The World has Changed

There was an unprecedented delay since the last post in The Frost Report, as you may have noticed.

I could write volumes about the reasons for this, but simple explanations are always best: a new position at a global financial institution, followed by several high intensity 60-hour workweeks. For the moment, life is back to normal.

So, what has changed since the last post?

For one, the subject of the last post - the lawsuits expected against Baja Mining - have now begun. 

On July 27th, a large shareholder initiated a class action lawsuit for over $250 million, claiming "misrepresentation" by Baja.  Although the shares are now sure to be worth almost nothing (creating a loss for me) I am nevertheless satisfied by this development.  As a speculative buy, I own just enough BAJ shares to be annoyed at their drop in value, but not enough to affect me in any material way whatsoever.  In this case, justice is more interesting than profits.

In anticipation of the inevitable slowdown of the Chinese economy (something The Frost Report has been writing about since early 2011), the XME Metals and Mining Index has dropped more than 50%, exactly as expected.  Interestingly, established mining companies were hit just as much as companies that own nothing more than a piece of land.  And, those that produce gold were hit just as much as those that produce iron.  One of these days I will remember that when a sector drops, even the best companies drop right along with it.

With many commodity-producing companies running at P/E Ratios of around 2.0, opportunities certainly abound.  Long-term investors would be wise to consider making regular purchases of commodity index funds, such as XME.  I say "regular purchases" because December of this year may mark the low point.  In December, many investors will be doing year-end tax loss selling of the most battered stocks.

The global housing market slowdown (also something that The Frost Report has been anticipating since 2011) is now well underway.

In Israel prices have notably softened and they are preparing for a hard landing (i.e. a drop that they will not be able to control).  In Canada, regional bank branches that were doing 6-10 mortgages a week in the spring of 2011 are now lucky if they do 2.  And in China, home prices are officially stable and robust, signifying that the government is lying its pants off.

And finally, the thing that hasn't changed at all since the last post...

Retail Investors remain deathly afraid of stocks.

A Financial Planner a few days ago mentioned that in 2006 their company's best-selling mutual fund was composed of 80% stocks.  Now, their best-selling mutual fund is composed of 80% bonds.

It seems that stocks are still, and for some time will continue to be, shunned by regular investors as a dangerous game.  And so it is, if you don't know what you are doing.

If you are a long-term investor with a eye for value, the 2008-2012 (+) period will likely be the single greatest stock purchasing opportunity of your lifetime.

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"The day I went to work in 1932, steel mills were running at eight percent of capacity.  I remember days when the trading was so slow people played ball on the floor of the exchange."

David Babson, as told to Adam Smith in Supermoney

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BlackBerry's Bold Move

Reuters news agency this week released an article with the hopelessly biased title, “RIM’s BlackBerry May Have New Hope in One Market.”  Within that article, however, Research in Motion outlines a great new sub-strategy to further increase sales in emerging market countries.

When I was in India just a few years ago, it was impossible not to notice how everyone – no matter how poor - has a mobile phone.

That bicycle-rickshaw driver may live in a hut made of dried cow dung and tin, yet he owns a mobile phone.  The street vendor who sells curried rice for $0.20, then washes the plates in a pothole filled with rainwater and cow piss…she has a mobile phone too.  The young call centre employee, who lives in his parents “condo” (three rooms and almost no furniture), owns both a mobile phone and a laptop: he is middle class.

RIM’s strategy is to capture the lucrative “trade up” market: the billions of people who currently own older mobile phones capable of talk and text but little else.  These people could never realistically afford an iPhone 4S, yet are willing to spend a few months’ salary to get a simple, reliable smartphone like RIM’s new BlackBerry Curve 9220.

The Curve 9220 is a sleeker version of the 8520, with improved Web browsing, Facebook and Twitter apps, FM radio, long battery life, and $48 US worth of free application downloads – including both business applications and games like "Ultimate Cricket." In other words, the features are simple, but are the most important ones for the customer base RIM is trying to capture.  Monthly plan fees start at as little as $5!

The Curve 9220 will sell for about $210 US (without contract), which compares nicely to the older iPhone 3GS which sells for $350 or more and has higher monthly plan fees.

Earlier this year, RIM made a great move by upgrading its Playbook tablet operating system, and slashing prices down to $199 to compare positively to the Kindle Fire.

RIM has been struggling of late, and no one yet knows if these and other strategies will give RIM its profitability back.

I’m not willing to make a huge investment in RIM – but I am willing to throw a few investment dollars their way.  I think RIM has been written off far too easily.

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"Asia is not going to be civilized after the methods of the West.  There is too much Asia and she is too old."

Rudyard Kipling

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Disclosure

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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I Hate Banks but I love JP Morgan

Contrarian investing is, in concept, one of the simplest things in the world.  It says that the masses are idiots and are always wrong; therefore, doing exactly the opposite of the masses is the correct thing to do.

The problem with contrarian investing is that the masses are sometimes right.

In 1985, faced with high interest rates, the masses said that interest rates could still go higher (and long-term bond prices lower)  – and they were right.  In 2009, despite falling markets and great valuations, the masses said that stocks would still go lower – and they were right.  Doing the opposite of what the crowd recommends isn’t always the best course of action.

And yet, contrarian investing works, largely because people make investment decisions based on emotions rather than logic.  Case in point: CEO Jamie Dimon's annual newsletter, released Wednesday.

