Grant's conference notes—Pt 2

After a fascinating morning session, outlined in Grant’s conference notes—Pt 1, 50-year market veteran Joe Rosenberg kicked off his lunchtime chat with a pearl of investing wisdom, a lesson all investors must internalise if they hope to succeed:

‘You can have good news or you can have cheap stocks. You can’t have both at the same time.’

It’s a lesson lost on Ford and General Motors, who in recent years have been progressively selling cheap stocks from their pension plan holdings.

Ford and GM now have about 80% of their pension plans invested in bonds. With US government bonds yielding a few percent and high-grade corporate bonds yielding 4% (a multi-decade low), they’ll have trouble meeting their obligations without significant extra investment. And they’ll take an absolute beating on those bonds if rates rise.

Meanwhile, equities of the largest, most well-capitalised companies in the US are ‘historically too cheap’, according to Rosenberg. Were Ford and GM to invest a greater part of their pension fund in equities (it shouldn’t surprise you to discover that they were more aggressively invested in equities before the financial crisis) at current prices, they would likely meet their obligations without additional investment.

US bonds have outperformed US equities over the past 20 and 30 years. This is very rare—the last time was in 1939 according to Rosenberg—and bodes well for today’s stock investor and poorly for bond buyers.

Rosenberg also called attention to ‘irresponsible’ monetary and fiscal policy, which hurts savers—through low interest rates and taxes—in order to bail out the profligate.

On a relative basis, ‘small caps are nowhere near the value of large, well-capitalised companies’.  Stock ideas Rosenberg mentioned, though carefully pointing out these weren’t recommendations, included Microsoft, Cisco, Merck, Johnson & Johnson, Staples and IBM.

Among more cyclical opportunities he cited Hewlett Packard and, proving he’s a contrarian not a dogmatist, the aforementioned GM and Ford.

Meredith Whitney on municipal finance

Whitney has come in for praise and criticism following her predictions a few years ago that many municipal bonds (debts issued by American cities and counties) would default.

Her presentation focused on the broader background. Whitney calls it the ‘bifurcation of the states’ and says ‘it will be one of the most important investment themes of the next 20 years’, though perhaps not from an Australian perspective.

In short, the area encompassing middle America, from Texas and New Mexico in the south all the way up to North Dakota, is booming and will continue to do so. This is being overshadowed by contraction in the coastal economies on both of America’s shining seas.

These central states had a much smaller housing boom and bust. Not coincidentally, they also have a consumer debt-to-income ratio of less than 100%, versus 140% in California. State and local government finances are also in better condition, although nationwide over the past decade, the states have spent about 2.5 times their tax receipts. Eventually, Whitney argues, this must be resolved by spending cuts or higher taxes.

The problem is that putting up property taxes in one area makes it uncompetitive and encourages tax arbitrage. Whitney pointed out that you lose your best customers under these circumstances—taxpayers move, recipients stay.

Alternatively, troubled municipalities can severely cut spending on services and public sector jobs but that will also result in a feedback loop. The companies that create jobs are facing similar decisions, explaining why Google, eBay and Amazon are now investing in Texas, not California.

The Midwest and South are growing about 1.3 times faster than the other regions of the US, a trend Whitney expects will last decades. Leaning on that trend, she cited Discover as a simple financial stock (and we thought that term was oxymoronic) that caters to average Americans.

Jim Chanos—A search for global value (traps)

Famed short seller Jim Chanos told us what he looks for in the ideal short position (selling a stock you don’t own to profit from its fall). He says value traps are often cyclical and overly dependent on one product. Hindsight drives expectations (meaning the companies have strung together a few good years, but they won’t last).

His best short ideas, he said, tend to have marquis management and/or, perhaps surprisingly, famous investors on the register. The stock usually appears cheap using management’s preferred metrics, but usually has accounting issues. Chanos then presented six sectors and stocks, all of which Kynikos Associates is short. One of them, which we’ll discuss first, is particularly relevant to Australian investors.

Chanos is acutely bearish on China, particularly what he sees as a real estate bubble. Iron ore is inexorably linked to Chinese construction, which consumed 66% of global supply in 2011, up from 51% in 2007.

Iron ore extraction is becoming more costly, due to large investment in rail, port and energy and rising labour costs. And governments are targeting the industry as a cash cow (super profits tax, anyone?).

In after-adjusted terms, the current iron ore price is a whopping twice the price of the second highest peak of the past 110 years, and more than four times the average. This peak has ‘brought forward a lot of capital expenditure in the field. People are starting to dig it up and get it to the coast.’

Chanos cited Australia’s Fortescue Metals as a favourite iron ore short. The company has made the ‘biggest bets’ and with the ‘biggest customer’ (98% of sales to China). It makes large profit margins but has large and growing debts—$1.5bn annual capital expenditure and rising (versus $2.5bn EBITDA).

He thinks management is ‘promotional’ and expects lower iron ore prices to translate into ‘much lower debt servicing capacity and a dramatically lower share price’. Interestingly, Chanos is long BHP Billiton but only as a hedge, an offsetting bet to limit the damage if he’s wrong on the iron ore price.

