Tuesday, January 26, 2010

A Look at Kraft-Cadbury (KFT-CBY)

This article was featured on the Reformed Broker and on the Rational Walk twitter stream.

Barbarian Capital was asked to express an opinion on the Kraft/Cadbury deal. This is a long post (definitely not for ADD readers) and there is nothing “actionable” in it. In short, Barbarian Capital is neutral to mildly negative on the transaction. There are better-run, less risky staple stocks with better track records than Kraft’s out there. This also grew to be a mini-lecture on staples stocks so beware.

I am breaking up the analysis in two parts: the business part and the financial part. For the business part, I will look at the actual business units (something that does not happen very often in the financial press).

One of the most basic questions a fundamental analyst can ask is whether the business is a commodity business, or not. A commodity business is largely a price-taker business, offering undifferentiated, fungible product or service. On the other hand, non-commodity businesses have products or services that are distinct, have high switching costs, etc. The non-commodity businesses tend to have steadier margins, less volatile earnings, and other generally “desirable” characteristics. Not to say that commodity businesses are bad investments: they can be great so long as you are riding the wave up and recognize that you are doing so. Stay away from commodity businesses whose management claims unique abilities when, in fact, they are simply in the right elevator at the right time.

Most consumer packaged good (CPG) companies try to stay away from the commodity side of the business. They try to have distinct, innovative branded products with unique value propositions. They develop a lot of new things every year that you see in the marketplace. A lot of these products are “high value added products.” If you think about it, it is not easy to replicate the taste of Coca-Cola, Oreos, Cheerios, Snickers, etc. These are generally “good” businesses: with steady earnings growth, predictable margins, low betas and small changes in the earnings multiples, among other characteristics. They will not double overnight, nor will they disappear overnight. Think of them as the bonds in the equity world.

Kraft has some genuinely good businesses here and abroad: Nabisco (i.e. Oreos, Triscuits), Jell-o (“owns” the market for jello), Lu (Europe and here, higher-end biscuits, like Le Petit Ecolier), Milka/Toblerone (dominant Europe chocolates), Jacobs (dominant Euro coffee), etc.

However, despite its marketing to the contrary (especially in the materials facing the investment community), Kraft has a substantial commodity-like business, or rather businesses. These ugly step-children are not featured in management’s presentations but they do appear on a regular basis around the quarterly calls.

Who are they? There is the dairy business (the eponymous cheese, along with Philadelphia cream cheese, Breakstone sour cream, Polly-O mozzarella, Velveeta cheddar). Then there is the nuts business (Planters). Then there is the supermarket coffee business (Maxwell House). There is also the dry mix drinks (Crystal Light). There is the dressings and mayo business. You get the picture: these are largely low value-added products with dubious brand equities. They compete largely on price, and are likely to be economically unprofitable in the long run. Further, they expose the company to single commodity price risks.

Further, for various reasons, Kraft over the last 2-3 years has shed 3 high value-added businesses: Post cereals, snack bars and, most recently, frozen pizza. It has acquired one high value-added business (Lu biscuits from Danone). However, KFT has not shed any of the low-value units.

Then there are the non-stop Kraft restructuring efforts. They have been at it for a while now, doing all sorts of realignments and such. I personally have no idea whether they will be successful. On top, Kraft just did a large acquisition in Europe (Lu), which also prompted reorganizations there. My view is that constant reorganizations/fire drills are distracting, harmful and are no way to run a business. There will be more on the way, of course, with the Cadbury acquisition.

On the other hand, Cadbury is a high value-add “pure play” confectionary business (chocolates, gum, breath mints, etc.). The confectionary business is a good business. The products are difficult to make at home or by small players (especially of equal quality). There is also a very, very low private label penetration in the space. Further, globally, the confectionary business is quite consolidated: Kraft, Cadbury, Nestle, Hershey and Mars/Wrigley are the major players. Oligopolies are good businesses to invest in.

Adding to Cadbury’s attractiveness is their presence in emerging markets. Emerging markets are attractive for CPG companies because packaged good consumption there is just beginning to take off. If you look at the charts, the spending on CPG goes up dramatically with GDP. Since earnings growth at home has a limit due to slower population growth and high product penetration, EMs can provide a good “kicker.”

EMs have been tricky for most CPG players. Here is why:

If you look at any business, there is what I would call a “natural optimal scale.” On one extreme, there are the true global businesses because it makes “optimal” sense to be global. Look at a mining company: they have to be where the deposits are. Once there, the drill is largely the same: same equipment, same materials, same process, same shipping, same customers. You can extend that to almost any extractive industry.

On the other extreme, you have businesses that are optimally what I would call “niche national”: think of law firms. Even the “global” ones are simply brand-connected independent groups with very high local specialization which may not be worth anything outside of its immediate context. Sure, having offices in Country X can land the big deal but this brings little to no direct business outside of Country X.

CPGs are somewhere in between. Some products are highly local (think prepared meals) while others are near-global (think cigarettes or “thirst” products). Obviously, emerging markets expansion is easier if your products are near-global. Philip Morris International does a superb job with Marlboro across the world, as do Coke and Pepsi with their mainstay beverage offerings. So products being closer to global are better, and I think Cadbury’s are “closer” to global: chocolate, gum, candy. There are other trickier parts in EMs, such as appropriate marketing, lack of scale, lack of proper infrastructure, on top of the “regular” emerging markets risks.But this would be another topic.

