Saturday, March 16, 2019

The Absence of a Trend can Mark Opportunity...

Marc Faber once wrote that all great commodity bull markets started from a low that was put in place by oversupply. The question to answer is whether the present glut of many commodities will one day be replaced by a tight supply. The Baltic Dry Index is a proxy for dry bulk shipping stocks. It has been plagued by continuous oversupply for the past 10 years. Faber attributes the depressed Baltic Dry Index to continued weak global demand, caused firstly from slowing growth from China’s steel production. As of 2016, the Baltic Dry Index had lost 98% of its value since 2008, marking the lowest level since 1985 [1].

Kopernik Global portfolio manager Mark Kinney offers an alternative theory for the depression in the shipping industry, stating that it is the result of the Fed’s QE programs that have created such an extreme. The toxicity of QE lies in its consequences. Industrial commodities like oil, coal, and iron ore become much cheaper, causing a premature end to the commodity super cycle. Those commodities are transported by dry bulk carriers. Additionally, because money flows into banks and M&A, dividend payouts, and share buybacks, investments for new productive capacity lack financing and liquidity. Quantitative easing also reduces the end user consumption of manufactured goods, leading to shocks all along the value chain.

In 2018, surplus tanker capacity - namely VLCC’s - and weak oil demand - due to production cuts by oil exporting nations - are still persistent. Earnings remain incredibly depressed, with an average about $6,000-$10,000 per day [2]. Meanwhile, the average break-even cost has risen to around $2,200 per day [3]. How did earnings become so depressed in the first place?

Rewind to the period between 2002 and 2004. Freight rates were increasing leaps and bounds in tandem with increasing commodity prices. As a result, container companies were cash-rich and highly profitable. Bankers, seeing opportunity to make returns for themselves and their firms, egged on the shipping boom by lending to shipping companies at artificially low rates. Emerging markets, led by China, were hooked. Lending increased profitability for the shipping companies themselves in the form of new container shipping orders. In the 1990s, the average ship earned roughly $10,000-15,000 prepay. By 2000 the average was around $24,000, $39,000 in 2004, and $50,000 by 2008 [5]. Many shipping companies were investing heavily in ship building projects at the height of the boom in late 2006 and 2007. (Note: for reference, new tonnage takes about 2-3 years to deliver) By the time the ships were being delivered in 2008, demand had already crashed.  Without adequate revenues from ships [4], shipping companies were unable to service their bank loans, leading to bankruptcies and the contraction of credit.

Similar market peaks in 1967, 1970, and 1973 triggered investment bubbles with resultant structural imbalances in supply and demand, which took 20 years thereafter to clear. In 1997, demand finally caught up with supply. What seemed to be a recovery was soon postponed by the Asia Crisis and the crash of 2001. As the average ship approached 30 years of age, the shipping industry entered the boom in 2003 with investment hardly sufficient to replace the remaining ships built in the 1970s bubble. The carrier building boom was driven by China’s steel production. Shipyards with little to no orders led to new building prices to double. Capacity expansion was undertaken at a very short notice, with the order book increasing from 15% in 2002 to 47% of the fleet at the late 2007 peak.

Given historical cycles, it could take anywhere from 10 years (which have already elapsed) to more than 20 years. Though monetary QT would serve to reverse the depressed cycle into a recovery, this is highly unlikely at this point. Instead, an inflection point will probably come from real interest rates rising, causing an increase in prices of commodities. Only then could we see a rise in the Baltic Index. For now, it remains both cheap and undervalued.

Source: CNBC charts

[1] Bulk Shippers Hit by Perfect Storm, Fortune (2016)
[2] Overcapacity Threatens to Capsize Global Tanker Market, WSJ (2018)
[3] A Storm is Gathering Over Container Shipping, WSJ (2018)
[4] The Financial and Economic Crisis and Impacts on Shipping, Journal of Social Sciences (2016)
[5] The Great Shipping Boom 2003-8, Stopford (2008)

Friday, March 15, 2019

Building Boom, Building Bust: Headlines Tell the Story

“‘There’s a lot of inventory to be cleared, and towns to be filled up, therefore the investment incentive is not strong.’”
China’s Ghost Towns Haunt Its Economy, WSJ (Jun. 2018)

[On China’s 22.4% vacancy rate] “‘There’s no other single country with such a high vacancy rate…should any crack emerge in the property market, the homes to be offloaded will hit China like a flood.’”
A Fifth of China’s Homes are Empty. That’s 50 Million Apartments, Bloomberg (Nov. 2018)