In the newsletter, Dimon pointed out that JP Morgan Chase had record earnings of $19 billion last year (that’s the best year ever).  He added that the earnings would have been even better if it had not been for still-high mortgage related losses.  As time has gone forward, these losses have been declining.

Most interestingly, Dimon hinted that the price of JP Morgan stock was likely low because of “hostility” toward him and to the banking sector in general.  Based on the comments seen after the newsletter was released, Dimon is right: he was called a “criminal,” “manipulator,” “slime ball,” etc.

By now, I’m sure Dimon is immune to such disparaging remarks.  As a banker myself, I occasionally have clients tell me that they “hate banks,” which I consider a polite (weak?) way of saying, “I hate you.”  Then again, I also have people tell me that I’m wonderful but that they hate bankers: is that a compliment or an insult??

Emotions aside, here are the facts that investors should be interested in:

-         Record earnings of $17 billion, up from $12 billion in 2009.

-         Return on equity of 15% (which Dimon thought was low).

-         Market share growth in almost every area.

-         Approved to implement stock buybacks.

-         Opening 120 to 200 new branches a year.

There are many headwinds in banking, to be sure, including new regulations, housing weakness, and worldwide economic uncertainly.  But none of these are reasons to not buy a company.

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“We all have a vested interest in getting this right.”

Jamie Dimon

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AIG gets its Pants Back On

There are some companies that the average investor simply will not touch; American International Group is one of them.  AIG is, after all, a poster-child for the excesses of the 2008 banking fiasco.  While America burned, AIG executives dressed in togas and had grand parties – literally!

At The Frost Report, however, we recognize that companies the public hates are often good bargains.  When the numbers make sense, we let bygones be bygones.

This Wednesday, AIG paid back the US Treasury an additional $1.5 billion in TARP money, eliminating the government’s preferred share stake.  Tim Massad, the Treasury department’s assistant secretary for financial stability, had this to say about the event: “In the dark days of the financial crisis, when commitments to AIG totaled $182 billion, few would have believed that we'd already be able to reduce that amount by more than 75 percent, or that we may be able to recover every single dollar invested in the company.”  And yet they have – ahead of schedule.

Consider these statistics: AIG has a book value of $55 per share, yet today’s closing price was only $28.27.  In what always strikes me as one of the wonders of Wall Street, you can literally buy $55 worth of goods for $28.27.  Of course, "book value" is useless if AIG is forced to have a fire sale on its goods and sell them for less than cost.  So, is the company profitable?

AIG had annual sales of over 64 billion dollars in 2011, with profit of $15 billion on 1.9 billion shares outstanding.  Return on equity also handily beat the market at 26%.

Like other companies in the pariah class, there is no big rush to buy AIG.  The government will be selling its stake for some time, and the stock will not likely jump until that selling pressure is over.  Having said that, the government has done a good job of letting other companies it owns (like Citi) rise steadily in value, selling them in a mellow and responsible manner.

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"I would suggest the first thing that would make me feel a little bit better toward them [AIG executives] is if they'd follow the Japanese example and come before the American people and take that deep bow and say, I'm sorry, and then either do one of two things: resign or go commit suicide."

Senator Charles Grassley, 2009

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Disclosure

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

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A Tale of Trading Woe

Last Friday, I was chatting on the phone with a friend of mine who is a talented and logical investor: one of the elite.  He and I often trade views on economic trends or discuss companies and stock tips, and this was just such a day.

He mentioned having recently bought a company called “Viterra,” which has a virtual monopoly on grain storage and shipping in central Canada.  He said that its price had dropped in recent quarters, and went through a short burst of statistics to back up his “great buy” claim, including earnings history, price to book value, and the nature of the industry.  I told him I’d check it out, and we each hung up the phone.

It only took a couple of minutes for me to realize that Viterra was indeed a great company at a great price, so I put in a limit order well above the current bid (at $11.50), to make sure I’d get in.  Then I hit the "enter" key and sat back.  But strangely, it didn’t fill.

I looked at my screen in disbelief as I read that trading had been halted pending an announcement.  The newswire then announced that “certain parties” had expressed interest in buying the company.  When the stock resumed trading a few minutes later, Viterra stock had jumped 29.8% to over $14 a share.  My order (at a now-measly $11.50) didn't fill.  Dammit!

Needless to say, my friend called back a couple of minutes later to casually jab me about my lost opportunity (“I didn’t know this would happen.  Honestly!”)

Shortly after that, I called him back to let him know that the transaction just made the cover story for the Globe and Mail’s online business section.

I completely missed out.

 

Lesson of the day: solid, undervalued companies do not stay that way forever.  Don't wait to buy.

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“We didn’t lose the game; we just ran out of time.”

Vince Lombardi

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Share Buybacks - Good or Bad?

A recent article from Canada’s Globe and Mail ("Share Buybacks: The wrong way to reward shareholders") suggests that stock buybacks are - as a rule - useless.

The Globe article states that after a buyback program is announced a company's stock price usually declines anyway; that is, the buyback typically signifies a peak, and does not add any value to shareholders.  But is this correct?  How can buying back shares not add value to shareholders?

The Globe's simple look at the statistics ignores the rationale for doing buybacks. In fact, there are good stock buybacks and bad ones, and management’s reasoning makes all the difference.

Share buybacks can be the best way to reward shareholders. The fact that the market doesn't immediately recognize this and boost the stock price is irrelevant.