So, if Kraft can issue its own less-than-inspiring equity for what could be great business, why not go for it? This is why, in my view, the Cadbury holders wanted more cash. I say that Cadbury “could” be a great business because we do not know yet. CBY spun off its beverage unit recently (Dr Pepper Snapple, traded as DPS) and is undergoing its own realignment.

This concludes the operating business review. Now on to the financials overview.

Owning Kraft stock has been a punishing experience for its holders since its float in 2001. The stock reached a high of $43 or so in 2002, and a low $21 last year, and has essentially gone nowhere since going public. The stock itself has a negative 9% return, which becomes mildly positive if you include dividends. KFT’s dividend yield is aligned with the industry but the share performance has really hurt the “total shareholder return.”

Taking a step back, as I mentioned above, staple stocks are the “bonds” of the equity world. The typical staple company is expected to have steady to growing margins, steadily growing EPS, steadily increasing dividends, regular buy-backs, steady earnings multiples and low volatility. If you look at how some management teams judge themselves, they focus on “cash returned to shareholders” via dividends and buybacks: as a shareholder, this is what you want to hear. What you do not want to hear is “our organizational realignment is progressing very well… we’re taking another $500 mm charge this quarter… oh, and yeah, price wars in our business killed the margins…” Kraft has been a lot more of the latter, and their share price shows it.

Comparing Kraft to some of its packaged foods peers, as I mentioned above, Kraft is at negative 9% since going public in 2001. For the same period, we've got KO +8.4%, PEP +35%, GIS +65%, K +105%, SJM +138%, all ex-dividends. If you expand beyond food/bev into other consumer staples, PG +89%, EL +25%, CL +37%, CHD +252%, CLX +73%. CBY (Cadbury’s ADR) is up 105% in USD at the deal price, plus the DPS spin-off, plus dividends.

You get the picture: Kraft has been a disappointment and continues to be a disappointment both from an absolute perspective (not behaving like a staple stock) and from a peer comp perspective.

Does this mean that Kraft stock is undervalued, like Warren Buffet believes? Not necessarily. KFT simply behaves more like a commodity stock like TSN (Tyson) or DF (Dean Foods) due to its large commodity business that I discussed above, even though Kraft goes out of its way to tell investors how many “billion dollar” brands they have. I would rather see the shareholders’ yachts, thank you very much.

So, to repeat from above, Kraft's using some of its not-so-great stock as an acquisition currency is not that bad of a move.

On to Kraft’s debt. Kraft has not been great for its shareholders, but has it been great with its bond holders? To reiterate some corporate finance basics, there is a natural tension between shareholders and bondholders. All the bondholders can hope for is to get their interest and money back as contracted. On the other hand, shareholders have a residual claim on the earnings, and are more likely to want to “go for broke”: exactly the opposite of what bondholders want. Bondholders do not like to fund share buybacks, special dividends or other “shareholder friendly” moves. Again, we know that Kraft has not been great for its shareholders, how has it been for its bondholders?

Not that great either. Kraft was just downgraded to the lowest investment grade level (a downgrade means that the value of the existing bonds drops to reflect the higher required yields). The problem with Kraft is that it already funded the $7 bn acquisition of LU with debt, and has not reduced leverage significantly since then. Now it is going for a major, major acquisition (=risk) by adding extra debt. Bondholders do not like this. A hiccup in the assimilation of the Cadbury assets can trigger a downgrade to non-IG, which itself can trigger a massive dump of KFT bonds as many funds are restricted from owning non-IG bonds. This in turn can trip up other funding venues, like revolving credit agreements and commercial paper (I do not know if they have any). So you get the picture.

Compare Kraft’s behavior to that of InBev before and after its acquisition of Anheuser-Busch. InBev communicated very clearly that they are taking on too much leverage, and that they will work hard to reduce it. They have been selling assets according to their promised plan, reduced or stopped the dividends, and redirected all cash to debt repayment. This is the kind of able, credible management team that both bondholders and shareholders want to see. InBev’s stock is 2x in a little over a year despite poor industry-wide conditions.

Now that we see that both shareholders and bondholders are suffering, what about the multiple Kraft is paying?

I am not worried about it at all. It is very much in line with the transaction comparables I have seen, may be a bit on the lower end due to the size and slower growth of the target. It is not a screaming deal, but it is not a rip-off either. I do not like that they are paying 2x the 52-week lows but this is life: if they had pulled an offer in early March, they would have deserved it.

The bigger issue (which is what my “non-thesis”) is based on, is how well Kraft will do the job of integrating and achieving the mythical synergies with Cadbury. Looking at Kraft’s record, I have my strong doubts that it will be a smooth sailing, and I fully expect “surprise” charges to come soon. Their task is further complicated by the high political visibility of Cadbury in the UK. Moreover, I think that considering Kraft’s difficult results in the US over the last 1-2 years create incentives for “kitchen sink” integration charges: this way the earnings improvement post integration will not be reflective of the true business trends but I would not be surprised if the market does not see through it.

