, here are some suggestions for ways to profit and protect your portfolio during the next 3-6 months.

 - Sell calls on stocks you own that are up.  I sold some Cigna 49 strike calls last month, essentially creating a covered call position.  The stock has been a big winner over the past year, and I do still think its cheap.  But if the market and the stock lag for the next couple months, I will get to keep the premium and effectively create a dividend on it while it lags.  That is, as long as it stays below 49 through expiration.  If it goes higher, my shares get called away so that I sold it effectively around 50.50.  I am happy with that trade too.

- Short SPY.  I almost always have a SPY short on, and its a good way to protect your longs.  It's my biggest single position right now after adding to it last month.

- Sell your losers.  Or sell half of your losers.  I almost religiously follow a 10% stop loss, and you should too.  Losers tend to stay losers, winners tend to stay winners.  See above on serial autocorrelation.  If you have a name down 20%, sell half of your position, which results in your owning 40% of your original position.  Its future impact on your portfolio will be mitigated.  And its likely to keep going down especially in a bad tape.

- Buy bonds.  I don't really recommend US treasuries, but ETF's like CSJ or LQD are great.  They benefit from lower rates, and declining yields, without taking on the balance sheet risk of the US government.  CSJ is a high grade corporate bond ETF, very short duration.  LQD owns the same high grade bonds, but is longer duration.  It's up 3% YTD, and yields 4.7% still.  CSJ is less risky, and yields 2.2%.  Please please please do not own government bonds maturing more than 1-2 years out.  I don't have a clue how much longer you can own them; if so you are just praying that this manipulated market continues to be manipulated. 

- Sell some EM stocks/funds.  Emerging markets tend to exhibit higher levels of autocorrelation than developed markets.  So much risk aversion money leaves these countries, that they get especially hard hit.  The diminished liquidity also makes for lower multiples, and bigger gap down risk.

- Reduce commodity exposure.  I have some British Petroleum BP on the sheets, but have been long puts on CHK.  Chesapeake was up over 50% in 6 months by April this year, and natural gas prices were roughly flat.  Didn't seem to make sense to me.  I bought some at the money puts that have been great in offsetting my BP losses.  (CHK is down over 10%, and my math on their ROEs is 2.7%, pretty lousy).

- Own defensive industries, Food/Utilities.  Food stocks have weak performers in the last six months, as many are grappling with higher input costs.  Corn and coffee prices have doubled in the past year, suger is up 63%.  These higher costs are not easily passed on to the consumer and pressuring margins at companies like P&G, Kraft KFT, Kellogg Co (K).   I think they will likely see some relief from commodities if the market continues to weaken post QE2.  I have owned KFT for about a year now, and not only will ag commodity declines help margins, but also their dividend yield (3.4%) becomes more attractive as overall yields fall. 

Same can be said for utilities.  XLU is a decent ETF holding utility stocks.  It yields 3.9%, and has been exactly flat as the market has sold off 5% since April 29th.  I own UTF which is a utility/infrastructure closed end fund, and its only off 1% or so vs the markets 5% decline.  Swap out of consumers/cyclicals into these names.

 - Gold/Silver?  No clue.  I lightened my GLD exposure, but really will never sell gold "as long as we have powerful fools running our central bank" in this country.  Marc Faber quote.  So far GLD has stayed near its highs.  SLV I think is broken and riskier.

I have very little confidence in the markets this summer.  If asset prices were cheap, it would be a different story.  But almost anywhere one looks, prices are fully valued, or near so.  Sure, a bubble could develop pushing prices higher, but I am not banking on it this time around. 

As Howard Marks points out in his latest letter, "asset prices fluctuate much more than fundamentals."  The emotional swings of fear and greed create far more changes in stock prices than is usually warranted.  I have been keeping my exposure around 30% all year, but now probably am closer to low 20s% now in equities.  Panic isn't here yet, but it may be coming.  And it's panic that you want to buy.