When a company's shares are trading at close to or below book value and at low P/Es, why would the company issue dividends or make acquisitions? Buying the stock of an underpriced company (their own) is the best choice. Every share bought back by the company means more earnings for remaining shareholders. For example, if a company has earnings per share of $.50 and you own 100 shares, your personal share of the earnings is $50.00. If the company buys back ¼ of its shares, your personal share of the same earnings is now $62.50. Eventually, more earnings per share = a higher stock price.

On the other hand, if a company's stock is overvalued either in terms of P/E or book value (or both),  then share buybacks are clearly a waste of money: why buy back overpriced shares when the same money could be used to make valuable acquisitions or pay a dividend? In this case, a share buyback doesn't make sense.

When management does a share buyback for the right reasons, people notice.  When Berkshire Hathaway, for example, announced in Sept of 2011 that it would buy back shares, BRK jumped 8% in a single day.

The Globe and Mail article notes that companies typically buy back stock when they are flush with cash but stock prices are high - which is the wrong time to buy back stock. At the moment, however, many companies are flush with cash at a time when their stock prices are low - the perfect time to buy back stock.

Good companies pay extra dividends or make acquisitions only when their stock is overvalued (or at least fairly valued).  When their stock is undervalued, buybacks are the best choice.

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"When companies purchase their own stock [at a discount to fair value], they often find it easy to get $2 of present value for $1."

Warren Buffett

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Berkshire Hathaway's Machine

If you believe recent commentaries, Berkshire Hathaway’s Warren Buffett – once considered one of the greatest investors in the world – is now “too old” for investing and is washed up, tired, and has lost his touch.  The people making these comments have clearly not taken the time to examine Berkshire’s financial statements!

In investing, timing is everything.  An undervalued investment can sometimes take months or years to begin rising in price; and, while waiting, returns will be stagnant.  Berkshire has found a way around this problem.  Berkshire is now so synonymous with safety and stability (and for being a good business partner) that it obtains exclusive deals – unavailable to anyone else - where it is actually paid to wait.

Take, for example, Berkshire’s investment in Bank of America.  BAC’s current share price is $7.07.  Berkshire bought preferred shares of BAC that earn 6%.  With this preferred share deal came warrants to purchase up to 700 million shares of BAC at $7.14 per share, and these warrants don’t expire until 2021.  In other words, any time between now and 2021, Berkshire can purchase BAC shares at $7.14 per share, even if the stock doubles or triples (or more).  While waiting, Berkshire earns 6% on the Preferred shares!

Berkshire has a similar deal with Dow Corporation.  Berkshire currently earns 8.5% on Dow Preferred Shares.  Berkshire can purchase up to 72.6 million shares of Dow at $41.32 per share with no expiry date, except the stipulation that Dow has the option to redeem the preferred shares when the stock attains stable prices of $53.72 or more!  Put more simply, this means that Berkshire will earn 8.5% from its investment in Dow for months or years, and then make at least $12.40 per share ($52.72-$41.32) when the Preferred shares are converted to common shares, for an additional profit of 900 million dollars.

Berkshire Hathaway is an incredible moneymaking machine...especially for those who have the luxury of time, and the patience to wait.

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"The most important attribute for success in value investing is patience, patience, and more patience.  The majority of investors do not possess this characteristic."

Peter Cundill

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Stocks I Like - Leucadia National Corp

Leucadia National Corporation (stock symbol: LUK) may be the biggest, most successful company you've probably never heard of.

A quick look at Leucadia's website (www.leucadia.com) reveals that this company is different; the homepage looks like it was designed by a high-school student twenty years ago (and maybe it was).  One would never guess that as of Q3 2011, the company had assets in excess of 9 billion dollars, and that in 2010 - Leucadia's last fully reported year - the company had $1.3 billion in revenues.

Virtually everyone these days has heard of Berkshire Hathaway and it's famous value investor, Warren Buffett.  Yet, Leucadia National Corp. has managed to stay under the radar of the average investor: presumably where they want to be.

Like Berkshire Hathaway, Leucadia is a conglomerate, specializing in the purchase of undervalued, under priced assets.  Also like Berkshire, their annual reports are easy to read, honest and straightforward.  Unlike Berkshire, Leucadia loves to buy "turnarounds" - companies with bad management, shoddy business practices, or lack of funding.  It then sticks with these companies - often for years - providing the management expertise and funding required until the moment of fruition.

At present, Leucadia owns investment banks, mines, timber companies, plastics manufacturers, wineries, energy companies, hotels , auto retailers and natural gas drillers.  Leucadia also has a 50% stake in "Berkadia Commercial Mortgage Inc.," a  joint venture with Berkshire Hathaway.

Leucadia frequently carries a massive cash and stock portfolio: as of Q3 2011, $306 million in cash and $811 million in investments.  Due to this large stock portfolio (and the fact that Leucadia purposely invests in money-losing companies), the company's income tends to swing wildly; despite this, the company has averaged a stunning equity growth rate of 20.2% annually since 1978.

Knowing that Leucadia's investors are value investors, you can be fairly certain that their current investments are drastically undervalued.

Leucadia is currently trading at $25.45 per share.

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"We quickly changed the name from Goober Drilling to Keen Energy Services."

Ian Cumming and Joseph Steinberg of Leucadia National Corp, regarding their 2009 purchase of Goober Drilling of Stillwater, Oklahoma.