The Barbarian Capital thesis is: keep an eye on Kraft. If the integration is not going well, the stock will be punished. This is the entry point. Why? Because the integration is not rocket science and things will straighten out sooner or later. If things go better than expected, then sit tight until they have a quarter or two of poor performance because of the commodity part of the business. Until then, stick with the guys who take pride in returning money to shareholders or make good on their deleveraging promises. There are plenty of other companies with steadier performance, better margins, and better yields that can fit in your “slow and steady” equity allocation.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

So What Was Your Stealth Inflation Last Year?

 This article was also a link on The Reformed Broker.
Special greetings to Sempra Energy Trading (Darien, CT), where someone really seems to like Barbarian Capital today.

So what was your stealth inflation last year? No, this is not a pick-up line from Argentina circa 2001. One has to be much more eloquent with the beauty queens from the land of Bife de Lomo and deep-hued malbec, as SC Governor Sanford can attest.
But since inflation has been a favorite topic for barbarians ever since Rome discovered it could pay more bills by reducing the silver content of the denarius, I thought I'd share some observations on what I call “stealth inflation”: price increases that are not likely to be captured by the official stats because they are household-specific and, yet, take money out of your pocket.

Most people simply accept the official CPI data, may be some even read into the first paragraph under the headline. For 2009, the headline number was negative 0.9%. But what does this mean to you personally? Is it meaningful? Probably not, unless your income is linked to some COLA index. As you probably know, the CPI tracks a basket of goods over the year, and does some adjustments if the price of one item becomes too high (i.e. they assume that if prices are high Jews and Muslims switch to pork from beef, or that Coke drinkers switch to RC Cola). The CPI does not track your basket of goods and services, nor does it track some other pertinent factors. In a couple of months, I will (probably) publish sample basket data that I collect but until then, here are a few locations where I have noticed “stealth” inflation.

Healthcare. Of course, “everyone” knows that healthcare costs outpace CPI. But here is something I have noticed that is not easily quantified. While your premiums certainly went up, did your co-pays and deductible also go up? Mine did. There are also reductions in lifetime maximums for certain conditions, as well as complete elimination of coverage for other conditions. These changes most certainly mean that you buy less healthcare coverage for your dollar, but they cannot be quantified within a basket of goods.

An additional non-quantifiable factor is if your doctor quit accepting your insurance, or started demanding full upfront payment, sticking you with the reimbursement waiting time. After all, MDs do get tired of waiting for three months to get paid 20% of the “list” price. Is there a price tag to this? Yes. Is it captured by CPI? No.

Transportation. Most places in the US one needs a personal motor vehicle to get around. While the costs of owning and operating one are known to most drivers (gas, maintenance, car loan, insurance) what happened to your registration fee this year? I am willing to bet it went up by multiples of CPI as most states are really scraping the bottom financially. Another stealth inflation factors are tolls: the Triborough Bridge here in NYC is now $5.50 each way, up from $5. It was also renamed the RF Kennedy bridge: quite appropriately for a taxing authority. I wish they’d sell the naming rights to Pepsi or something, instead of feed into this personality cult towards the descendants of Boston’s biggest bootlegger.

Speaking of NYC, the highly visible and politically important single ride is up 12.5% this year, while two train lines and several bus routes are likely to be eliminated (so you pay more with your time). Of course, the MTA really soaked the “rich” who buy the monthly passes.

Housing. Even if you own your home outright, what happened to your association fees? Property taxes? Especially if you consider property taxes vs. services provided: chances are you are getting less services locally per dollar. The only deflation in the housing market applies to people either actively shopping in the areas with the biggest decline, or to mobile renters who do not mind changing apartments every year. The alleged housing “deflation” is not helping out most households, in my view.

Stealth tax increases. Again, not likely to be captured by the regular CPI measures, but one or more of these may have happened to you in the last year. Remember that if the same item takes more money out of your pocket, this is inflation, whether the CPI thinks so or not. If you are a roll your own cigarette smoker, your federal excise tax went up 2,000% last April. If you were a saltwater fisherman in the state of NY, you now need a license, which is not free of course. Same with professional licensing fees and some permits. Are some items in your basket now a taxable sale in your state, when last year, they were not? Take a look at your utility bills: are there a bunch of little surcharges that keep increasing every year? I am sure you can come up with a load of examples on your own.

So, my message is this: Do your own thinking. CPI is a data point that may or may not have great relevance to you personally. At best, CPI presents an incomplete (and allegedly over-manipulated) picture of the real price levels across the economy. More importantly, if you are a businessman, do not price your products or services based on CPI: your finger should be on the pulse of your own costs, customers and competitors.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Saturday, January 23, 2010

Why Are Academics Dangerous?

 This article was also excerpted and recommended by The Reformed Broker. It was also linked to by Henry Blodget's BusinessInsider/Clusterstock.

Now that Dexter, Dasan and the Davian Letter have exposed smidiots, asset-gatherers, master extrapolators and link aggregators, let's talk about another dangerous element of the human ecosystem: the academics, and in particular, economists.

You see them everywhere: Bernanke, Krugman, Shiller, Stiglitz are well-known, but there are plenty of others in positions of real power like Christina Romer PhD, Chairman of the Council of Economic Advisers.