A building splurge…ended in half-finished projects and a trail of angry investors from some of the country’s wealthiest areas.”
China's Building Boom Hits a Great Wall of Debt, WSJ (Feb. 2019)

"The whole entrepreneurial class is, as it were, in the position of a master builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master builder’s fault was not over investment, but an inappropriate employment of the means at his disposal." -Ludwig von Mises

Wednesday, February 27, 2019

Tomorrow's Gold: Russia's Opportunity

In 2017, Polyus PJSC, Russia’s largest gold mining company, bought rights to Sukhoi Log, a prospective gold mine in Siberia. Then, in 2018, a study was conducted revealing just how much gold there was buried underground. Sukhoi Log hold approximately a quarter of all Russia’s known gold underground, or 63 million ounces [1]. Currently, the company has a 58.4% stake in the plot, and is eventually planning on buying the rights in its entirety. But what does a publicly listed mining company have to do with the Russian currency?

Here’s where it gets interesting. Polyus sells their gold exclusively to large Russian state banks, who resell it to Russia’s central bank. According to the article by the Wall Street Journal, that gold can be used to support the ruble, and can increase reserves for cushioning the Russia’s financial system in times of crisis. From an Austrian perspective, a gold-backed currency checks inflationary booms by the withdrawal from the reserve of gold, and the redemptions and cancellation of paper currency that follows. It sets limits for a currency to fluctuate, because it is bound by a limited supply.

Reviewing recent data from recent years shows that the Russian central bank is no stranger to increasing its exposure to the so-called “barbaric” metal. Since 2014, the country’s central bank has been increasing its gold reserves from around 10% to the roughly 17% it stands today. That upward trend is rather significant, even compared to China, whose reported reserves have been stagnant during the same period.

Spurred by increasing tensions with the US, including the recent US-imposed sanctions, Russia is acting in anticipation of moving away from a dollar reserve world. In mid-2018, Russia transferred nearly a $100 billion in US Treasury notes into yen and yuan [2]. Simultaneously, it bought 274.3 tons of gold, according to the World Gold Council. It now stands the Russia has more gold, in tonnes, than China (see photo below). As of November 2018, its stockpile of treasuries has around $12 billion [3], eliminating Russia from the US Treasury’s list of major holders [4].

But back to the ruble. Although the Russian currency has lost nearly a quarter of its value against the US dollar in 2018, the decision to move towards a currency backed by a commodity such as gold is a smart one. It could enlarge the means of payment, making it easier for Russia to pay cash for imports of finished goods and services. Furthermore, it would reduce the need for direct or indirect granting of credit to weak import-balance nations. If anything, the point to remember is this:

In a world where central banks see the solution to every problem as opening the floodgates of easy money, in the long run, it’s better to have backings in something intrinsically valuable, than to have blind faith in fiat.


Friday, February 8, 2019

The Italian Tragedy

Towards the end of 2018, Italy slipped into a (technical) recession. Italy's GDP growth was -0.2% in Q4 [1]. For several years now, Italy's economic position has been in a very fragile state. At present, its country's debt to GDP ratio stands at 132%. Although one measure makes the situation warrant concern, more worrisome is how the country has attempted to deal with the lofty sum.

Since 2015, the ECB has executed a QE program encouraging member central banks to purchase their own country's debt in proportion to the size of the country. In some cases, this has led to triangular transactions, in which the foreign sellers of Italian bonds will ask the ECB to credit the payment orders [2]. So, the Bundesbank has to credit not only the direct payment orders from the Italian government but also in the indirect orders resulting in the Bank of Italy's repurchases in third countries. Because of these transactions, the ECB has been the biggest buyer of Italian government debt. On behalf of the ECB, the Bank of Italy has bought more than $350 billion of multi-year treasury bonds since May 2015 [3]. The proportion of Italian gov. bonds held by the Bank of Italy since 2015 has grown from 5.8% of total outstanding debt to 19.3% [4]. The country itself has the highest proportion of debt held by residents and the lowest proportion held by foreigners.

Large foreign banking investors and institutions have continued to shed close to $69 billion (net) of Italian government debt. Since June 2019, capital flows have recovered somewhat [5]. Foreign direct investment, has also shown signs of substantial weakness since then [6]. The BTP 10-year spreads have been above 200 basis points for several months now, which (according to one source) can have spill-over effects into other EMU sovereigns [7]. Sharp moves in that spread, say an increase by 100 basis points, reduces the Common Equity Tier 1 capital of Italy's two largest banks by 35 basis points. The impact is nearly twice as large for mid-sized banks. Already we're beginning to see how fragile the Italian banking system is. Banca Carige recently received a $400 million emergency injection of cash to stay afloat after declaring bankruptcy [8].