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Disclosure

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

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Bill Miller vs. Instant Gratification

From 1991 to 2005, value investor Bill Miller headed one of the most successful investment funds in the world, beating the S&P 500 (“the market”) for 15 consecutive years.  On November 17 2011, however, Bill Miller stepped down as superstar manager for the fund he made famous.

It is said that Bill Miller has lost his touch.

During 2008 and 2009, Bill bought “horrible” companies like U.S. financials.  Many of these picks lost large amounts after his purchases (some up to ¾ of their value), and are still now languishing as losers.

Phil Pearlman said this of Bill Miller and of mutual funds in general: “Mutual funds remind me of AOL dial-up (Internet service): a dwindling collection of old people who don’t know better, contributing monthly to a comically inferior product.”

What many consider to be the new and superior product is the Hedge Fund.

Hedge Funds assets have grown dramatically, from just $38 billion in 1990 to more than $1600 billion in assets today.  Hedge funds are hip, cool, young, exciting, and promise to make you more money with less risk - even if they have higher fees (see the next Frost Report article for more about this).

In many ways, Bill Miller is the latest victim of a worldwide phenomenon – lack of patience and the desire to get rich quick.

The very word “investing” implies buying an undervalued company, then waiting for the company to improve and grow and the stock price to improve along with it.  Virtually no one does this anymore.  People want instant gratification.  They think that if a stock doesn’t rise in 6 months or a year (or, god forbid - that it drops even more), the stock pick must have been “wrong.”  Others believe that the market is so rigged against them there is no point investing at all.

For value investors of the world, the societal shift from value investing to stock trading and hedge fund purchasing is a blessing.  The fewer the number of people who believe in value investing (picking great, out of favor companies and holding them for years), the more successful the strategy is.

Bill Miller was ruined not because his value picks were bad, but because they didn’t bounce back fast enough to prove the quality of his convictions; and, his investors didn't have the patience to find out.

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"The market does reflect the available information, as the professors tell us. But just as the funhouse mirrors don't always accurately reflect your weight, the markets don't always accurately reflect that information. Usually they are too pessimistic when it's bad, and too optimistic when it's good."

Bill Miller

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How to Invest if you are Worried about Losing Money

These days, many are tired of the crazy gyrations of the stock market, and worried about losing their savings.  How do you invest your money and still sleep at night?

This article gives the most common options for investing hard earned but frightened dollars, ranked from worst to best.

5.  High-Interest Savings Accounts

Worried investors love the idea of savings accounts because they are guaranteed by the government (up to limits), because the money can be taken out anytime, and because you don’t have to make any future decisions – just leave the money there.  However, savings accounts always pay far less than the rate of inflation – usually 3% less.  For example, if the rate of your high-interest savings account is 1.5%, the inflation rate for the same period is probably 4.5%.  So, you are actually losing 3% of your purchasing power for every year you keep your money in the account.

If you invest $50,000 in a savings account and keep it there for 2 years, you appear to have $51,511.  But in fact, the purchasing power of your money is now worth only $47,045.

No one should leave money in a savings account unless it is for a few weeks or less.

4.  Guaranteed Mutual Funds

Guaranteed mutual funds are a relatively new concept.  You buy a mutual fund today that has a “maturity date” of, say, 10 years later.  As long as you hold the mutual fund until the maturity date, your principle is guaranteed!  Even if the market crashes you can’t lose your principle.  Sounds great, except that the issuer (typically a bank) can change the nature of the fund at any time.

Say, for example, you buy a guaranteed fund full of stocks and then the market drops.  The bank can remove all risk for itself by changing the holdings of the fund from stocks to safe but low-paying government bonds.  After the change, there is no hope for you to make any substantial amount of money.  You can hold this now ultra-safe fund for 10 years and get your principle back, or sell it and lose money.

In short, guaranteed funds tend to charge higher fees for their “protection, ” then screw their investors anyway.

3.  GICs

Guaranteed Investment Certificates are extremely popular because they pay more than savings accounts and feature two beautiful words – “guaranteed” and “investment.”  Some people love rate shopping for GICs, and pride themselves on getting the best rate.  Professionals consider people who buy GICs as long-term investments foolish.  That’s because GICs are designed to give rates close to the rate of inflation but not exceeding it (see option 1, Savings accounts).  So, the only thing that is guaranteed is that you will slowly lose money.

GICs are excellent for elderly clients who are unable or unwilling to understand any other type of investment.

2.  Index-Linked GICs

The best way to explain an index-linked GIC is to give an example.  Say you buy a 5-year S&P 500 index-linked GIC.  Over 5 years, the return of your GIC will be half that of the stock market, as measured by the S&P 500 (500 large US companies).   So, if the stock market goes up 25% in five years, you will get 12.5%.  If the stock market goes up 80%, you will get 40% and so on.  If the market drops, you will get your principle back.

Index-linked GICs are a great way to play the stock market for those who are too skittish to invest directly.

1.  Short-Term Bond Funds

When you buy a short-term bond fund, you are lending your money to large and reliable companies and the government, who in turn pay you interest.  Because the money is leant over a short period of time, there is little danger that a company’s fortunes will change, rendering them unable to pay you back.  And, because each bond fund holds so many companies, you don’t really need to worry even if a couple of companies do go bankrupt.  Since the bonds are short-term, you won’t lose money due to changes in interest rates (long-term bond prices go down when interest rates go up).   Finally (and importantly), short-term bond funds always beat the rate of inflation. 