They all let you know how smart and useful they are, and they do sound pretty convincing. The intellectual lilliputians in the mass media can hardly hold their excitement once the academics show up on the screen. So why are the academics dangerous?

(1) An aura of absolute authority: what is the first thing your mother told you when she sent you to school? Listen to the teachers. Years of schooling reinforces "listening to the teachers" to the impressionable young minds, and this near-instinctive compliance and respect carries over in the adult world. In addition, our media is highly deferential to "experts" of all sorts, and someone with a PhD in subject X is often the ultimate, unquestioned "expert". Further, there is acceptance of scientific findings in "hard" sciences, such as physics, as the "truth", but this has carried over unjustifiably to social sciences, such as economics or finance. Shake off what your mothers told you, and do your own thinking.

(2) A pretense of objectivity: when a fund manager discusses an issue, more often than not, the listeners are aware that the manager is "talking his book", and is, hence, biased. If you are that guy running the $1 Tril "West Coast Fed", you'd probably never come out and say, "listen, I really do not think that most people should have bond funds" even if you earnestly believed that rates and spreads can only go up from here.
Academics, on the other hand, flaunt their objectivity when, in fact, they are just as conflicted as a fund manager. How is that? One, academics are slaves of their own work and would never, ever, do anything to undermine their pedestals. Second, many are pushing their ideas in books, thus their "assessments" of "the situation" (not to be mistaken with "The Situation") are nothing more than PR stunts and should be treated as such. Third, if you know anything about high-level academia, you know that many of these guys are heavily reliant on grants, and, thus, have a strong incentive to influence the federal policies in their own space, and often become nothing but mouthpieces for the official line. This goes well beyond finance/economics: academics are interested in creating "crises" that benefit them: "ClimateGate" and "swine flu" are recent examples of modern-day charlatanism. You can also see the excellent marketing effort surrounding AIDS, a 99.99% preventable disease with very low annual mortality rates. So whenever you hear about a "crisis", hold on to your wallet, or, better yet, figure out how to invest in the sham early.

(3) Lack of real-world experience: most academics are what The Governator once called "people who only sign checks on the back" They've never had to make payroll or rent. They've never made a sales call. They've never fired someone with a newborn. Most, I think, do not realize that their "success" comes from the structured, cuddly world of academia where the rules and relationships are not only clear, but also predictable. Those of us operating in the real world do not have that luxury, and yet, somehow the "distinguished John Q. Public professor of Economics" gets more airtime, more respect and more job security than the guy down the street trying to run a business. Makes no sense whatsoever.
Actually, often our "acclaimed" economists are business disasters: look at the imploded housing market ETFs from Shiller, or the Nobel winners at LTCM. Only academics can come up with theories based on a world with no taxes, or on efficient markets everywhere, or run a super-leveraged fund based on everything going right at all times. The reason why such absurdities exist is because there is no real clash of ideas in the Ivory Tower: they are all in the same boat, and pad each other on the back. For us, having the wrong idea hurts only the way a short squeeze or a big drop on volume can hurt.

(4) Expertise creep: most academics are highly specialized in a certain area. This is simply a necessity in a world with an ever-expanding body of knowledge: as one progresses in research, theoretically, one needs to discover "new things." These highly specialized academics are the academic world equivalents of specialization in many other fields: surgery, fixed income, engineering, etc. Most people would not voluntarily accept to have a knee replacement done by a neurosurgeon who has spent the last 20 years trying to reconnect neuron synapses inside patients' crania. And, yet, somehow most "popular economists" feel like they are experts on everything financial. Krugman won a Nobel prize for... international trade theory. And, here he is, The Authority on government spending, stimuli, and so on. Same with the other, more rotund bearded Nobel-winning fellow Stieglitz, an expert on globalization with an affinity for unsolicited advice to anyone who'd listen. Unfortunately, lots of lawmakers do listen.

What is the damage done?

There is a quite a bit, but the big one for me is the misallocation of resources. For example, the push for alternative energy has already resulted in the ethanol fiasco, and is also blowing up entire nascent industries, like solar: witness the wealth destruction last week when the word came out that Germany can cut the subsidies. Academics, in our case spearheaded by Steven Chu PhD, Energy Secretary, do not get that if something is a great idea, THE MARKET WILL SHOW IT.
Apple does not need special tax incentives to sell iPhones, right? Henry Ford did not need special handouts for Model T, right? P&G does not need tax incentives for the innovative Infinity pads they've got, right? The best, most competitive, most dynamic areas in business are the ones with the least amount of government interference: the federal government does not mandate quotas of certain classes of songs on iTunes, or certain features in enterprise management software products. The market does! If solar technology is not ready to compete, then, guess what, let it go on for one or two more iterations. But hardly a day goes by without some expert crying for a handout in his field.

Then you have the push for more spending at all levels of government based on "models" that someone like Krugman, in his $1.6 mm Riverside Drive coop, came up with. Stop it already: we were deep in debt before the current crisis. (This can be a very long paragraph but this is not the main topic, so I am stopping.)