Italy Capital Flows

Italy Foreign Direct Investment

A leading indicator of Italy's impending debt crisis can be observed through CDS spreads [9]. In 2015, ISDA introduced a new CDS contract to protect against euro area countries redenominating their debt into new national currencies. The spread between the new contract, and the old contract (2003) shows the potential for depreciation in the event of a redenomination. The only way that doesn't trigger a credit even is if Italy's debt is redenominated into a reserve currency, such as USD, CAD, the British pound, the yen, or the Swiss franc.


As of February 7th, 2019, Italy's 5-year CDS rose to 232 basis point, UniCredit's 5-year CDS to 169 basis points, and Intesa Sanpaolo's 5-year CDS to 178 basis points [10].

If and when the debt crisis does play out, some economists at the Bundesbank have advocated for a national fund. The fund would be financed through "solidarity bonds" that Italian households would be forced to purchase according to a fixed proportion of their net wealth. As bleak as this may seem, it highlights the ignorance of economists refusing to acknowledge the problem itself: a common currency system within a network of nations who have vastly different fiscal and political systems.

With that, I'd like to end with two quotes from Friedrich Hayek's wonderful book, The Road to Serfdom:

"We are ready to accept almost any explanation of the present crisis of our civilization except one: that the present state of the world may be the result of genuine error on our part and that the pursuit of some of our most cherished ideals has apparently produced results utterly different from those which we expected."

"Only if we understand why and how certain kinds of economic controls tend to paralyze the driving forces of a free society, and which kinds of measures are particularly dangerous in this respect, can we hope that social experimentation will not lead us into situations none of us want."


Friday, February 1, 2019

The Fed's Trouble with Leverage

QT is coming to end after a very short run. Since 2017, the Fed was attempting to "wind down" its massively bloated balance sheet of worthless mortgage securities and monetized debt (Treasuries) from the last financial crisis. While the truth was long overdue, in a recent WSJ article [1], Lorie Logan, an executive at the NY Fed, finally admitted last May that she saw, "virtually no change of going back to the pre-crisis balance sheet size." Unfortunately, what this means is that with an end to QT, there will be an inevitable transition to QE.

Even more troublesome is looking at what's already on the Fed's balance sheet. On first glance at the balance sheet as of Jan. 16th, 2019 [2], the Federal Reserve has a leverage ratio of approximately 103:1 (total assets: total capital). However, the real problems are swept under the footnote rug. An article by Alex Pollock [3] delves into the Fed's accounting rules, and sheds light on some financial shenanigans. Supplemental Information #2 in the Sep. 30th, 2018 financials [4] shows information on "System Open Market Account Holdings," In other words, these are the securities that the Fed purchased after 2008 as part of the QE programs.

It writes: "Treasury securities, government-sponsored enterprise (GSE) debt securities, and federal agency and GSE mortgage-backed securities (MBS) are reported at amortized cost in the Combined statements of condition." (emphasis mine)

First of all, is it allowed? According to rules from 1931 and 1992, it is. In 1931, it was allowed that banks could value certain "investment-grade bonds" at "intrinsic value" instead of at market. This allowed for other methods which were deemed more appropriate at coming to the real value of the securities, where the market would mark them too low. A government accounting rule enacted in 1992 pertaining specifically to real-estate related assets, extended the old rule, allowing their net worth to be valued by their "intrinsic value" as well. Unfortunately, it is also permitted that a government and the Fed can make up their own accounting rules.

It is important to point out that amortized cost is not the same as mark-to-market. Mark-to-market method is much more conservative, and if there are losses in these securities, it underestimates the number. As it happens, the Fed does have unrealized losses on those QE-purchased securities. Contrary to what economists and mainstream media practitioners say, those securities are indeed worthless.

Moving onto the table below the footnote, it shows just how big these losses are, at amortized cost. While the cumulative unrealized losses on Treasury Securities notes are approximately $27.76 billions dollars (as of 9 months ended, 2018), but the total Treasury Securities unrealized loss is only $770 million. Meanwhile you also have to factor in the other row: the total cumulative unrealized losses on Federal agency and GSE MBS are $66.453 billion.

And what's paid in capital again? As of Jan. 16th, 2019, the total capital paid-in is $32 billion. 
According to Mr. Pollock from an interview in the Grant's Pub Podcast [5], the Fed can raise another $32 billion from shareholders. That is, from commercial banks who are members of the Federal Reserve.