For these reasons and more, short-term bond index funds are great investments.  Do not confuse short-term bond funds with more risky high-yield bond funds, long-term bond funds, or real estate bond funds.  Note that although short-term bond funds are very safe, they are not guaranteed by either the bank or the government – they are subject to the good credit of the companies in the fund.

Short-term bond funds include:

VCSH - Vanguard Short Corporate Bond Index ETF

SCPB - SPDR Barclays Capital Short Term Corporate Bond ETF

BSV – Vanguard Short-Term Bond ETF (mix of corporate and government)

So there you have it – five common ways to invest without losing your shirt, the final two of which I highly recommend.

Investing safely is a solid first step to investing, but far from the last.  To be a superior investor, you really shouldn’t be worried about money at all (something that is far easier said than done).  Ironically, the more worried you are about losing money, the more likely you are to do something silly and lose money.  For those who know they have not mastered their fear of loss, please note that I wrote a book specifically for the purpose: The Intelligent Investor’s Mind.  The link can be found at the top right of this page.

Good luck and happy investing!

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"The first rule of investing is don't lose money; the second rule is don't forget Rule #1."

Warren Buffett

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Buffett and the Beautiful Banks

For months now, The Frost Report has been recommending the purchase of US bank stocks. For months now, US bank stocks have been dropping in price.

Earlier this week, Dick Bove of Rochdale Securities received a lot of heat after saying that people were “simply flipping out” about bank stocks, and that valuations were “ridiculous.” He pointed out, wisely, that although bank stock prices were falling, bonds prices were not.

Unlike stockholders, who tend to speculate, bondholders simply want the company to stay in business so they can collect interest and then get their money back. If a company is in danger of going bankrupt, bond prices drop. Yet, financial bond prices are holding steady, some even rising, showing that bondholders are not worried.

On Tuesday, billionaire Warren Buffett was at home taking a bath, thinking about how BofA was suffering confidence-wise and yet was solid financially. He called BofA and made them a win-win offer, and by Thursday morning (24 hours later) he owned 5 billion dollars worth of Bank of America, with warrants to purchase 700 million shares. When the news was released, BofA’s stock price rose 10% in a single day. Fortunately, I had loaded up on BofA stock just three days earlier, when it dropped after a string of rumor emails hit Wall Street claiming that the company was filing for bankruptcy.

US Banks are shouldered with large amounts of potential litigation (ie. they are being sued). They still own thousands of underwater mortgaged properties. Interest rate spreads are affecting bank profitability. Why would an investor with the stature of Warren Buffett be interested in buying bank stocks? Why would Berkshire Hathaway, Buffett’s company, be holding more than 40% of its total investments in the financial sector?

It’s simple. Great investors don’t care about rumors or fear, or whether the stock price is currently falling or rising – they just look at the facts. And, as a sound investment, the facts about banks are compelling. Bank of America is a perfect example:

Bank of America has a Mt. Everest balance sheet, with $140 billion in cash and more than twice that in securities. It actually has $13.86 in cash per share, yet the stock is trading at only $7.76. Put another way, for $7.76 you receive $13.86 in cash, $30 worth of securities, and a business that is gaining market share.

I have to admit, I have found the continuing drop in bank stocks to be both annoying (why are people still afraid?) and exciting (I can buy more!) at the same time.

Perhaps Buffett’s timely investment in Bank of America will finally make people see the light.


Update: On Monday Aug 29th, BofA announced it had successfully sold half of it's 10% stake in China Construction Bank, for a gross profit of 5.3 billion USD. A wise move if ever there was one.

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"A public-opinion poll is no substitute for thought."

Warren Buffett

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For more information, see:

Stock Market Flipping Out on US Banks

Buffett Bolsters Bank of America

BofA Sells Half of China Bank Stake, Raising $8 Billion

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China's SEC Visit

Just two posts back, I wrote about a problem of Chinese publicly-listed companies; namely, that many of them don't exist.

Well, it seems like their party is one step closer to ending.

The American Public Company Accounting Oversight Board (PCAOB) and Securities and Exchange Commission (SEC) is sending over a delegation to establish oversight of Chinese auditing firms. At the same time, Canada's Ontario Securities Commission (OSC) will be "reviewing" emerging market companies listed on Canadian exchanges.

Although China forbids US auditors from exposing, um, I mean, inspecting Chinese companies directly, the US auditors are hoping to create a list of companies willing to be inspected voluntarily with Chinese government consent. Presumably, most of those willing to be inspected would be legitimate.

When I was in India a few years ago, I saw a "steel products manufacturing company" that consisted of one skinny guy with a small pile of coal, a bellows, a hammer, and an anvil. He was seated inside a cubicle made of sheet metal at a New Delhi marketplace, hammering out a kitchen knife. A sign behind him proudly announced that his company was publicly-traded on an Indian stock exchange.

Companies in China already hire white people with no qualifications or job descriptions, so that their offices can look international and important. Predictably, shell companies will hire people off the street to play the roles of office employees during the audit visits; or, they will just try their luck with red envelopes full of cash. Nonetheless, I suspect that the paperwork will not be so easy to fake. Since the Chinese government cannot afford to lose face, many more companies will be de-listed.

Yet another nail in the coffin of the bloated Chinese market.

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"The superior man understands what is right; the inferior man understands what will sell."