The last example of misallocation of resources comes up in the indiscriminate push for higher education. Some researchers, obviously trying to protect their cushy academic jobs, found that going to college is a great idea because (on average) the college grads earn $X more. This has lead to an absolute overcapacity in the education space as people who really should not be going to college do (and fail to graduate even within six years but do create artificial demand for education). Imagine the contraction in the higher ed space once the flow of bodies reverts to what actually makes sense.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Monday, January 18, 2010

If Bernanke Were a Biologist...

 This article was also featured on The Reformed Broker's reading list.


If Bernanke were a biologist, he would understand that the financial eco-system needs a process to excrete waste. That waste then becomes feeding stock for the real green shoots (some are affectionately known as "turd blossoms"). By keeping rates low and buying securities at mark-to-fantasy prices, the Fed is trying to recapitalize the entities that should be dead and thus stifling the true green shoots (in this case, able banking operators that can take over).

If Bernanke were a biologist, he would embrace natural selection. Generally defined, natural selection ensures the survival of the fittest and the smartest. By rewarding failure, the Fed does just the opposite as the fittest cannot take on the assets from the less fit. In addition, by punishing savers (the animals that stock up for the winter) via low rates, the Fed discourages what is prudent behavior for the participants in the system.

If Bernanke were a biologist, he would understand experimental learning. The frog that gets stung when it tries to eat a wasp, does not try to eat insects that look like wasps every again, not even ones that do not sting. We got in the current mess in a large part because of easy money over the last 10 years. How are we trying to fix the problem? More easy money.

If Bernanke were a biologist, he would understand that animals respond to incentives. Much like you should not feed birds and other wildlife as it creates incentives for them not to migrate in the winter, and to multiply beyond the area's "carrying capacity," ZIRP encourages malinvesment and the proliferation of various products that should not exist, and, more dangerously, it incetivizes people to gamble with reckless abandon as the chips are on the house (and "The Put" will be there.)

If Bernanke were a biologist, he would understand that systems are cyclical. Some years there are more wolves, some years there are more rabbits. By focusing on "full employment" and "price stability", both cyclical in nature, the Fed is interfering with the signals both markets would send to participants much to the long-term detriment of all parties involved.

If Bernanke were a biologist, he would understand that animals need food, warmth and shelter. By basing rate decisions in part on "core CPI", which excludes food and energy, and did not capture housing inflation in the 00's via owners' equivalent rent, the Fed's rate decisions are the old GIGO ("garbage in, garbage out"). Barry Ritholtz, quite accurately, calls core CPI "inflation ex-inflation."

If Bernanke were a biologist, he would understand that plants and animals need to adapt to survive and prosper. Contrary to that view, we have seen the Chairman do one thing, and one thing only, and that one thing is based heavily on his views of the Great Depression. These views have given him the academic acclaim and the resulting image to get the job, but what if the job requires some qualitatively different thinking?

For the record, I have never been a biologist and I do not aspire to be one.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Wednesday, January 13, 2010

Saturday Fireside Chat

This article appeared originally on The Davian Letter, a premium content site for traders and investors. At least for the month of January, I will be posting the articles there first. I am not affiliated with the DL in any other way than just posting on their blog. This particular post was also a featured link on the Financial Times/Alphaville section, as well as on The Reformed Broker.



Let me tell you about this wonderful rock band from Liverpool, England. They were formed in 1959 and went on to have a three #1 singles in a quick succession. They were managed by Brian Epstein and signed with one of the EMI labels. You know who they were, right? They are Gerry and The Pacemakers.

Here's another story. In the early 1980's, a software company from Seattle develops and licenses a highly successful operating system for IBM 8086 PC's defacto becoming the (highly profitable) standard O/S for years to come. You know who they were, right? They were Seattle Computer Products who licensed the O/S exclusively to MSFT for redistribution for a fixed sum.

Here's something else. Have you tried France's oldest distilled spirit? It has been made in a specially designated geographic region for 700 years. There are also strict grape varietal requirements. The beverage is distilled and then aged in oak barrels. VSOP is an example of a grade for this spirit. You know what it is, right? It is armagnac.

And one final story. There are many sculptures and other artifacts left from a once-great civilization that lived on the territory of modern day Italy. They adopted Greek-style architecture, fought wars alongside with Carthage, mined copper and iron. You know who they are, right? They are the Etruscans.

This isn't some silly game show blog, why am I feeding you all the trivia?

I was listening to some Symphonic Pink Floyd on YouTube, and one of the suggestions that came up was a symphonic ABBA "Winner Takes All," a song where the Scandinavian beauties of the days past sing "the winner takes it a-a-a-ll..." Rome eventually absorbed the Etruscans and conquered a lot of other lands. Armagnac's largest export market is 22 thousand cases by my estimate (vs. cognac's 12 million case global volume). Microsoft went on to replicate its lack of original thinking by copying or acquiring Windows, Office, search, web-based email, game consoles, music devices, etc. And Gerry Marsden lives in anonymity while "Sir" Paul McCartney is worth over $1 bn, and enjoys a number of carnal privileges that come with fame and fortune.

The stories above are "winner take all" stories.

But there is something else in these stories that is relevant to investing. The winner took all, but at a time, the non-winner had even, may be better, chances to win. Something to keep an eye on with the smartphone wars, Defense Dept. orders, battery technologies, exploration permits, drug approvals, patent approvals, gambling licenses, toll infrastructure projects, radio frequency auctions and other apparent "winner takes all" competitions.

