Suppose an American investor was concerned the market was pricing risk assets too agressively relative to his estimate of fair value for the market index. The investor may decide to be 100% in cash and wait for the right moment (when risk assets are priced less than what he believes they are worth).
However, the USD depreciated 20% during the last 2 year. This means his purchasing power globally has declined, though he may say it has not locally (he would be foolish, in America many goods the investor purchases are made abroad, hence his purchasing power has decreased because his costs have increased whilst his capital has generated zero income due to 0% interest rates). Overall, his wealth has decreased by making what seems like a wise decision.
We can say he was wise because he lost less money than if he was invested 100% in the market - at least that seems to be the case for the moment.
However, the reality was he was foolish because he explicitily assumed (without even probably being aware) that the USD was the only currency in the world, hence why he only holds USD.
Making a decision to hold cash may be a good asset allocation decision when compared to bonds or equities and other risk assets - but it might not be the same as having held cash in AUD or SGD during that same time period as the investor was holding USD cash.
Furthermore, often when currencies decrease in value, their assets may increase in value. This typically happens in the US due to the strong faith people have in this currency. Hence when it weakens, many foreign investors buy US assets which seem cheaper relative to foreign currencies. Hence our USD American cash investor is priced out of the market and is forced to continue holding USD cash paying zero income if he keeps his same criteria.
To ignore that financial markets are becoming more globally interconnected and hence one must appreciate the cost of a security and the value of the money the security is priced in, is to be foolish and to ensure certain suffering.
Friday, 19 August 2011
Real assets versus financial assets
We note the ongoing theme of capital flowing to real assets relative to financial assets seems to continue. As a result the USD continues to weaken and the Shiller P/E multiple will continue to decline.
We feel a European alliance on supporting periphery countries can be a critical event in starting the decline of the EUR and the increase of the cost of borrowing for the USD.
The other great event that can start such a large shift is the de pegging of the USD for many emerging countries. This will have the effet of reducing demand for USD and weakening the link between emerging markets (EM) and developed markets (something which is urgently needed due to the inflation this policy is creating in EM).
Support to periphery countries will reduce the spread in the cost of borrowing between such countries and Germany.
We fear the USD can only decline - it is the most important varible (and easiest to change in the current global system) that can reduce the huge imbalances that have built up within the global system.
Main themes
Buy real assets at cheap prices. We prefer timber and oil and are investigating agriculture (we find it hard to invest in this sector at the moment)
Short the USD for the long term
Buy high quality companies
Currency management is becoming more important. The lack of a freely tradable currency in many countries that are accumulating cash makes this difficult and distorts the market (i.e. the need for the Euro and the CHF)
Buy cheap insurance against increasing interest rates (market determined interest rates such as government cost of borrowing or libor rates. The authorities in DM will do all they can to keep interest rates low) in developed markets that have large debt burdens (US, UK, many european countries)
Deep value investments that are considerably less dependent on macro issues. A iliquidity premium may be available here
We feel a European alliance on supporting periphery countries can be a critical event in starting the decline of the EUR and the increase of the cost of borrowing for the USD.
The other great event that can start such a large shift is the de pegging of the USD for many emerging countries. This will have the effet of reducing demand for USD and weakening the link between emerging markets (EM) and developed markets (something which is urgently needed due to the inflation this policy is creating in EM).
Support to periphery countries will reduce the spread in the cost of borrowing between such countries and Germany.
We fear the USD can only decline - it is the most important varible (and easiest to change in the current global system) that can reduce the huge imbalances that have built up within the global system.
Main themes
Buy real assets at cheap prices. We prefer timber and oil and are investigating agriculture (we find it hard to invest in this sector at the moment)
Short the USD for the long term
Buy high quality companies
Currency management is becoming more important. The lack of a freely tradable currency in many countries that are accumulating cash makes this difficult and distorts the market (i.e. the need for the Euro and the CHF)
Buy cheap insurance against increasing interest rates (market determined interest rates such as government cost of borrowing or libor rates. The authorities in DM will do all they can to keep interest rates low) in developed markets that have large debt burdens (US, UK, many european countries)
Deep value investments that are considerably less dependent on macro issues. A iliquidity premium may be available here
Thursday, 21 July 2011
Direct and indirect exposure to European peripherals is huge!
It is assumed that banks that hold Greek debt will have write downs.
But what if they bought CDS's? Who wrote the CDS will suffer the lose from a restructuring! It is hard to know who wrote the CDS, so libor rates will increase due to the mystery!
Majority of the debt is from retail/commercial loans (75%). Then interbank lending and soveriegn debt.
Insurance companies only really have exposure to the sovereign debt side. Hence are less at risk then the banks - unless they were the ones that wrote the CDS's!
What is a safe haven currency? A country that has favourable macroeconomic features in difficult times. But Switzerland has a banking sector considerably larger than its total GDP. Hence, though Swiss bank exposure to peripherals is small, it is over 100% of GDP to other European sovereign. Do you think German banks would be immune from restructuring of debt in Spain or Italy? There will be blood! And even a 10% haircut for Swiss banks would be huge in absolute terms.
Is the NOK safer? What is there pension fund invested in? How would oil react in such circumstances? The advantage is that there is likely to be slightly less damage to the Norweigian banking system. But there would be little money moving around if oil is not increasing! There are bad, and more bad! Gold would see a chunk of money momve towards it I suppose?
But what if they bought CDS's? Who wrote the CDS will suffer the lose from a restructuring! It is hard to know who wrote the CDS, so libor rates will increase due to the mystery!
Majority of the debt is from retail/commercial loans (75%). Then interbank lending and soveriegn debt.
Insurance companies only really have exposure to the sovereign debt side. Hence are less at risk then the banks - unless they were the ones that wrote the CDS's!
What is a safe haven currency? A country that has favourable macroeconomic features in difficult times. But Switzerland has a banking sector considerably larger than its total GDP. Hence, though Swiss bank exposure to peripherals is small, it is over 100% of GDP to other European sovereign. Do you think German banks would be immune from restructuring of debt in Spain or Italy? There will be blood! And even a 10% haircut for Swiss banks would be huge in absolute terms.
Is the NOK safer? What is there pension fund invested in? How would oil react in such circumstances? The advantage is that there is likely to be slightly less damage to the Norweigian banking system. But there would be little money moving around if oil is not increasing! There are bad, and more bad! Gold would see a chunk of money momve towards it I suppose?
Commodities, bonds and equities
History suggests that commodity prices and the multiple on equities are inversely correlated to each other over many years. There period of evolution also seems to be similar, suggesting one may affect the other directly.
When commodities are going through a decade of increasing prices, history would suggest in that decade the price/earnings ratio for stocks would decline.
There is some sense to this. Many companies have raw material and transportation costs that make up a significant portion of total costs.