Confucius

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Buffett States the Obvious

Warren Buffett...perhaps the only person in the world who can make huge headlines by stating the obvious.

Today's headline on CNBC.com: "Berkshire Will Not Exercise Goldman Stocks Immediately." The story explains that Buffett will not exercise his Goldman Sachs warrants - even though he would make a profit by doing so - because....(wait for it) he thinks the stock is worth more than it is trading at!

Pardon me, but isn't that why most people buy stocks in the first place - because they believe they are worth more than they are paying for them? Am I missing something? The article goes on to say Buffett believes that over time, the stock market will go up. During the credit crisis in 2008, Buffett made headlines by saying that the economy will "eventually recover."

It's hard to say why Buffett makes headlines with these statements. Is it that trading has become so prevalent that no one believes in investing anymore? Or, is it because pessimism has grown to such an extent that any positive statement, no matter how obvious, is embraced with open arms?

Whatever the reason, Buffett continues to be a source of sensibility - and the obvious.

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"Well, I just don't know. I don't know whether Cotton's going to go up."

Warren Buffett, 2011

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For additional information, see Berkshire Will Not Exercise Goldman Stocks Immediately

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Japan Finds the Downside to Nuclear Energy

About 5 years ago, I toured the Hamaoka nuclear power plant in Japan. Like all things Japanese, the mood and theme surprised me. Nuclear energy, I learned, is really fun!

First was the powerful “green energy” spin. Part of the tour included watching a show of robotic animation characters (similar to “Bear Country Jamboree” at Disneyland), singing and dancing about the joys of safe and green nuclear energy. There were nuclear games and activities for kids. There were clam-digging tours out back of the reactor. Clams and other shellfish thrive in the heated waters expelled by the nuclear reactor, so local residents dig for clams there. Paradise!

The Hamaoka Nuclear Power Plant's IMAX theatre is, at the time of writing this article, playing "IMAX Under the Sea," and advertising the upcoming Walt Disney flick, "Mars Needs Moms."

Yet, there were always reminders about the negative side of nuclear energy. Worker exposure to radiation makes the news regularly. My friend Mamoru, a nuclear safety inspector, was on NHK news one night explaining how a small crack in the retainer at one of the plants was nothing serious. Then there was the time I had to write diplomatic letters to the Kazakhstani government, asking them to allow human blood samples from radioactive fallout victims to be shipped to Japan via courier for study.

Yes, nuclear energy is a big source of power in Japan, and has thus far been relatively safe. We shall see if it stays that way. If you live on the West Coast of the United States, buy iodine just in case.

As for stock picks as a result of the disaster…Sekisui house (a Japanese homebuilder and Division of Sekisui Chemical) seems like a smart buy. Sekisui builds semi-prefabricated homes, and forms a large part of the new home market. Importantly, Sekisui has seismic test platforms in their factory, and they shake the living hell out of each new home design to make sure they stay together. No doubt, many people will be replacing their traditional homes (or destroyed homes) with Sekisui branded homes.

For obvious reasons, Tokyo Electric Power Company (TEPCO - the nuclear plant owner) is a “sell” until further notice.

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For further information, see:

Sekisui Earthquake Resistant Housing

Nuclear Power Plant safety measures

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Four Classic Hedges

"Hedge your bets," say the wise.

In the beginning, "hedge funds" actually hedged, meaning that they would make money in both rising or falling markets. Nowadays, the "hedge" in "hedge fund" has lost all meaning. Hedge funds simply invest in risky investments and/or use leverage (borrowed money). Most hedge funds these days do not hedge at all.

So what does it mean, exactly? What is hedging?

Hedging, in simple terms, is a method for taking precautions against financial risk. The goal of hedging is not to make money; rather, it is to prevent losing money.

As an example, if you are worried about a stock market crash, you can buy put options against the stock market, which gain in value if the market drops. Of course, if the stock market goes up, the value of your put options goes down – and the outcome is neutral. If you are a baker and are worried about the rising cost of grain, you can buy wheat futures that gain in value if the price of grain increases. If the price of grain declines, you will lose money on your wheat futures, but also pay less for the wheat you need – again, a neutral outcome.

The financially sophisticated investor has almost unlimited choices for hedging. But, this article is not about these sophisticated hedging choices. It is about simple hedging for the layman.

Hedge #1, Insurance
Say, for example, that you are a married father of two. If you were to pass away, your spouse would be left with the mortgage payments, the costs of raising two children, etc. Therefore, the wise person buys life insurance. If you pass away, your income to the family is gone forever; however, the life insurance pays off the mortgage, with hopefully enough money left over to see the children through college. Thus, life insurance is your “hedge” against possible financial ruin caused by your premature death. Virtually everyone should have life insurance, disability insurance, home insurance, and home content insurance (the building and its contents are usually insured separately). The goal of insurance is not to have so much as to guard against any possible occurrence – it is to buy just enough to prevent extreme financial hardship.

Hedge #2, Gas and Oil
If you drive, consider buying stocks of a large oil company, or an energy mutual fund. As the price of oil (and gasoline) goes up, you can be compensated by an increase in the value of your oil company stock, and also an increase in the amount of dividends it pays you. If the price of oil goes down, your oil stock may decline in value, but so will the price you pay at the pump – this is classic hedging.