But, it's still not enough. How will the Fed cover the rest of the losses? With interest rates rising, the unrealized losses will grow bigger, and the Fed's net worth will be more negative. As noted earlier, there is a strong probability that the Fed will attempt QE yet again to reverse the losses.

Since I do not claim to be a forecaster, I will invoke Mark Twain on this one: History seldom repeats, but it does rhyme. This is to say that this instance of financial shenanigans is quite reminiscent of the 1980s savings and loans crisis. Readers of history are all too aware of the ending in that story…


Sunday, January 20, 2019

Alcon, Part III: Financial Analysis, Risks, Catalysts

Financial Analysis
Luckily, Alcon’s financials are pretty straight forward. To analyze, it’s best to compare Alcon’s present condition with the “old Alcon.”

To start, let’s look at factors surrounding working capital. Working capital turnover presently is faster than it was at Alcon 2010 and before (3x vs. 2x). This shows that over time, the company has improved on its working capital management and is more efficient today. In contrast, Fixed asset turnover is much slower in the present Alcon than at old Alcon (2-3x vs. 5x). This is due to the fact that Alcon produces much less revenue than it did in the past. The number should increase in the future as the company turns around. Inventory turnover is slightly faster in recent years than it was in 2010 and before (3x vs. 2.5x). Although, if looking at inventory compared to sales, the number has risen from 2010, but stayed constant, at around 0.18 vs. 0.1. This is again due to the fact that sales have been depressed after Alcon was acquired by Novartis. Alcon’s receivables turnover is roughly the same as it was in the past (5-6x), as is the payables turnover (6-7x).

Alcon’s current ratio is much more stable (and higher) now than it was in the past (3.5x vs. 1.5-3x). Its cash ratio, on the other hand, is much smaller now than was before (0.2x vs. 1.2-1.4x). Comparing cash to debt, the ratios were 1.15x (2017), 0.65x (2016), and 1x (2015) compared to 7.49x (2010), 4.54x (2009), and 2.18 (2008). In the absolute sense, Alcon’s cash on balance sheet has significantly decreased from $1B to around $170M. Debt to equity is roughly zero as is LT debt to equity in the present Alcon. In 2010 and before, it was roughly 10-50% (decreasing over time), and 1%, respectively.

Alcon’s debt situation will change with the spin-off, however. The company plans to incur $3.5B in debt financing from Novartis, resulting in a debt/equity ratio of 0.15. At Sept. 30th 2018, Alcon had cash of $172M, current financial debt of $115M, and non-current financial debt of $87M. Interest expenses are expected to be between $140 and $160M per year.

How well does the company cover interest now (the little it has currently)? By operating cash flows, interest is covered 94x (2017), 59x (2016), and 91x (2015). By free cash flow, interest is covered 62x (2017), 38x (2016), and 62x (2015). With the extra debt financing it will incur, interest coverage by FCF will drop to roughly 4x and by OCF, approx. 8x.

The company is highly cash flow generative. It produces free cash flow of $803 (2017), $801 (2016), and $924 (2015). The old Alcon produced much higher free cash flow, but as the company recovers, it may return to these levels: $2,066 (2010), $2,074 (2009), and $1,730 (2008). In terms of the investment trend, the new Alcon’s capital expenditures are much higher than its depreciation, mirroring the healthy trend at the old Alcon.

1.     Major competitors in contact lenses offer competitive products, plus a variety of other eye care products including ophthalmic pharmaceuticals, which may give them a competitive advantage in marketing their lenses.
2.     Vision care competes with eye glass manufacturers and providers of other forms of vision correction including ophthalmic surgery
3.     Contact lenses market characterized by declining sales volumes for reusable product lines and growing demand for daily lenses and advanced materials lenses
1.     Alcon expects cannibalization of reusable contact lens sales
4.     Voluntary market withdrawal of CyPass micro-stent glaucoma product (Aug. 2018) will have adverse impact on business ($337M impairment charge)
5.     Pricing pressure from government and insurance programs
1.     Physicians, eye care professionals, and other healthcare providers may be reluctant to purchase our surgical products if they do not receive adequate reimbursement
  1. Alcon surgical experiencing slight decline due to competitive pressures on IOLs
  2. Vision care, private label growth and retailer branded lenses may drive the commoditization of contact lenses and further boost the bargaining power of our distributors and retailers

1.     $5B in share buybacks
2.     margin expansion due to cutting amortization expense
3.     progression of innovations as mentioned in previous sections