However, the operating margin does not follow the commodity cycle! (debt cycle has more influence)
During 2002 - 2007 margins increased whilst commodities also increased in price - no doubt both fueled by the increase in credit in the system. It is the multiple, hence the markets perception of what a future stream of cash flows are worth, that has a strong relation to the price of commodities. Hence it may well be the FEAR of inflation in the future that reduces the multiple on equities. The fear that interest rates will be higher, and a dollar will be worth less.
Debt cycle is longer than the commodity and equity multiple cycle.
Credit is what makes booms and busts according to Ray Dalio. They are what makes GDP growth vary around the increase of productivity. Population growth is the second source of GDP growth. If GDP/capita is constant and the population doubles over time, so will the GDP. Population growth is also what determines the population structure in an economy, i.e. number of 25 to 50 year olds in a society. This will determine the liabilities of a society that has a develope economy, i.e. a welfare system. Productivity needs resources - if it is not funded because capital allocation becomes worse, the GDP growth rate can change?
Credit determines the demand in an economy. Hence can provide purchasing power to companies (support margins) and keep consumers spending. The authorities artifically prop up debt markets, is that why they last longer? Does inflation follow the credit cycle? It seems to. We assume that inflation follows the credit cycle (or is it vice versa).
The margin cycle seems simply to be a function of the business cycle. We note that the 1980 peak was the same as the 1995 peak. The three bottoms between 1980 - 2010 in 86, 01, 09 were all similar. The big difference were the peaks in 06 and 10, which were much larger than any point in the last 30 years. Credit led initially and then cost cutting led? During the first few years of the strong bull market in the 1980s the margin was actually decreasing, reaching its bottom in 1986. Prices were so cheap by that time that multiple expansion was the primary source of equity market returns. Can you imagine the newspapers then, margins are following, beware of stocks! When there is margin pressure you need multiples to be low to make money, when margins are increasing, a high multiple can be mitigated by stronger earnings growth.
So where are we today?
Debt: cost of debt has been falling for 30 years. History suggests it should start increasing. Led by need to attract capital to an economy as short of capital (rather than authorities increasing rates to decrease speed of a recovery in the business cycle. Short of capital as there will be capital destruction and a run for cash, but there is not enough cash). Due to less demand for there currency and their assets because of (1) Lower growth than in the past (paradigm shift in the way the country is perceived. If dollar pegging decreases, less demand for USD. Need to attract it back with a higher interest rate, not with the title of being the reserve currency of the world. FX foreign reserves will decrease in USD etc), or (2) Risk spread increases as fear of default increases? Risk assets will have a headwind as a result, decreasing in price as there yield must increase. Need to buy at low multiples
Equities: Almost 2/3 through a multiple decline process. On a normalised basis (Shiller P/E) equities are trading at an above average multiple. Again, focus on buying low multiples. Very careful with cyclicals whose multiple may look low to very high profits created during a boom time difficult to replicate in the next decade. Opportunities exist in high quality where earnings are more stable and where normalised P/E are relatively attractive: yields are between 7.5 - 10%. We would suggest a buy should have a minimum earnings yield of 2% above equity markets average return: 8.5%. Less, sell - unless you feel very stable and visible earnings.
Margins: Seem to be too high. Again, as a result, caution on assessing earnings in the last five years when credit growth was strong and recent cost cutting was very swift. Demand a higher yield if buying on potential cash flow. With regards to asset plays, need to consider the potential of weak growth, hence a catalyst is required or the physical assets may decrease in value.
Commodities. Developed market money printing has not increasing lending (but is another solution to dilute the value of the currency and provide more cash for a country that has too many assets and not enough cash generation). No dubt because the lenders have poor balance sheets, but also because they fear that their currency in the future will be worth less, hence may make a real negative return. This money has gone to inflation hedge assets - primariy equities and commodities. Excess liquidty has pushed up commodity prices, which will put pressure on equity multiples. This cash is also going to regions where countries are growing faster. Many of these countries currently have USD pegs - hence extremely loose monetory policy whilst plenty of cash is coming there way and their GDP growth is strong. If this continues, the USD peg will not be sustainable as it will lead to a dangerous inflation (In EM, not in the US! What a strategy to force the Chinese to de peg. But this will reduce further USD demand making potentially the USD weaker. Hence more exports for the US, less imports, reduce trade deficit, help bring the economy back on track, but the USD will fall. As a result households will reduce quality of life as cant import as many goods as before, but they will start getting more manufacturing jobs. BUY US EXPORTERS WHILST SHORTING THE USD WITH A FORWARD CONTRACT. The US stock market can do well, but the household will have less purchasing power. Need to supplement that with investing in their corporations who will be doing well selling and investing in other countries as well as in the USA!
The USD weakening is a central part of the world economy clearing itself up. It is the fountain that will led to change as EM de peg and start losing their export competitiveness - a major source of the imbalance. They will consume more, leading to more imports hence creating more jobs for others! But can China survive this change? The USD policy as the reserve currency is what is holding many imbalances back from being rectified? Reminscent of an old system that now does not exist. There are different engines in the global economy and they need to be set loose, not tied to the USD.
THE PROBLEM IN A SENTENCE IS A LACK OF GLOBAL AGGREGATE DEMAND! THOSE WHO HAD ACCESS TO CREDIT TO CREATE DEMAND ARE TAPPED OUT. THOSE WHO NEED TO TAKE OVER DONT REALLY HAVE ACCESS TO CREDIT AND DONT EVEN HAVE THEIR OWN FREELY FLOATED CURRENCY. HENCE THE OLD SYSTEM NEEDS TO MAKE CHANGE FOR THE NEW WHERE THESE IMBALANCES CAN BE CLEANED UP. Buy developed market banks that can lend to EM, who have experience of those markets and the cutting edge knowledge of having worked in DM for many decades, like standard chartered, HSBC.
A weakening currency in developed countries will not only help them export more hence create jobs and GDP growth, it will reduce the burden of their debts as they are de valued away! This alongside capital destruction will do a good job of clearing up the mess!
I see the problem primarily from the point of view of europe, as I live there. However, it is a global problem. What seems like a lack of change and finding solutions in Europe, is a consequence of also lack of change globally. The old system continues - it needs to be changed. It is slowly being down as we see the USD weaken, the Chinese consume more. But the EUR getting stronger? There is a tension between these currencies as there is a lack of alternatives. The strength of the EURO seems to be a consequence of living in a new world with the old system. The euro is the punching bag due to it having weak political strength. Indeed, history suggests the market likes it when the politicians are weak, because they cannot decide anything! Hence they cannot commit to surprise policies which the market does not like! Such as money printing! How convenient! So the euro strength is a consequence of having poorer options, not because it is the best. There is a consensus that the USD weakening is the most dominant theme in making the world clean up the imbalances we have..