Hedge #3, Real Estate (for current non-owners)
If you rent, consider buying a real estate investment trust (REIT), a form of stock market real estate investment. If real estate values increase (along with your rent), the income provided by the REIT will also increase. If real estate values decline, your rent will likely not decline (unless you change buildings), but it won’t go up, either – a 3/4 hedge.

Hedge #4, Household Energy
Almost everyone pays for electricity and heating supplied by a utility company. Utility companies are not only some of the safest investments around, but they also pay regular dividends. The more money they make, the larger the dividends. Utilities can be bought through utility ETFs or utility mutual funds.

The first hedge (insurance) can save you from ruin and protect your family. The final three are long-term inflation killers. Together, and for a minimal outlay of cash, they protect you from both unforeseen circumstances and unexpected costs.
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"(Gold) gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

Warren Buffett

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Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

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Beware of the Bond

In one of the earliest posts on this site, I wrote: “Bond Fund – ‘Bonds’ are essentially loans that you give to a company. In return, these companies pay you interest. A bond fund is a nice mix of short- and long-term bonds of good companies that pay a rate of interest beating inflation. Almost everyone should own at least some bonds in their investment portfolio.”

Times have changed.

While short-term bond funds are still reasonable, those holding medium- and long-term bonds - and especially bond funds that contain government debt - should strongly consider getting rid of them.

During the credit crisis and still today, the retail investor stayed away from stocks entirely, shunning the very word “equity mutual fund.” This of course resulted, and is still resulting, in excellent bargains for some areas in equities. But, where did all the retail investors go?

Retail investors did not buy stocks, as indicated previously. They certainly did not and are not buying real estate, even in the bargain zone that is the USA. Instead, they bought gold (hence ridiculous current prices), money market funds, bond funds, and government debt.

Whenever the retail investor shun a large asset class like stocks, other areas grow bloated and overpriced. As the chart below indicates, whenever the financial news was worst, investors bought bonds the most (bond yields decline when purchases increase).


(click to enlarge)

If you want income-producing investments, consider purchasing those investments that remain deeply unpopular in today’s market: dividend mutual funds or ETFs (consisting of dividend-paying corporations) such as SDY and DWX; Real-Estate Investment Trusts such as IYR; Mortgage Bonds (which are currently being avoided like the plague) such as MBG and VMBS; and, stocks of large oil and gas companies (that are backed by hard assets and typically also pay a dividend) such as CVX and BP.

Like the gooey, sticky mess in the 1950s classic, “The Blob,” the long-term bond market is currently bloated from gluttony, and only a cooling off period can stop it.
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"When a horse learns to buy martinis, I'll learn to like horses."

Steve McQueen, actor
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Disclosure
Do not buy stocks, sell short, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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The Retail Gold Rush

Gold bullion is at record highs, and is set to rocket still higher. At least, this is the official sentiment of The London Bullion Market Association. But with prices already at record highs, is this the time to buy gold or the time to sell it?



There are two reasons commonly given to buy gold now. The first is that gold is a store of value. That is, although inflation eats away at the value of currencies, gold has a value that cannot be taken away. The second reason is that uncertainty drives gold prices higher, and today’s markets are certainly uncertain.

Gold is indeed a store of value, a currency, a component of jewelry and electronics, and more. The problem is that gold – like other commodities - usually keeps up with inflation and the business cycle but does not exceed it. In the past 3 years, however, gold has exceeded inflation greatly. Fear and speculation are the drivers of gold prices now.

Earlier this year, we saw the advent of gold-to-go machines. These vending machines hold a quote for 10 minutes, then scan the market and recalculate so the customer is always getting an up to date (but marked up) price. In Europe, these machines can be found in airports, hotels, and even supermarkets. For me, the gold-to-go machine marked the entry of retail “stupid money” into the market - money that arrives too late and stays too long.

If gold vending machines weren’t enough, consider the rise of solid or yellow gold miniatures. A few years ago, gold miniatures were an exclusive novelty. These days, the windows of high-end Chinese jewelry stores are loaded with solid gold rabbits, dragons, boars, oxen, and popular cartoon characters. The miniatures are popular with Chinese, since they offer a way to store wealth for posterity while simultaneously flaunting it.

The final sign of the gold peak is the de-hedging process of the gold producers themselves. In order to reduce income fluctuations caused by changing gold prices, most gold producers partially hedge their gold using futures or options. For example, companies buy futures that go up in value when gold goes down, and that go down in value when gold goes up. By hedging with futures, companies will not benefit as much from rising prices, but they will also not get stung by falling prices (arguably more important for profitable companies).

This year, many major gold producers have greatly reduced or even stopped hedging in the expectation of forever-rising prices. Barrick Gold, AngloGold Ashanti, Gold Fields and other companies have reduced their gold hedging by millions of ounces.

So, is gold going to drop? Should you short it?

At this point, there is still widespread fear all over the world, and this is partially justified by a worldwide housing bubble and precarious economies. Shorting gold at this point is probably not justified. However, neither is jumping on the bandwagon.

Gold prices are high – really high. Both as an investment and as a novelty, gold is more popular now than it has been in a very long time. I would refrain from buying. If you already own gold, consider selling some.

If you believe the world's currencies are being debased and you need to protect yourself, buy producers of commodities that have uses beyond merely a store of value - such as oil, uranium, lithium, and copper.

Buying something at the peak of its popularity is not always a stupid financial move, but statistics are against you.

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"My dear girl, there are some things that just aren't done, such as drinking Dom Perignon '53 above the temperature of 38 degrees Fahrenheit."