His other short ideas include:

• US domestic coal through Consol Energy, as ‘shale gas is a game changer’ for America.
• National oil companies, which are ‘almost all destroying value despite high oil prices’. He’s short Brazilian giant Petrobras, which ‘spent $40bn last year for no increase in production’, which aggressively capitalises almost all its interest payments and which he feels will need to raise $100bn of equity soon – ‘with oil over $100!’
• The death of the personal computer, with a focus on Dell. The tablet revolution is about to take off, and Dell has no meaningful presence. He also called Dell’s finance arm a ‘subprime lender’.
• Digital distribution—citing HMV and Blockbuster as great past examples that ‘looked cheap all through their decline’, he focused on Coinstar, owner of Redbox DVD hire kiosks. Perhaps he read James Greenhalgh’s Doddsville post, Prediction: Death of the DVD kiosk.
• Troubled national balance sheets—Spain’s fiscal house is in ‘disarray’, with 23% unemployment and 50% youth unemployment. Its bank accounting is in ‘fantasyland’, the ‘least reserved, most troubled in Europe’. Kynikos is short Banco Santander. It has significant real estate exposure in Spain, where 29% of loans are non-performing and rising (‘went to 40% in previous, lesser panics in Spain’). Non-Spanish lenders have taken huge charges on Spanish exposure, but local banks are yet to.

James Aitken—the plumbing of the financial system

Aitken talked about the ‘plumbing’ of the financial system and despite my best efforts, some of it was lost on me. But enough sunk in to make it worth covering.

His central argument is that in a ‘financed financial system’, it’s not money supply than matters—‘collateral is money’. The velocity of collateral—the number of times an asset can be pledged and repledged—is the real grease of the global economy.

The world is taking two lessons from the AIG and Lehman collapses. For banks, the lesson is, ‘You will need more collateral than you think’, and for investors it’s ‘You will need your collateral in segregated accounts’ (where the bank can’t grab it during its demise).

The two lessons, in concert, have set up a huge reduction in the velocity of collateral. This has a depressing effect on economic activity that more than offsets increases in the money supply.

According to Aitken, the United States looks ‘relatively fabulous’ and, on the European Monetary Union, he believes ‘it’s over!’ Austerity measures ‘passed’ and ‘implemented’ are two very different things and, in Spain in particular, the crisis ‘only begins now’.

He cleverly called the European Long Term Refinancing Operation (LTRO)—where the ECB lends cheaply to banks to buy government debt—the ‘first credible can kick for two years’. He anticipates harsh knock on effects, ‘Why would an undercapitalised European bank lend to a corporate with the LTRO in place?’

He cautioned conference goers to avoid unsecured loans to European financials, and that more aggressive investors might consider shorting Spanish and Italian banks.

Simon Mikhailovich—Do you have systemic insurance?

Having grown up in the Soviet Union, Mikhailovich’s attitude to risk stands out even among the bearish mob at this conference: ‘Insurance is not the opportunity of profit, it’s the cost of avoiding unaffordable losses’, he says.

Mikhailovich argues not enough has changed since the last crisis. Widespread defaults, sovereign debt crises, devaluations and capital controls will occur in the future—‘with no warning, done on weekends, always involving the transfer of wealth from those that have it to others’. ‘The governments of the world always use the threat of Armageddon to push their barrow.’

Mikhailovich pointed out that all recent government solutions have ‘been driving up correlations’—but you need to reduce correlation and build firewalls to end crises. Past safe havens included real estate, diamonds and collectables, but only precious metals preserve value through a crisis and provide liquidity (there’s always a world gold price and illiquidity is never an issue).

Unlike other presenters, Mikhailovich strongly favoured holding physical gold rather than derivatives—foreign-owned gold in America is generally held in a Manhattan vault, but ‘America’s gold is protected by the military, not the financial system…do what they do, not what they say’.

To counter the argument that gold is in a bubble, he pointed out that Western investors remain very sceptical and are buying the trade (derivatives), not physical gold—80% of physical gold production is being sold to emerging markets.

To highlight the point, he asked who in the audience owned physical gold, with perhaps 15% of participants holding up their hand. He then asked only those with more than 5% of their wealth in physical gold to keep their hand up—leaving perhaps just 10-15 hands raised among 300-400 participants. At a Grant’s conference, a gathering of the truly wary, it was an eye-opener.

He believes insurance is cheap ‘because demand for physical gold is low in the west, where the majority of financial assets reside’. ‘Everybody has to have a certain amount of gold.’

James Grant—A history lesson for Chairman Bernanke

‘Bernanke calls himself a historian. I will take his lead and call myself an astrophysicist and major league baseball player.’ Thus went the initial shots from James Grant, himself the author of five books on finance and financial history.

Having read the transcript of a speech Bernanke gave recently at George Washington University, unprecedented by a sitting Fed chairman, Grant—a long time critic—nevertheless found himself stunned at Bernanke’s interest ‘in non-facts and discordant facts’.

Talking about wage controls in the 1970s, Bernanke said they shouldn’t have happened because ‘prices are the thermostat of the economy’. But, Grant argued, look at how he’s manipulating both short and long-term interest rates today.

Grant is convinced the chairman misreads history—‘he doesn’t realise how far out on a limb he’s taken us, and he’s willing to go further’. His only solution is for more regulation, ‘he doesn’t believe in capitalism’. As much as he doesn’t like the current trend, Grant believes there is the possibility of a sharp turn ‘away from statism towards liberty’.

In the meantime, ‘we love gold stocks, but they don’t yet love us back’. He also likes ‘old houses’ (American real estate). He suggested the audience consider a portfolio of gold mining stocks—‘knowing what I know about the chairman, the gold price might yet reward gold stock investors’.

‘Newmont (Mining) is a very cheap stock,’ he suggested.

For information on future Grant’s conferences, held twice-yearly in New York, or to subscribe to this excellent contrarian publication, visit grantspub.com