Last thing to do is reduce their rights to the good things which has made us lazy and feel we deserve (have the right) to a good life and most of the basic things to enjoy life. NO! Take away healthy pensions, only enough to survive. Watch how people will work!
Reduce government liabilities by reducing pension benefits, increase the work ethic of the population
Kill the USD reserve currency, float EM currencies openly. Less demand for DM currencies. Then interest rates increase (force default, or govt print money to reduce further value of money)
DM currency decrease from less demand from more alternatives and money printing. This will make them more competitive in exporting. Create jobs and foreigners attracted to their assets. Improve the current account by reducing the trade deficit. BUT TOO WEAK A CURRENCY WILL CREATE A PROBLEM WITH BUYING ENERGY/OIL! HENCE NEED TO BE MORE ENERGY INDEPENDENT BEFORE FOLLOW THIS STRATEGY. IN THE US HAVE FOUND LOTS OF GAS! HENCE CAN FOLLOW THIS IDEA! More of a problem for Europe, hence the greater focus on renewables, energy emissions to force the issue, etc. UNLESS RUSSIA USES THE EURO, THEN CAN BUY ENERGY IN EUROS AND NOT A PROBLEM TO DEVALUE THE CURRENCY TO GENERATE GROWTH!
Weakening DM currency will reduce burden of debt, as many companies will be paid in the newly floated currencies. Build up reserves and debt burdens decrease
If China de pegged - then in theory they would not need to print as much money to keep the currency weak. Hence less money printing for them. Investors that bought gold can buy the YUAN. Hence GOLD COULD FALL IF CHINA DE PEGS. US WOULD ALSO NOT NEED TO PRINT AS MUCH MONEY TO WEAKEN ITS CURRENCY, THERE WILL BE A MORE NATURAL ROUTE! HENCE GOLD IS USED AS THE SAFE HAVEN DURING THE MID WAY POINT - AS WE MAKE THE TRANSITION. BUT WHEN WILL THE TRANSITION BE MADE!? UNTIL THEN HOLD GOLD? THE CHINESE WANT GOLD TO BACK THEIR CURRENCY UP AS WELL?
The reason the EUR is strong is a similar reason to why gold is strong. Gold has a historic reference as a store of value due to its physical properties and historical use, and the fact that GOVERNMENTS CANNOT PRINT IT! THE EUR HAS THE SIMILAR PERCEIVED STABILITY, AT THE MOMENT, AS ITS POLITICIANS ARE SO WEAK TOGETHER THEY CANNOT AGREE ABOUT ANYTHING. IT IS THEREFORE PERCEIVED IT IS UNLIKELY THEY WILL PRINT MONEY! HENCE THE EUR MAINTAINS ITS VALUE VERSUS THE USD. LIKELY VERSUS GOLD IT HAS NOT DONE MUCH AT ALL! AND ALSO WEAKENED VERSUS THE CHF
(To understand why incentive for authorities to print money - need to appreciate the difference between CREDIT & MONEY. The debt burden that has been created is phenomenal, and unprecendented. When people want access to money by liquidating assets - need to appreciate in the US there is 2 trillion in cash, and 50 trillion in financial assets. There is simply not enough cash for everyone without printing money or having defaults/write downs etc). Credit appears, and can as easily diseappear...! If it is backed by future promised earnings that cannot be met (ie buying expensive assets with debt) then write downs must be made. This reduces the stock of capital (assets) in the world - this is exactly what is required as too much money should simply not have been created! Leading to spreads for returns becoming too small. This needs to expand so new capital can come in and start the cycle anew. Capital destruction is required - or money printing. The latter is viewed as being more politically savvy in gaining votes)
THE CHF TAKES THE ROLE OF THE DEUTSCHEMARK FOR MANY EUROPEANS, as that currency is deeply hidden within the Euro. It is seen as safe haven, but will a strong enough currency erode its economy to self correct those self haven characteristics it has, ie less exports, more imports, hence trade deficit etc. SHORT CHF at what level?
If you want to gain the most by doing the least, you should move to Singapore over the next 50 years.
It is considerably harder to know what will happen tomorrow, which depends on sentiment, then what happens in 10 years, which depends on reason.
(why do cycles exist? Part of human nature, the system. Also, when something exists, it is hard to get rid of. It becomes part of us, how we perceive the world. It is an unconscious reference that affects the behaviour of all of us)
When commodities are going through a decade of increasing prices, history would suggest in that decade the price/earnings ratio for stocks would decline.
There is some sense to this. Many companies have raw material and transportation costs that make up a significant portion of total costs.
However, the operating margin does not follow the commodity cycle! (debt cycle has more influence)
During 2002 - 2007 margins increased whilst commodities also increased in price - no doubt both fueled by the increase in credit in the system. It is the multiple, hence the markets perception of what a future stream of cash flows are worth, that has a strong relation to the price of commodities. Hence it may well be the FEAR of inflation in the future that reduces the multiple on equities. The fear that interest rates will be higher, and a dollar will be worth less.
Debt cycle is longer than the commodity and equity multiple cycle.
Credit is what makes booms and busts according to Ray Dalio. They are what makes GDP growth vary around the increase of productivity. Population growth is the second source of GDP growth. If GDP/capita is constant and the population doubles over time, so will the GDP. Population growth is also what determines the population structure in an economy, i.e. number of 25 to 50 year olds in a society. This will determine the liabilities of a society that has a develope economy, i.e. a welfare system. Productivity needs resources - if it is not funded because capital allocation becomes worse, the GDP growth rate can change?
Credit determines the demand in an economy. Hence can provide purchasing power to companies (support margins) and keep consumers spending. The authorities artifically prop up debt markets, is that why they last longer? Does inflation follow the credit cycle? It seems to. We assume that inflation follows the credit cycle (or is it vice versa).
The margin cycle seems simply to be a function of the business cycle. We note that the 1980 peak was the same as the 1995 peak. The three bottoms between 1980 - 2010 in 86, 01, 09 were all similar. The big difference were the peaks in 06 and 10, which were much larger than any point in the last 30 years. Credit led initially and then cost cutting led? During the first few years of the strong bull market in the 1980s the margin was actually decreasing, reaching its bottom in 1986. Prices were so cheap by that time that multiple expansion was the primary source of equity market returns. Can you imagine the newspapers then, margins are following, beware of stocks! When there is margin pressure you need multiples to be low to make money, when margins are increasing, a high multiple can be mitigated by stronger earnings growth.
So where are we today?