Sean Connery as James Bond, GoldFinger, 1964

Rare Earth Metals – China’s Trump Card?

Historical enemies Japan and China are at it again, this time about a disputed territory in the Diaoyu islands (known as the Senkaku islands in Japan).

On Sept 7th, two Japanese coast guard ships collided with a Chinese fishing vessel (or perhaps spy ship, since fishing vessels are used as spy ships by many nations). The Chinese captain (agent?) is now incarcerated in Japan, and Chinese officials are demanding his release.

There are many uninhabited "islands" in the oceans East of Japan, some of which are no more than lumps of rock a few inches above sea level, surrounded by concrete and tetrapods so they don’t wash away. The islands are important, of course, because whoever owns them can claim the surrounding mineral rights. At least, this is the presumption, despite a UN convention that “rocks that cannot sustain human or economic life of their own shall have no exclusive economic zone…”

What is interesting about this most recent incident is that China may be playing the “rare earth metals trump card" to end the conflict.

Rare earth metals are used in batteries, wind turbines, lasers, cell phones and other high-tech devices. In this latest diplomatic incident, China's customs clearance of rare earth metals into Japan has been “delayed.” China of course denies that they have implemented a trade ban.

Since China produces the vast majority of the world’s rare earth metals (more than 97% by some estimates), rare earth could become a handy negotiating tool for China in the future.

There is no doubt that rare earth metals - and therefore rare earth mining - will be an important area for investors to watch in the years to come.
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See also:

Govt Probing China's Rare Earth Trade Embargo

China will never waiver on issue of sovereignty: experts

Chinese people's willingness to travel to Japan drops amid diplomatic dispute

China denies tightening rare earth trade

Mabuchi worried about China fallout
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“Life is really simple, but we insist on making it complicated.”

Confucius
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Thank you, Frost Report Readers!

Last Wednesday marked the 10,000th unique visitor to the pages of The Frost Report.

I would like to thank all those who have visited my site, and all those who took the time to email me with their feedback and ideas (marketsandfinance AT gmail.com).

I try to reach strong conclusions only after studying all the facts (never predetermined), and point out prevailing illogical bias whenever possible. I am suspicious of any news article that gives opinions without revealing the facts that formed them. And, as every good investor should, I regularly try to prove myself wrong.
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To date, the top five all-time favorite articles for The Frost Report are:

Spin City

Chinese Real Estate - Trip Report

Stocks I Like – Citigroup

The World Housing Bubble

The US Economy - Headed in the Right Direction?
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Thanks again for your readership, and cheers to more insight in the future!

E. Frost,
The Frost Report

Mad About Taxes

The media and the public are divided and angry.

Some people, such as billionaire Warren Buffett, say that tax increases for the rich are “fair,” since the rich currently pay less tax than the poor. For others, any increase in taxes for the wealthy is an example of socialist government, and a disincentive for hard work.

The expiration of the Bush tax cuts has been called “the wrong move at the wrong time.” This expiration, combined with Obama’s proposed tax increases for those earning more than $200,000 per year has been dubbed the “small business killer.” Should we be worried?

When I worked as a lender, a consistent thing I noticed about small business owners is that they claim to have almost no income. A man could own a successful business, drive a Mercedes and take annual vacations to France, yet according to his company's financial statements be making $20,000 a year. This was normal.

For lenders, the financial statements of small business owners can be frustrating. Owners typically often write off so much (to avoid taxes) that it becomes difficult to approve their loans.

“Just show a little more income next year,” lenders often tell business owners.
“But then I will have to pay income tax," the owners counter. "You know I make lots of money. Can’t you just approve it?”

The proposed tax changes would raise taxes for individuals earning $200,000 per year, or families earning $250,000 per year, with lower taxes for those earning less: this is hardly a small business killer. A small business owner that shows an income of $200,000 per year would, in all likelihood, be earning at least 3 times that much - and there are simply not many small businesses pulling in that level of income.

Then there is the debate about lowering taxes for the middle class. Many members of the middle class themselves are opposed. Personally, I find this hilarious. One of my favorite things about the GOP is that they have actually convinced people earning less than $200K a year that tax cuts for the rich are good for the economy, but tax cuts for themselves are unnecessary. I love it! Gullibility knows no limits.

From an economic standpoint, lowering taxes for the nation’s middle class makes sense. The middle class tends to live “paycheck to paycheck,” spending almost everything they earn. Any decrease in taxes (increase in money to spend) would go directly into the local economy. High-income earners, on the other hand, tend to save more, or spend their money overseas. In terms of boosting the economy, a tax decrease for low- and medium-income earners gives far more bang for the buck.

Being that the US has a record deficit, somebody’s taxes need to increase. Increasing taxes for corporations is a bad idea, since unemployment is still far too high and corporations are the nations largest employers. Tax increases for the middle class is also a bad idea, since their spending levels (which constitute most of the US economy) are already low. The wealthy are the best choice for tax increases, because their personal spending levels will be least affected.

Tax cuts for the rich after the economy is rolling smoothly again – sure, why not? Everyone believes in the American dream. Everyone believes that someday, they too will earn more than $200,000 per year. And, they want to make sure tax levels are low when they get there.
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“In 1790, the nation which had fought a revolution against taxation without representation discovered that some of its citizens weren't much happier about taxation with representation.”

President Lyndon B Johnson