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Monday, April 30, 2012

A Value Guy Goes Macro

 Every once in a while I like to take a peek out of the office and see what is going on in the world around me. My decisions are made on a company company, security by security basis and I try to ignore what I consider the white noise of short term market movements. I keep the financial networks on in my office but for the most part I find them more humorous than useful. Making investment decisions based on market gyrations or news flow has always ended badly for me so I eschew that type of behavior most of the time. I am trying to buy decent businesses at very cheap prices and own them for the long term.  Short term events do not factor into my decisions unless they provide better price points and even that is determined by individual company value and stock price evaluations.

 Once or twice a year I do find it helpful to stop for a minute and consider the bigger picture. I am not looking for trends or trying to make predictions as much as I am looking for potential cheap assets and sectors I may have overlooked. I push aside the stack of 10Qs and 10Ks, temporarily return my copies of Security Analysis and the Baseball Prospectus to the bookshelf (or according to my wife the top of the stack on the floor) and focus on charts of the world. I start with global stock markets, currencies and even commodities. I will look at the sector and industry charts from various markets. I even break out the commodity charts to see what physical and financial assets are trading at multiple year lows and may lead to safe and cheap investing opportunities.

I started that process this morning by looking at global stock market performance over the past year. We have seen a global coordinated stimulus program inflate many asset prices and keep some markets from collapsing in the aftermath of the credit crisis. It has worked for the US as markets are up 10% year to date and stock prices have doubled in the past three years. A quick look at global stock prices shows that most indexes are up year to date with Spain and Italy being the most notable exceptions.

However the year to date figures masks a much greater long term weakness in stock prices. When I look at the past 52 weeks most stock markets are still solidly in the red. Over the past three years very few markets have had a price recovery anything close to what we have experienced here in the United States. Many markets including the market many consider key to full recovery, China, are still trading relatively near the 2009 lows. Japan has improved over the past three years but not by anywhere near as much as the United States. Only India has had returns approaching those of the US domestic stock market. I have no interest at all in anything China but the relative weakness of Japan may be worth investigating for potential safe and cheap stock opportunities. I am already long some major Japanese banks (MTU and MFG) and am not opposed to buying more stocks in the Land of the Rising Sun.

It will come as no surprise that Europe is where the real stock pain is located. Most of the major European markets are down over the past 52 weeks. Spain and Italy are two of the major concerns on the continent these days and their markets reflect that fact. Both are down year to date, the past 52 weeks and are showing negative returns over the past three years. Although Spanish and Italian bond yields are rising I do not think we have reached the point of maximum pessimism in those two trouble nations yet. It is worth the time to check out some of the major companies in those nations for stocks like Telefonica SA (TEF) or Telecom Italia (TI) that may become bargains as maximum pessimism moves closer to reality. I am also tracking the major Spanish Banks such as Banco Santander (STD) but they have a ways to fall before reaching that 40% of book value I consider a good entry for distressed banks.

The next part of my search for cheap is flipping through commodity price charts to see which of these markets has collapsed and declined over the past year. When I was a younger man I was fascinated by the idea of trading commodity futures but the markets quickly proved to me that a value bias in futures is not really healthy unless you approached it with a much larger bankroll than I had at the time. In spite of that paying attention to commodity prices makes sense for a fundamental investor. They are the raw ingredient for the products made by many companies and are a huge input into margins and profits. Cheaper steel could mean more profitable cars for Ford (F) and cheaper coffee prices could boost Starbucks (SBUX). I do not trade commodities anymore but I do check the prices from time to time to see if anything unusual or potentially profitable is occurring.

One commodity that leaps off the chart book for me is cotton. Cotton prices on the New York Exchange have plummeted by more than 40% over the past year. Slowing demand, the end of China’s purchasing program and an export ban in India have helped the fluffy stuff declined over the past several months. Demand is expected by many analysts to remain weak and that could keep prices fairly low thought the summer. This could be a boost to the margins of apparel manufacturers like Oxford Industries (OXM) or PVH industries (PVH) for whom cotton ins an important raw material.

Coffee and Cocoa have both declined over the past 52 weeks and that is welcome news around Chez Melvin. I drink coffee like water all day and the wife and daughters are overly fond of cocoas end products as well. These declines are not only helpful to consumers but a company like Starbucks (SBUX) that uses a fair amount of both could benefit as well. Most coffee firms lock in prices well ahead of time so the boost in profits for these companies may not come until the end of 2012 or early 2013. Even if delayed a more than 30% decline in a raw material that is around one sixth of your cost of goods has to help the profit margins eventually. I am not a fan of the coffee stocks like Starbucks as Dunkin Donuts (DNKN) but momentum investors may want to be aware of the potential for positive earnings surprises the next few quarters.

Lower wheat and corn prices could be great news for consumers as well Wheat is down more than 20% over the past year and it looks like there will be a surplus that could put additional pressure on prices. Corn is down a little less than 20% but any decline in these key grain market form shoppers feeling the pinch of food inflation over the past year. The declines in many food commodities could also provide a small boost to margins for some of the beleaguered grocery chains such as SuperValue (SVU).