Debt: cost of debt has been falling for 30 years. History suggests it should start increasing. Led by need to attract capital to an economy as short of capital (rather than authorities increasing rates to decrease speed of a recovery in the business cycle. Short of capital as there will be capital destruction and a run for cash, but there is not enough cash). Due to less demand for there currency and their assets because of (1) Lower growth than in the past (paradigm shift in the way the country is perceived. If dollar pegging decreases, less demand for USD. Need to attract it back with a higher interest rate, not with the title of being the reserve currency of the world. FX foreign reserves will decrease in USD etc), or (2) Risk spread increases as fear of default increases? Risk assets will have a headwind as a result, decreasing in price as there yield must increase. Need to buy at low multiples
Equities: Almost 2/3 through a multiple decline process. On a normalised basis (Shiller P/E) equities are trading at an above average multiple. Again, focus on buying low multiples. Very careful with cyclicals whose multiple may look low to very high profits created during a boom time difficult to replicate in the next decade. Opportunities exist in high quality where earnings are more stable and where normalised P/E are relatively attractive: yields are between 7.5 - 10%. We would suggest a buy should have a minimum earnings yield of 2% above equity markets average return: 8.5%. Less, sell - unless you feel very stable and visible earnings.
Margins: Seem to be too high. Again, as a result, caution on assessing earnings in the last five years when credit growth was strong and recent cost cutting was very swift. Demand a higher yield if buying on potential cash flow. With regards to asset plays, need to consider the potential of weak growth, hence a catalyst is required or the physical assets may decrease in value.
Commodities. Developed market money printing has not increasing lending (but is another solution to dilute the value of the currency and provide more cash for a country that has too many assets and not enough cash generation). No dubt because the lenders have poor balance sheets, but also because they fear that their currency in the future will be worth less, hence may make a real negative return. This money has gone to inflation hedge assets - primariy equities and commodities. Excess liquidty has pushed up commodity prices, which will put pressure on equity multiples. This cash is also going to regions where countries are growing faster. Many of these countries currently have USD pegs - hence extremely loose monetory policy whilst plenty of cash is coming there way and their GDP growth is strong. If this continues, the USD peg will not be sustainable as it will lead to a dangerous inflation (In EM, not in the US! What a strategy to force the Chinese to de peg. But this will reduce further USD demand making potentially the USD weaker. Hence more exports for the US, less imports, reduce trade deficit, help bring the economy back on track, but the USD will fall. As a result households will reduce quality of life as cant import as many goods as before, but they will start getting more manufacturing jobs. BUY US EXPORTERS WHILST SHORTING THE USD WITH A FORWARD CONTRACT. The US stock market can do well, but the household will have less purchasing power. Need to supplement that with investing in their corporations who will be doing well selling and investing in other countries as well as in the USA!
The USD weakening is a central part of the world economy clearing itself up. It is the fountain that will led to change as EM de peg and start losing their export competitiveness - a major source of the imbalance. They will consume more, leading to more imports hence creating more jobs for others! But can China survive this change? The USD policy as the reserve currency is what is holding many imbalances back from being rectified? Reminscent of an old system that now does not exist. There are different engines in the global economy and they need to be set loose, not tied to the USD.
THE PROBLEM IN A SENTENCE IS A LACK OF GLOBAL AGGREGATE DEMAND! THOSE WHO HAD ACCESS TO CREDIT TO CREATE DEMAND ARE TAPPED OUT. THOSE WHO NEED TO TAKE OVER DONT REALLY HAVE ACCESS TO CREDIT AND DONT EVEN HAVE THEIR OWN FREELY FLOATED CURRENCY. HENCE THE OLD SYSTEM NEEDS TO MAKE CHANGE FOR THE NEW WHERE THESE IMBALANCES CAN BE CLEANED UP. Buy developed market banks that can lend to EM, who have experience of those markets and the cutting edge knowledge of having worked in DM for many decades, like standard chartered, HSBC.
A weakening currency in developed countries will not only help them export more hence create jobs and GDP growth, it will reduce the burden of their debts as they are de valued away! This alongside capital destruction will do a good job of clearing up the mess!
I see the problem primarily from the point of view of europe, as I live there. However, it is a global problem. What seems like a lack of change and finding solutions in Europe, is a consequence of also lack of change globally. The old system continues - it needs to be changed. It is slowly being down as we see the USD weaken, the Chinese consume more. But the EUR getting stronger? There is a tension between these currencies as there is a lack of alternatives. The strength of the EURO seems to be a consequence of living in a new world with the old system. The euro is the punching bag due to it having weak political strength. Indeed, history suggests the market likes it when the politicians are weak, because they cannot decide anything! Hence they cannot commit to surprise policies which the market does not like! Such as money printing! How convenient! So the euro strength is a consequence of having poorer options, not because it is the best. There is a consensus that the USD weakening is the most dominant theme in making the world clean up the imbalances we have..
Last thing to do is reduce their rights to the good things which has made us lazy and feel we deserve (have the right) to a good life and most of the basic things to enjoy life. NO! Take away healthy pensions, only enough to survive. Watch how people will work!
Reduce government liabilities by reducing pension benefits, increase the work ethic of the population
Kill the USD reserve currency, float EM currencies openly. Less demand for DM currencies. Then interest rates increase (force default, or govt print money to reduce further value of money)
DM currency decrease from less demand from more alternatives and money printing. This will make them more competitive in exporting. Create jobs and foreigners attracted to their assets. Improve the current account by reducing the trade deficit. BUT TOO WEAK A CURRENCY WILL CREATE A PROBLEM WITH BUYING ENERGY/OIL! HENCE NEED TO BE MORE ENERGY INDEPENDENT BEFORE FOLLOW THIS STRATEGY. IN THE US HAVE FOUND LOTS OF GAS! HENCE CAN FOLLOW THIS IDEA! More of a problem for Europe, hence the greater focus on renewables, energy emissions to force the issue, etc. UNLESS RUSSIA USES THE EURO, THEN CAN BUY ENERGY IN EUROS AND NOT A PROBLEM TO DEVALUE THE CURRENCY TO GENERATE GROWTH!
Weakening DM currency will reduce burden of debt, as many companies will be paid in the newly floated currencies. Build up reserves and debt burdens decrease
If China de pegged - then in theory they would not need to print as much money to keep the currency weak. Hence less money printing for them. Investors that bought gold can buy the YUAN. Hence GOLD COULD FALL IF CHINA DE PEGS. US WOULD ALSO NOT NEED TO PRINT AS MUCH MONEY TO WEAKEN ITS CURRENCY, THERE WILL BE A MORE NATURAL ROUTE! HENCE GOLD IS USED AS THE SAFE HAVEN DURING THE MID WAY POINT - AS WE MAKE THE TRANSITION. BUT WHEN WILL THE TRANSITION BE MADE!? UNTIL THEN HOLD GOLD? THE CHINESE WANT GOLD TO BACK THEIR CURRENCY UP AS WELL?