Appearances might be deceiving and a fundamental investor should be highly paranoid about competitive threats and the prospects of industry-wide profitability.

Air transportation "won" the long-distance passenger business but has been a losing investment proposition. Automobiles "won" personal transportation but only one non-bankrupt US manufacturer has survived. There is more information now than ever, and yet the information carriers of yesterday are near-dead. So are physical bookstores. So, go ahead, challenge those who assure you that their company has the winning model: they are the ones most likely to be asleep at the wheel.

Saturday, January 9, 2010

Two for One Posts

Dear Readers: at least for the month of January I will be posting my articles first at the Davian Letter blog section. They will continue to appear on here with a delay at least until the end of the month. DL is an up-and-coming site for investors and traders with various styles. I was invited to post there; otherwise I have no relationships with the site or the people running it.

How to Select Assets for Inflation
So let's chat about inflation, and investing for inflation (this blog is not investment advice).
If you listen to the eggheads, there are many ways to define "inflation." The more academic one is the increase in overall money supply (inclusive of credit). On the other hand, the esteemed Garage Logic University School of Economics defines inflation as the increase in the overall price levels, much like Yogi Berra's famous "a nickel ain't worth a dime anymore." There are quite a few shenanigans in the headline CPI number which I am not going to discuss here (substitutions and adjustments) so I personally keep track of my own inflation in different expense baskets. I recommend that you do that too: housing, food, transportation, utilities, sales tax, education, and others. You should track items that do not change across the years, such as a gallon of milk, gallon of gas, a NYC subway ride, price per kWh, tuition credit cost at the local school, men's haircut, whatever. Healthcare costs are a little trickier because it is difficult to assign values to coverage and deductible changes, but it is still a good idea to keep track of it. You can do it once a year, or twice a year, and compare your basket to the "official" CPI. I can almost guarantee you that you would be surprised.
So let's do a rundown of the more popular ways historically (or currently) for protection of your purchasing power. I will try to give a balanced view on each as there is no silver bullets (pun intended). Also please note that I am discussing a "manageable" inflation level (that is, no complete societal breakdown).
Gold: on the positive side, widely recognized as money. Durable material. No industrial (jewelry) demand above certain prices. On the flipside, it can be the ultimate "greater fool" trade. Once there is a belief that inflation will be controlled, the stampede for the exits will be ugly. Additionally, gold provides no current income. Having GLD is actually costing you (you read the prospectus like a good boy, right?).
Silver and Platinum: not dissimilar to gold but also have legitimate industrial uses that play a role in supply/demand.
TIPS: if the government determines the CPI to which its interest expense is indexed, what do you think are the incentives?
Foreign bonds/Foreign TIPS: similar story here. No country will let its currency appreciate too much versus the other currencies.
Stocks: one has to be very, very careful. Some of the things to consider here are: discretionary vs. staples (and Coke is NOT a staple; neither are iTunes); capital structure (interest rates are rising in an inflationary environment so look at the debt maturities for refinancing risks, fixed vs. floating, and property-level/non-recourse); pricing power (lots of factors here); "hard" assets/general asset quality. Also pay attention to the commodity cycles: farm and energy will likely outperform base metals/other materials.
REITs: while "real estate" has been a good play traditionally (especially if they can pay debts in "old" dollars and charge rent in "new" dollars), pay attention to the refi risks. Some REITs (office, industrial) are heavily linked to the overall economy as well. Also beware of mortgage REITs with debt duration mismatch (if you pay floating and short but receive fixed and long during a rapid rise in rates, you're in a tough shape once the rates move up).
Residential RE: has been one of the trades of the century for people who bought in the early 1970s on fixed rate. My caution here is that too many people take the availability of mortgages for granted. The 30-year, fixed-rate is something rare globally and it will be very expensive/not available at high rates, so once your house is less leverageable than before, it loses "real" value. See what happened to RE prices in emerging markets once mortgages (a new product) appeared in the late '90s/early 00's: they shot up not based on productivity but based on people being able to pull forward 15-20-30 years of future income. This can reverse just as quickly.
Productive land: again think whether current prices are influenced by leverage and productivity that cannot be sustained if fertilizer prices are too high. I think one of the safer plays.
Timberland: also a "classic", one can even choose the harvest timing over years. The issues there are (1) unlike prior inflation episodes since Gutenberg invented the press, pulp demand is in a secular downtrend, (2) new housing may not be coming back for years and (3) again, what happens if you try to exit when buyers have no access to credit.
Food, personal care, tobacco, alcohol, medical supplies, ammo, heating oil/wood/coal, useful stuff: good bets; works for bartering, too
Livestock: my bet is on poultry. Easy upkeep, small space needs, eggs without a "bull" unlike milk, and best feed-to-weight gain ratio. Goats and donkeys live long and are easy to keep though milking the latter is not recommended by farm experts. Farm ponds with carp are also good feed-to-weight investments.
1st Class Stamps: have been reflecting inflation well but (1) email has displaced mail and (2) the services will likely change (e.g. less delivery days) so the real "value" will be less.
Children: the timeless retirement plan. Cash-flow neutral by year 20-25. Some economies of scale and quantity discounts.