One of the more interesting commodity developments is in the energy sector. Natural gas has been talked almost to the point of exhaustion. We all know that slowing demand and an enormous amount of new supply has driven the price of NG to decade lows. At the same time increasing regulations and slow demand has pushed the price of domestic thermal coal to low prices as well. Coal is not quite back to the lows of 2002 but it is not far from those levels either. Digging a little deeper I see the uranium Oxide is selling neat five year lows as well.  These are the three major fuel sources for electricity generation in the United States and the prices have been falling for some time. One would think that this would be a boon for electric utility companies.

When I look at the profits for the regulated utility companies in the United Sates I see this is far from the case. Most are struggling to get back to the profit levels of several years ago and the return on equity and capital for much of the industry is still well below pre-recession levels.

When I look at electric utility stocks none of them are cheap in spite of the obstacles and weak profit environment. Yield chasing has pushed them well above tangible book value.  I have never lost money buying a regulated utility below tangible book value and I have never seen much money made purchasing these stocks above that level either. If the costs of fuels such as natural gas, coal and uranium begin to rebound over the next year or so profits for these companies could plunge even further. Reviewing commodity charts makes at least one thing very clear to me. Electric utility stocks as a group are a sell and avoid.

I am not a macro, chart or commodity guy as you well know by now. However spending a little time with charts of various assets and markets around the globe can provide valuable information even for a value guy like me.

As the final step in my annual to semiannual macro review I like to look at sectors and industries in the stock market to see what is way up and what has lagged the market by a large amount. Often I find that some sectors that do not show up in my traditional stock screening methods have performed in a manner that gives valuable economic information and may also provide investable opportunities. When you tend to have your head down in individual company reports you can miss some trends and data that can improve your understanding of the big picture as well as factors that may affect stocks I already own.

Searching don the list of top performing sectors I see some predictable groups like Luxury Goods. Those that have money can spend money. During the early days of the recession this sector dropped off a little as the wealthy curtailed spending for the sake of appearances but they are back with a vengeance. Companies like Coach (COA) and Tiffanys’s (TIF) are doing very well as those who have it, spend it. Barring a deep double dip recession that is not going to change. The stocks are too rich for me to buy but I do not suggest shorting them either and momentum types might want to have these stocks on their radar screen.

One group that is initially a huge surprise is Recreational vehicles. The group has performed extremely well and with high gas prices and a cautious consumer that does not appear to make much sense. When I dig a little deeper I see that it is companies like Artic Cat (ACAT), Polaris (SNO) and Harley Davidson that have done well. Traditional RV companies like Winnebago (WGO) are still struggling and their stock price is languishing. Motorcycles, snow mobiles and Jet Skis all fall under my addictive lifestyle banner and are seeing some pent-up demand emerge as the economy becomes less horrible. These companies may face tough comparisons next year as demand flattens and gas prices remain high.

One group on the non-performers list that is interesting is long term care facilities and providers.  Intellectually this would seem to be a group that would be booming. Demographics are strongly in their favor as the population ages and long term heath care becomes more of a concern. However rate reductions from Medicare and aggressive claim processing to avoid what Medicare officials deem over treatment are hurting most of these firms. Should the Supreme Court throw out Healthcare reform most analysts feel that this would be another negative for the industry. Many of the companies in this industry use a lot of leverage and that’s where my interest lies. I am far more interested in the debt and potential recovery rates of long term care companies than I am in the equity. It is worth investigating potential high yield and distressed opportunities in this group.

Looking at the rest of the nonperforming groups there are not any real surprises. Coal and natural gas related companies are on the list as those two commodities prices have declined. These are two sectors I am watching closely. Most of the stocks are not cheap enough on a price to book value basis yet but I am confident they will get there. So far my two major longs in natural gas are Penn Virginia (PVA) and EXCO (XCO) but I expect to add to that list over the rest of the year. So far I have not bought any coal stocks but I expect that to change by the end of the year as well.

I also note that in spite of the news and trading action in larger regional and money center banks that community bank stocks have not rallied much yet. The Aba Community Bank Index is still down almost 7% on the year and over the past five years has fallen by almost 50%. The Trade of the Decade is still very much viable and I am still selectively buying stocks across the group.

As I conclude my peek at the macro picture I find that it is very much in line with the micro view uncovered by single stock screening and investigation.  When I stick my head up each year and take a macro look I scribble down and my findings and create a mythical macro fund and track it over time. Last year my imaginary macro fund was long the dollar and Japanese banks and that worked out pretty well.. This year it would be long Japanese and British banks, long coal, uranium and natural gas, short electric utilities and recreational vehicles and long high yield debt in long term care facilities. I would also be long community banks and cotton. It will be fun to track how these work out over the  next year but more importantly I have gained some insights and information that will help me select potential safe and cheap stocks that can return in multiples not percentages.

Originally published as a series on Real Money

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