The reason the EUR is strong is a similar reason to why gold is strong. Gold has a historic reference as a store of value due to its physical properties and historical use, and the fact that GOVERNMENTS CANNOT PRINT IT! THE EUR HAS THE SIMILAR PERCEIVED STABILITY, AT THE MOMENT, AS ITS POLITICIANS ARE SO WEAK TOGETHER THEY CANNOT AGREE ABOUT ANYTHING. IT IS THEREFORE PERCEIVED IT IS UNLIKELY THEY WILL PRINT MONEY! HENCE THE EUR MAINTAINS ITS VALUE VERSUS THE USD. LIKELY VERSUS GOLD IT HAS NOT DONE MUCH AT ALL! AND ALSO WEAKENED VERSUS THE CHF
(To understand why incentive for authorities to print money - need to appreciate the difference between CREDIT & MONEY. The debt burden that has been created is phenomenal, and unprecendented. When people want access to money by liquidating assets - need to appreciate in the US there is 2 trillion in cash, and 50 trillion in financial assets. There is simply not enough cash for everyone without printing money or having defaults/write downs etc). Credit appears, and can as easily diseappear...! If it is backed by future promised earnings that cannot be met (ie buying expensive assets with debt) then write downs must be made. This reduces the stock of capital (assets) in the world - this is exactly what is required as too much money should simply not have been created! Leading to spreads for returns becoming too small. This needs to expand so new capital can come in and start the cycle anew. Capital destruction is required - or money printing. The latter is viewed as being more politically savvy in gaining votes)
THE CHF TAKES THE ROLE OF THE DEUTSCHEMARK FOR MANY EUROPEANS, as that currency is deeply hidden within the Euro. It is seen as safe haven, but will a strong enough currency erode its economy to self correct those self haven characteristics it has, ie less exports, more imports, hence trade deficit etc. SHORT CHF at what level?
If you want to gain the most by doing the least, you should move to Singapore over the next 50 years.
It is considerably harder to know what will happen tomorrow, which depends on sentiment, then what happens in 10 years, which depends on reason.
(why do cycles exist? Part of human nature, the system. Also, when something exists, it is hard to get rid of. It becomes part of us, how we perceive the world. It is an unconscious reference that affects the behaviour of all of us)
Wednesday, 22 June 2011
Quality, price, patience, diversification and the financial position of the client
When one invests as an outside, passive, minority investor there are two prinicipal considerations the investor must make:-
1 The quality of the investment
2 The price of the investment relative to your estimate of intrinsic value
The further out you are of the company, the more concerned you are with quality.
The closer you are to the company, e.g. an inside investor or an activist investor, the more important price becomes to the equation. This is because you have more detailed or timely knowledge, or you can act as a catalyst to unravel the value that exists in that company.
Another factor, is of course, the financial position of the client. For example, this can affect how long you can wait for the investment to work out.
The emphasis must always be in using public information and clever investigation that any well respected analyst can do, but doing superior anaysis and knowing when we are out of our circle of competence. This will generally limit us to a few sectors where we build deep understanding and so we can more easily spot opportunities by analysing more companies per unit of time.
If one has a long term investment horizon, companies that dont have an immediate catalyst but are very cheap and slightly lower qualitym may be considered by the outside, minority, passive investor. However, only if plenty of data is available for many years and physical data measurements can be made in terms of volume, production capacity etc to verify the accounts, and this data can be verified by independent parties.
If one has limited time or knowledge to analysis in great depth the companies under investigation, then diversification can compensate for a lack of knowledge. Buying deep out of the money put options when interestingly priced is another means.
However, for one with deep knowledge of a company, and who by concentrating their portfolio may achieve control to the extent they can form their own catalyst, it makes sense to have a more concentrated portfolio. This investor generally has strong know-how and know-who, and large financial resources. For example, it makes more sense for the founder of a company to have a large portion of their wealth in their company, then a builder who notices the company on the pink sheets. The founder has considerably more knowledge on the company and the sector, hence is better able to make a good decision. They also have timely knowledge on competitors.
One must always examine odds, and consequences.
1 The quality of the investment
2 The price of the investment relative to your estimate of intrinsic value
The further out you are of the company, the more concerned you are with quality.
The closer you are to the company, e.g. an inside investor or an activist investor, the more important price becomes to the equation. This is because you have more detailed or timely knowledge, or you can act as a catalyst to unravel the value that exists in that company.
Another factor, is of course, the financial position of the client. For example, this can affect how long you can wait for the investment to work out.
The emphasis must always be in using public information and clever investigation that any well respected analyst can do, but doing superior anaysis and knowing when we are out of our circle of competence. This will generally limit us to a few sectors where we build deep understanding and so we can more easily spot opportunities by analysing more companies per unit of time.
If one has a long term investment horizon, companies that dont have an immediate catalyst but are very cheap and slightly lower qualitym may be considered by the outside, minority, passive investor. However, only if plenty of data is available for many years and physical data measurements can be made in terms of volume, production capacity etc to verify the accounts, and this data can be verified by independent parties.
If one has limited time or knowledge to analysis in great depth the companies under investigation, then diversification can compensate for a lack of knowledge. Buying deep out of the money put options when interestingly priced is another means.
However, for one with deep knowledge of a company, and who by concentrating their portfolio may achieve control to the extent they can form their own catalyst, it makes sense to have a more concentrated portfolio. This investor generally has strong know-how and know-who, and large financial resources. For example, it makes more sense for the founder of a company to have a large portion of their wealth in their company, then a builder who notices the company on the pink sheets. The founder has considerably more knowledge on the company and the sector, hence is better able to make a good decision. They also have timely knowledge on competitors.
One must always examine odds, and consequences.
Sunday, 19 June 2011
A word about confidence....Greece
Greece has a budget and trade deficit. This means the government and the people of the country, in general, must borrow to maintain their quality of life, as they spend more then they earn. This means the country is dependent on foreign parties supplying capital to maintain their quality of life. This was expected to continue unless the Greeks (1) spend less, (2) sell more, (3) both. When one depends on foreign funds to live your daily life, in my opinion, you do not control your future anymore. In recent months we have all been made aware that the supply of capital from external parties to Greece is drying up. Hence the country is forced to aggressively apply one, or all, of the above mentioned points.