(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)


The "If You Have to Ask/If You Have to Say It" Principle

Here's something to ponder. I call it the "if you have to ask" principle: if you have to ask, chances are, it is not for you. Similarly, if you have to say it, chances are you are not "it."
What got me thinking is this (automatically placed) Google ad above one of my posts: "Prestigious Healthcare MBA from XYZ University"
Well, if you have to say it...
I have never seen any top 10 program advertise itself as "prestigious." Marketing for the bonafide prestigious brands (both products and services) is substantially more subtle. It often targets the top of the Maslow pyramid: self-actualization. The "brand ambassadors", if used, are people who have either explicitly or implicitly reached a very high level of achievement in their field. Kimbo Slice will never (I think) market Patek Phillipe.
How many people "say it" and describe themselves as "confident" or "smart" or "a winner" when these qualities are, at best, at the aspirational level for them? How many schemes market themselves as "the real deal"? How many day trading systems "really work"?
Similarly,
if you have to ask, it is not for you.
A lot of learning comes from osmosis: simply picking up pieces from your environment, or, alternatively, from being in an environment where the answer process is structured. If you have to ask, you might be from the "wrong" background, and you will be treated as such.
I spent some time on an associate-level front-office recruiting committee at a major Wall St. institution (I think I am still paying the wages of that sin, but this is another topic all together). "Non-core" school resumes are
not
considered via the official channels. Period. If you (or your dad) knew someone important at the firm who then passed it on, it would be considered but otherwise, no. One level above "us" were the "relationship hires": the no-questions-asked hiring decisions for the daughter of the CFO of client X and the like. Do you think they had to ask about "the process"?
Most career "authors" advise you to "network": well, just trying to reach out to an associate puts you in the "if you have to ask" category. Because the system works with feeder schools and if you are not invited to the dance to begin with, then your resume is destined for the shredder. You would not need to "network" if you belong in the network; you'd be networked by default (at least at this situation: I can see the value of the advise in some other fields).
Similarly, how many potential buyers of high-end brand "timepieces" are concerned with the price? How many people walk into an exotics or a yacht dealer wondering if they can "make the payment"? How many NYC coop boards do not allow mortgages (if you're thinking twice, it is not your kind of a building)? If you are concerned that the menu has no prices, then you are at the wrong restaurant.
So how does this all tie together? One of my favorite topics on DL is the smidiot discussion. Smidiots almost always have all the right labels (the right high school, the right undergrad, the right grad/law; the right mega co's on the resumes; the right vocabulary; the right tastes, hobbies and interests; the right UES/UWS "residence") but these labels came to them without much effort or original thinking, or, in some cases, even without an acceptable IQ level.
Unfortunately, smidiots are often gatekeepers of desirable resources (FoF managers, headhunters/HR chicks, MDs, PMs) and use a variety of mental shortcuts to see if you're from the herd. It is important not to ask the wrong questions.
So when you are surrounded by them, make sure you've done your homework so that you can do your best mimicry to further your ends. 

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Saturday, January 2, 2010

Early January Mental Potpourri

Here are some more thoughts. I hope you all had a good New Year's celebration, and wish you the best for the new one. A few years ago I gave up hoping for specific outcomes: I just hope for the best as it would be arrogant of me to assume that I know for sure what is best in aggregate, in the long-term for me and for the people I care about.

* How to tell if WMT is killing a certain competitor? Well, consider this press release "Weis Markets, Inc. today announced it has lowered the prices on 2,600 staple items, effective December 31, and frozen these lower prices for 90 days through April 1, 2010. It has also moved to freeze the prices on an additional 624 products...Founded in 1912, Weis Markets, Inc. (NYSE: WMK) is a Mid-Atlantic food retailer operating 165 stores in five states: Pennsylvania, Maryland, New Jersey, New York and West Virginia."

Just a reminder, businesses, no matter what the ads say, do not like lowering prices (unless there is some sort of a network effect or an exponential threshold to cross).

If I had to guess, in 10 years, most mid-sized supermarkets (think WMK GAP RDK WINN SPTN ARDNA VLGEA) will be either a part of the larger chains or not be around at all.

I'd be concerned longer term about the pharmacy chains, too (CVS, WAG, RAD), especially the latter two.

Also think about what this (and AMZN+EBAY) mean longer term for retail CRE.

* The connection between low and falling interest rates and outperforming equities. The first level of the relationship is pretty obvious to everyone: equity benefits from lower borrowing costs; also lower coupons make dividends more attractive. But there is another level of the relationship. Equities are like a perpetual call option on earning. Options' values, if priced by Black-Scholes, have an e^(-Rf) element in them. In other words, they are more valuable with a lower risk-free rate.

* Then there is the discussion of stocks as a protection for inflation. The Inoculated Investor has found something interesting. Read the whole thing but here is a snippet:

"In this issue Colin Moran and Geoff Gentile of Abdiel Capital discuss their study of the impact of inflation on stocks:

“The U.S.’s last stretch of high inflation was between 1973 and 1981. In the early 1970s many equity investors, as they do now, imagined generally rising prices would make earnings grow faster, sending stock prices higher and giving investors a good real rate of return.