Cutting costs (reduce spending) is an evident way of showing the people in a country that their quality of life is being reduced. Hence, it is often meet with social unrest. The deeper the cuts, the larger the backlash. Rather then phasing budget cuts slowly over a number of years to responsibly manage the economy when capital was available in the market for Greece, bail out funds have been received from European governments that want to see the money returned quickly, so that they do not receive public backlash at home for their actions. The budget cuts are therefore deeper and must be orchestrated over a considerably shorter period of time. This means shock treatment for the Greeks, which is always extremely uncomfortable. Since EU country governments are voted into power by the national population, they are more likely to follow policies that are for the national interest, not Europe’s. Hence Greece received several billions in Q2 2010 to meet conditions that they must affectively reduce 10% of its GDP in two years. Of course it will not be achieved without a near civil war. However, at that time markets rallied and the Euro strengthened. We believe that leveraged companies or countries don’t get out of trouble by cutting costs only. They must invest in new initiatives that can generate future income to meet obligations and generate future prosperity. This is an incentive for people to work, and gives confidence to foreign investors so more capital becomes available if projects are developing positively. This is only achieved by receiving fresh capital injections and seeing that capital deployed productively. In the past this was achieved in Greece by devaluing its currency. With the country now using the common currency that is the euro, it cannot apply this strategy anymore.
Selling more means more work in the same unit of time (increased productivity) or simply working more hours. This also reduces quality of life as it generally means working harder and for longer. However, if done well, financial compensation need not be reduced and unemployment rates may not have to increase harshly. However, the question is what do the Greeks sell? Since they primarily deal with agricultural goods and low to medium quality industrial goods, they compete very heavily on price. Since they sell primarily to countries that use the same currency, they must either become more productive or wages must fall to become more competitive and generate higher returns on capital, which can attract fresh capital into the country. As mentioned above, in the past this was achieved by devaluing the currency, a more socially accepted practice to make the country competitive.
When a country is dramatically cutting costs (the public and private sector), all economic participants spend/invest less due to increased uncertainty and unemployment rates, and no new money is coming into the country, there is effectively less wealth in the country as assets prices are declining and the incoming cash flow is being reduced. This means the government is also receiving less tax income, reducing further its creditability and strength. Countries within the EU have also forsaken the ability to print their own currency, a privilege now held only by the ECB. Governments can only ask to borrow more money in the market. When a country reaches the stage Greece is in, this door becomes firmly closed.
As a result the Government of Greece received a bail out package from the European Union countries and the IMF under some very extreme conditions in Q2 of 2010. Furthermore, the Greek banks can only receive funding from the ECB as no other party accepts Greek bonds as collateral for loans.
Because of the extreme cuts required to receive the bailout package, unemployment will rise in Greece. This will encourage less spending, hence the government receives less tax as less business is being conducted. This forces the country to need to borrow more. Hence cutting costs whilst not receiving the benefits from these savings (i.e. used to pay interest payments), or new capital from abroad to invest in the country, will lead to a reduction in GDP. This will lead to more Greeks defaulting on bank loans. This forces the banks to need to raise capital. But the market is not welling to inject new equity into Greek banks at the moment due to the lack of clarity in what will happen. Hence the only funding avenue for Greek banks is the ECB. A lack of confidence in a country is a vicious circle.
So European countries should inject more money into Greece? But the voters in the European countries ask why should they help a country that overspent and did not work hard enough to overcome their problems when they were manageable? Other European countries are also suffering various degrees of discomfort due to a weak economic environment in developing countries in general.
So let the country suffer and pick itself up alone? Why should a single country affect the sustainability of a currency for several economies much larger then Greece’s?
This is a good question. The answer is the financial market in Europe is considerably more advanced in being “Europeanised” then a common European labour market, fiscal policy or language. French banks hold Greek bonds and German banks hold Portuguese debt etc etc. If Greece was to say they could not redeem their debt because they don’t have the cash, then banks around Europe will have to make write downs of several tens of billions of Euros. This would require a number of banks to raise capital, likely creating pressure in European equity markets. Furthermore, Euribor rates would most likely increase as interbank lending costs increase due to a lack of trust amongst banks on who held Greek debt and who would have to make the highest write down and how it could affect their solvency. Europe contains many leveraged economies and increasing the cost of a loan would likely boost default rates if they stayed high for too long.
But again, Greece is such a small economy relative to the EU, the European banking sector could absorb the write downs – only a few aggressive hedge funds would go bust.
However, the real fright comes when you look into the details. The ECB cannot fund the Greek banks if the government defaults on the debt. If Greek business people see their government default on Greek debt: they know the biggest holders are Greek banks and that these financial institutions now have no sources of funding: Greek money will be pouring out of Greek banks into German bank accounts in a last dash attempt to preserve their wealth before their banks collapse. However, governemtns are well trained in such affairs. Capital will be refused to leave the country, as was most recently done in another European country, Iceland. When external capital is not available for banks, deposits are there only source of funding and governments will try to keep them there at whatever cost.
The question is, how will other “weak European economy business people” react if they see that happen in Greece? Will we see large cash movements out from Spanish and Portuguese banks to German banks? Of course we will! Hence, suddenly, there really isn’t a single Europe! Capital cannot move freely around Europe! There is only Germany and a few select others. The market will make that happen. If the politicians don’t throw out the weaker economies by letting one default, the market will probably do that job for them very quickly…
The weak European countries will become like sieves: capital will not be retained in them – what goes in will come out as a result of a total loss of confidence.
Now that is what we envision happen if Greece does not redeem their bonds by taking that decision themselves. There has been discussion of having a voluntary roll over of debt so that a technical default does not occur and hence the Greek banks can continue to receive ECB funding and the Greek government do not need to meet their immediate financial liabilities. But how does this solve their problems? They still have no new capital coming into the country to help rebuild the economy! Hence it is simply being kept afloat! They must create liquidity from the assets they have. This means forced privatizations. But with the economy so weak, these assets would be sold at below normal market condition prices. But this is the price Greece will have to pay. There must be wealth destruction. It can come from a number of ways including defaulting on debt, selling their assets at a cheap price or wages falling (as it cannot come from a devaluing currency anymore). Funds from these savings can be used to reduce their debt load. When this is reduced, new capital from the markets may start coming in.
Wealth destruction is the procedure of removing the money that should have never existed, because it was poorly invested in the recent past. The mis allocation of capital always leads to an eventual reduction of the total capital in the world, as it has not been wisely deployed to increase its size. This would reduce the wealth of the country and hence the quality of life of its inhabitants. How will Europeans react to this? This is a question we do not know how to answer.
But what about the Euro?
If several weaker European countries are made to become “economic sieves”, this would scare foreign investors and likely lead to a sharp reduction in the valuation of the Euro. However, this is only likely to happen in the unlikely event that Greece decides not to pay its debt.
What if the rollover happens, how would the other “weaker countries react?”
“Same as usual.” “Just keep on going and wait for something to change?”
Probably.
An external catalyst seems to be required to start the wealth destruction process. In a capitalist system, this is the most efficient way to allow unsustainable countries, or companies, to start again in less onerous terms.
Another alternative is that the ECB starts printing more money to fund the weaker economies. This is "a la USA", hence would probably lead the Euro to display a pricing behaviour we have seen recently for the USD. However, Germany is very much against this solution and the ECB has so far positioned itself with a similar stance, even if it has bought many billions of government bonds already....
Indeed, one could day that the bailouts are a way of making it easier to have political, fiscal and economic union. Creditors will become the "equity" owners of these countries....
Cutting costs (reduce spending) is an evident way of showing the people in a country that their quality of life is being reduced. Hence, it is often meet with social unrest. The deeper the cuts, the larger the backlash. Rather then phasing budget cuts slowly over a number of years to responsibly manage the economy when capital was available in the market for Greece, bail out funds have been received from European governments that want to see the money returned quickly, so that they do not receive public backlash at home for their actions. The budget cuts are therefore deeper and must be orchestrated over a considerably shorter period of time. This means shock treatment for the Greeks, which is always extremely uncomfortable. Since EU country governments are voted into power by the national population, they are more likely to follow policies that are for the national interest, not Europe’s. Hence Greece received several billions in Q2 2010 to meet conditions that they must affectively reduce 10% of its GDP in two years. Of course it will not be achieved without a near civil war. However, at that time markets rallied and the Euro strengthened. We believe that leveraged companies or countries don’t get out of trouble by cutting costs only. They must invest in new initiatives that can generate future income to meet obligations and generate future prosperity. This is an incentive for people to work, and gives confidence to foreign investors so more capital becomes available if projects are developing positively. This is only achieved by receiving fresh capital injections and seeing that capital deployed productively. In the past this was achieved in Greece by devaluing its currency. With the country now using the common currency that is the euro, it cannot apply this strategy anymore.
Selling more means more work in the same unit of time (increased productivity) or simply working more hours. This also reduces quality of life as it generally means working harder and for longer. However, if done well, financial compensation need not be reduced and unemployment rates may not have to increase harshly. However, the question is what do the Greeks sell? Since they primarily deal with agricultural goods and low to medium quality industrial goods, they compete very heavily on price. Since they sell primarily to countries that use the same currency, they must either become more productive or wages must fall to become more competitive and generate higher returns on capital, which can attract fresh capital into the country. As mentioned above, in the past this was achieved by devaluing the currency, a more socially accepted practice to make the country competitive.
When a country is dramatically cutting costs (the public and private sector), all economic participants spend/invest less due to increased uncertainty and unemployment rates, and no new money is coming into the country, there is effectively less wealth in the country as assets prices are declining and the incoming cash flow is being reduced. This means the government is also receiving less tax income, reducing further its creditability and strength. Countries within the EU have also forsaken the ability to print their own currency, a privilege now held only by the ECB. Governments can only ask to borrow more money in the market. When a country reaches the stage Greece is in, this door becomes firmly closed.
As a result the Government of Greece received a bail out package from the European Union countries and the IMF under some very extreme conditions in Q2 of 2010. Furthermore, the Greek banks can only receive funding from the ECB as no other party accepts Greek bonds as collateral for loans.
Because of the extreme cuts required to receive the bailout package, unemployment will rise in Greece. This will encourage less spending, hence the government receives less tax as less business is being conducted. This forces the country to need to borrow more. Hence cutting costs whilst not receiving the benefits from these savings (i.e. used to pay interest payments), or new capital from abroad to invest in the country, will lead to a reduction in GDP. This will lead to more Greeks defaulting on bank loans. This forces the banks to need to raise capital. But the market is not welling to inject new equity into Greek banks at the moment due to the lack of clarity in what will happen. Hence the only funding avenue for Greek banks is the ECB. A lack of confidence in a country is a vicious circle.
So European countries should inject more money into Greece? But the voters in the European countries ask why should they help a country that overspent and did not work hard enough to overcome their problems when they were manageable? Other European countries are also suffering various degrees of discomfort due to a weak economic environment in developing countries in general.
So let the country suffer and pick itself up alone? Why should a single country affect the sustainability of a currency for several economies much larger then Greece’s?
This is a good question. The answer is the financial market in Europe is considerably more advanced in being “Europeanised” then a common European labour market, fiscal policy or language. French banks hold Greek bonds and German banks hold Portuguese debt etc etc. If Greece was to say they could not redeem their debt because they don’t have the cash, then banks around Europe will have to make write downs of several tens of billions of Euros. This would require a number of banks to raise capital, likely creating pressure in European equity markets. Furthermore, Euribor rates would most likely increase as interbank lending costs increase due to a lack of trust amongst banks on who held Greek debt and who would have to make the highest write down and how it could affect their solvency. Europe contains many leveraged economies and increasing the cost of a loan would likely boost default rates if they stayed high for too long.
But again, Greece is such a small economy relative to the EU, the European banking sector could absorb the write downs – only a few aggressive hedge funds would go bust.
However, the real fright comes when you look into the details. The ECB cannot fund the Greek banks if the government defaults on the debt. If Greek business people see their government default on Greek debt: they know the biggest holders are Greek banks and that these financial institutions now have no sources of funding: Greek money will be pouring out of Greek banks into German bank accounts in a last dash attempt to preserve their wealth before their banks collapse. However, governemtns are well trained in such affairs. Capital will be refused to leave the country, as was most recently done in another European country, Iceland. When external capital is not available for banks, deposits are there only source of funding and governments will try to keep them there at whatever cost.
The question is, how will other “weak European economy business people” react if they see that happen in Greece? Will we see large cash movements out from Spanish and Portuguese banks to German banks? Of course we will! Hence, suddenly, there really isn’t a single Europe! Capital cannot move freely around Europe! There is only Germany and a few select others. The market will make that happen. If the politicians don’t throw out the weaker economies by letting one default, the market will probably do that job for them very quickly…
The weak European countries will become like sieves: capital will not be retained in them – what goes in will come out as a result of a total loss of confidence.
Now that is what we envision happen if Greece does not redeem their bonds by taking that decision themselves. There has been discussion of having a voluntary roll over of debt so that a technical default does not occur and hence the Greek banks can continue to receive ECB funding and the Greek government do not need to meet their immediate financial liabilities. But how does this solve their problems? They still have no new capital coming into the country to help rebuild the economy! Hence it is simply being kept afloat! They must create liquidity from the assets they have. This means forced privatizations. But with the economy so weak, these assets would be sold at below normal market condition prices. But this is the price Greece will have to pay. There must be wealth destruction. It can come from a number of ways including defaulting on debt, selling their assets at a cheap price or wages falling (as it cannot come from a devaluing currency anymore). Funds from these savings can be used to reduce their debt load. When this is reduced, new capital from the markets may start coming in.
Wealth destruction is the procedure of removing the money that should have never existed, because it was poorly invested in the recent past. The mis allocation of capital always leads to an eventual reduction of the total capital in the world, as it has not been wisely deployed to increase its size. This would reduce the wealth of the country and hence the quality of life of its inhabitants. How will Europeans react to this? This is a question we do not know how to answer.