It didn’t work out that way. Inflation turned out to be a kind of neutron bomb that left revenues and profits standing while decimating the free cash flow available to owners. Even if a company’s GAAP earnings kept pace with the general level of prices, higher working capital needs and increased prices for capital spending meant that free cash flows failed to keep up with the price level.

Overall, inflation and taxes together stripped public-company owners of more than 100% of their reported profits from 1973 to 1981. We measured that by tracking the book value per share of companies in the Fortune 500, which compounded at 10% per year over that period, adjusting for share repurchases and including the after-tax value of dividends paid out. Someone who bought a business in 1973 and sold it in 1981, in both cases for book value, would have actually lost ground. After capital-gains taxes, the investment would have doubled, but over the same period the overall price level more than doubled."

Something to keep in mind. Remember that you get taxed on nominal gains. There are a few more interesting things about how other instruments performed.

* In one of the more popular articles in this blog, I made a number of scatter-shot predictions as to how healthcare services will change under the current POS HCR that is being pushed through.

Quoting myself:
(4) Since the bill does nothing to address supply and demand, HC costs continue to outpace inflation to the politicians' surprise
(5) Attempts at cost-fixing in healthcare lead to rationing
(6) Rationing leads to a two-class health care system: one for the "rich" and one for the "masses". The "rich" pay cash to providers who do not want to deal with insurance companies or the government.
(7) The cash-only providers are banned because it is not egalitarian. End result: Royal Caribbean retrofits a few cruise ships into healthcare centers/hospitals, parks them in international waters near the big coastal cities and operates heli/ferry services lifting cash customers for treatment.

Well, it is already starting.

I strongly urge you to go read Yves Smith's whole article and commentary here. Interesting discussion in the comments, too. I recommend you read them, too.
"More than 3,000 patients eligible for Medicare, the government’s largest health-insurance program, will be forced to pay cash if they want to continue seeing their doctors at a Mayo family clinic in Glendale, northwest of Phoenix, said Michael Yardley, a Mayo spokesman. The decision, which Yardley called a two-year pilot project, won’t affect other Mayo facilities in Arizona, Florida and Minnesota….
Mayo’s hospital and four clinics in Arizona, including the Glendale facility, lost $120 million on Medicare patients last year, Yardley said. The program’s payments cover about 50 percent of the cost of treating elderly primary-care patients at the Glendale clinic, he said."
For the benefit of my non-US readers, the Mayo Clinic is a major cream-of-the-crop R&D and treatment clinic with several locations across the country. Also, Glendale, a Phoenix, Arizona, suburb, is a popular retirement destination for people from the northern mid-West, much like Spain and Southern France are popular with UK/Northern Europeans. Retirees are also a large voting block with high participation (which enables the current wealth transfer via borrowing from the younger folks to them).

So what is happening here? It must not have been an easy decision: Mayo is cutting a large chunk of its patient population because the government reimbursements (which are due for a cut this year) do not cover the costs of treatment by far. This is particularly true for primary care physician services, so no doc wants to do primary care (unless they are foreign grads slaving away for their green cards in some forsaken location).

As you can notice, cash patients are welcome. What is the conclusion? Despite some people's insistence that healthcare is a right, not a good, we have reached the natural state of affairs. Healthcare is a good that costs money. The money/coverage from the government is no longer accepted. Now at Mayo Glendale, soon at other places. This will lead to huge waiting lists (a form of rationing where one pays with his time) at the places that do accept Medicare patients.

This is not all bad, BTW. Cash customers are smarter customers and will shop around actively (right now medical services pricing in the US is rather hard to find). More clarity should lower costs. The "break" in the imaginary "social contract" with regards to elderly and poor healthcare will hopefully lead to real reforms that aim to address supply and demand, like I suggested, rather than the stinkers in discussions now. We are also going to see some forced austerity in care provision, such as not treating life-threatening conditions on otherwise terminally ill patients. We are also going to see more inter-generational strife playing out.

* On to some more seasonally appropriate topics.

Finding a true "independent" spirit brand is increasingly difficult. Producer and retail consolidation and shelfspace wars make it tough, so do the tons of federal and state regulations which act as taxes disproportionately borne by small businesses. Case in point, Big Tobacco supporting tobacco regulation by the FDA thus effectively crushing any potential entrants.

So I was rather happy some time ago, when I discovered and blogged about an independent French cognac brand: Jules Gautret. Yesterday, I came across a similar product states-side. This is Elijah Craig 12-year Old Bourbon. I enjoyed it neat. It is 47% alc. (94 proof) and has a surprisingly mild taste. I seem to have developed a taste for brown distillates, such as bourbon, armagnac, calvados, cognac, scotch and, to a lesser extent, rakia, and, to a much lesser extent, rum, so I have been enjoying my trips in the premium bourbon space.

Elijah Craig is owned by Heaven Hill Distilleries, which is a family-owned business. Most US bourbons are either owned by Fortune Brands (Jim Beam and extensions, Booker's, Knob Creek, etc.), Brown-Forman (Jack Daniel's-- not a bourbon, Southern Comfort, Woodford, etc.) or one of the other "majors".

Heaven Hill's master distiller is Parker Beam, whose grandfather was the brother of Jim Beam (yes, that Jim Beam).

So, there: Elijah Craig is another brand you can have an honest relationship with. If you're into brand relationships.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)