But what about the Euro?
If several weaker European countries are made to become “economic sieves”, this would scare foreign investors and likely lead to a sharp reduction in the valuation of the Euro. However, this is only likely to happen in the unlikely event that Greece decides not to pay its debt.
What if the rollover happens, how would the other “weaker countries react?”
“Same as usual.” “Just keep on going and wait for something to change?”
Probably.
An external catalyst seems to be required to start the wealth destruction process. In a capitalist system, this is the most efficient way to allow unsustainable countries, or companies, to start again in less onerous terms.
Another alternative is that the ECB starts printing more money to fund the weaker economies. This is "a la USA", hence would probably lead the Euro to display a pricing behaviour we have seen recently for the USD. However, Germany is very much against this solution and the ECB has so far positioned itself with a similar stance, even if it has bought many billions of government bonds already....
Indeed, one could day that the bailouts are a way of making it easier to have political, fiscal and economic union. Creditors will become the "equity" owners of these countries....
Wednesday, 1 June 2011
St Joe Review
Description
St Joe is the largest private landowner in North West Florida, owning over 550,000 acres in this region. The company operates in four segments: Residential Real Estate, Commercial Real Estate, Rural Land Sales, and Forestry.
Current situation
The company has had a lackluster record in making the transition from a paper mill manufacturer to real estate developer. This has attracted the interest of many short sellers who feel the company needs to write down projects they have on their balance sheet. Though we do not disagree with the ideas presented, we feel assets bought many decades ago are more heavily undervalued on the balance sheet then recent projects are overvalued.
The strong reduction in bank lending over the last few years has had a powerful effect on real estate prices, which have fallen strongly in the region where St Joe conduct business. As a result, sales have reduced significantly and profits have been negative for three consecutive years. We note that free cash flow is, however, positive during that period.
The need to maintain properties built and pay employees to (attempt) to sell assets imply the income statement is likely to continue bleeding until the real estate market improves. This situation could continue for a number of years.
However, we believe the large cash load and the strength of the St Joe balance sheet allow the company to survive a very turbulent number of years (net debt is negative).
The survivability of St Joe and the price being paid to purchase their land considering the current price of their stock on the equity market ($21/share) makes it an interesting ASSET PLAY proposition.
Attributes of the investment
A fear of inflation and a weakening USD can lead to more foreigners purchasing US land. St Joe is a pure, debt free, land play in the USA. As a result, in the above mentioned scenario it is likely to attract more attention than it does now. We are also comfortable holding cheap land in a strong inflationary environment relative to cash.
We are also attracted by positive moves with changes in the members of the board of directors (and changes in the executive team) and the consequential focus on reducing non core costs, as well as building relationships with skilled partners in developing new projects on their lands. They seem happier to outsource business that they are not skilled in executing. We are happy by the first developments and the recent candor presented in ST Joe´s Q1 2011 report.
What can go wrong
The company is currently bleeding due to having fixed costs and no sales. This situation can be maintained for some time by the company due to the low debt, high cash position of the company. However, if the company does not invest wisely to ensure buyers/tourists are attracted to the region, land values may not increase strongly or quickly enough before the company is forced to sell more land at undeveloped prices to meet fixed costs paid to ensure the land can be developed wisely.
This investment therefore requires confidence in managements ability to achieve this objective. For the moment we are confident with the changes we are seeing with regards to capital allocation and operating decisions for the company. We follow developments closely.
Catalysts
New management and their initiatives. Improving US economy and real estate markets. New joint venture/ partnerships with skilled and experienced partners to develop new projects on their lands. Increasing traffic at new international airport.
Why is St Joe mispriced (in our opinion)
Large fear in real estate markets at the moment (especially in Florida. We have other investments in this region related to real estate due to the current pricing available). Large short sell position in the stock from recognised hedge fund managers. Poor execution record with regards to sales relative to built capacity.
St Joe is the largest private landowner in North West Florida, owning over 550,000 acres in this region. The company operates in four segments: Residential Real Estate, Commercial Real Estate, Rural Land Sales, and Forestry.
Current situation
The company has had a lackluster record in making the transition from a paper mill manufacturer to real estate developer. This has attracted the interest of many short sellers who feel the company needs to write down projects they have on their balance sheet. Though we do not disagree with the ideas presented, we feel assets bought many decades ago are more heavily undervalued on the balance sheet then recent projects are overvalued.
The strong reduction in bank lending over the last few years has had a powerful effect on real estate prices, which have fallen strongly in the region where St Joe conduct business. As a result, sales have reduced significantly and profits have been negative for three consecutive years. We note that free cash flow is, however, positive during that period.
The need to maintain properties built and pay employees to (attempt) to sell assets imply the income statement is likely to continue bleeding until the real estate market improves. This situation could continue for a number of years.
However, we believe the large cash load and the strength of the St Joe balance sheet allow the company to survive a very turbulent number of years (net debt is negative).
The survivability of St Joe and the price being paid to purchase their land considering the current price of their stock on the equity market ($21/share) makes it an interesting ASSET PLAY proposition.
Attributes of the investment
A fear of inflation and a weakening USD can lead to more foreigners purchasing US land. St Joe is a pure, debt free, land play in the USA. As a result, in the above mentioned scenario it is likely to attract more attention than it does now. We are also comfortable holding cheap land in a strong inflationary environment relative to cash.
We are also attracted by positive moves with changes in the members of the board of directors (and changes in the executive team) and the consequential focus on reducing non core costs, as well as building relationships with skilled partners in developing new projects on their lands. They seem happier to outsource business that they are not skilled in executing. We are happy by the first developments and the recent candor presented in ST Joe´s Q1 2011 report.
What can go wrong
The company is currently bleeding due to having fixed costs and no sales. This situation can be maintained for some time by the company due to the low debt, high cash position of the company. However, if the company does not invest wisely to ensure buyers/tourists are attracted to the region, land values may not increase strongly or quickly enough before the company is forced to sell more land at undeveloped prices to meet fixed costs paid to ensure the land can be developed wisely.
This investment therefore requires confidence in managements ability to achieve this objective. For the moment we are confident with the changes we are seeing with regards to capital allocation and operating decisions for the company. We follow developments closely.
Catalysts
New management and their initiatives. Improving US economy and real estate markets. New joint venture/ partnerships with skilled and experienced partners to develop new projects on their lands. Increasing traffic at new international airport.
Why is St Joe mispriced (in our opinion)
Large fear in real estate markets at the moment (especially in Florida. We have other investments in this region related to real estate due to the current pricing available). Large short sell position in the stock from recognised hedge fund managers. Poor execution record with regards to sales relative to built capacity.
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