Tuesday, July 30, 2013

Investing Series Part 3: Accounting Frauds: Lessons for investors

What is accounting fraud?

Accounting fraud is committed when a company makes adjustments to its financials to hide negative financial developments. Commonly known as "cooking the books", accounting frauds are actually more common than the famously known Enron or Worldcom.  Finding them takes a bit more work than just reading the financial statements or digging through the footnotes. Investors are better off by just avoiding what looks like an attractive investment. The investment may be attractive but if you don't understand how does the company makes money, you are better off investing in other boring stocks.  To quote Ben Franklin, "An ounce of prevention is worth a pound of pure."

As an introduction, Worldcom was one the largest telecommunication in the world at the height of the 2000 dot com bubble. It expanded through various acquisition in the 1990s and become the second largest phone company in U.S. (after AT&T). Enron started as a energy pipeline company but ended up more like a financial services company by focusing more on energy trading rather than energy transportation.

Why Commit fraud? Cooking the book is not as fun as cooking a meal

Both companies got a tailwind from the raising bull market of the 1990s. Managers, like the ones at Enron and Worldcom, were playing a special game called `"earnings management". In Layman`s terms, the earnings management is merely a game where the  management wants to at least match what the average earnings expectation numbers estimated by Wall Street analysts every quarter (every 3 month). Usually quarterly profit numbers that are better than expected is rewarded with a higher share price while those companies that report profit numbers that are worse than expected is punished with a lower share price. By the end of 1990s, analysts increased earnings expectations by a rate of 2X while the companies can only grow at a rate of X. Pressured at meeting those high expectations and maintaining a high share price, companies like Worldcom and Enron decided to do cheat the system a little bit. What turned out to be a little cheating snowballed into a lot of cheating.

One of the main reason for keeping a higher share  price  is due to the vast amount of stock options held by corporate managers and officers. Managers were increasingly being paid in options, not cash. Option is a right but not an obligation to buy the company`s share at a pre-determined price in the future. To put that in plain English, it is a lottery ticket on the stock price but essentially given to the officers of the company for free. (Note: Prior to 2006`s implement of the FAS123R rule, companies did not have to expense stock options whereas cash compensation would have reduced earnings). Companies argued it aligns manager's interest with shareholder by focusing on shareholder wealth; the argument is totally false: shareholders suffer the full downside of the stock if the price drops below strike price X while holders (managers) of these options have no downside at all.  For the managers, its head I win, tails I don't lose at all.

After being rewarded those lottery tickets, it doesn't take a high IQ person to realize that the managers will do whatever they can to maximize their own interest, especially since they have the ability to affect the value of these options through the reported financials. Hence the vicious cycle continued until the two companies got pulled back to earth by financial gravity.

Accounting 101 example: Worldcom`s fun with the accounting equation

Worldcom's fraud is actually simple.  It only takes elementary accounting 101 to explained what they did. Let's just review the fundamental accounting equation of Assets = Liability + Shareholders equity. It is an entity because anything increase on the left hand side will increase on the right hand side. Now expand the equation into Assets = Liabilities + Beginning equity + Revenues - Expenses (ignore share issuances and dividends for simplicity). Now, in order to increase profit (Revenue - Expenses), the company has to either increase revenues or decrease expenses.

One infamous method that Worldcom used to decrease expenses is to capitalized them. In accounting, companies  may capitalize expenses (put on the balance sheet) as long as they provide future economic benefit for more than one reporting period. A big capital expenditure like buying a machinery will significantly impact net income if expensed immediately. To solve this problem, accountants allowed these expenses on the balance sheet and charge an expense called depreciation that allocates the cost of assets over their useful life on the income statement. By capitalizing an expense (increasing the left side of the accounting equation), expenses on the right side of the accounting equation shrink, making net income higher and achieving the goal of artificially boosting profits. Also, operating cash flow is increased as well by the additional depreciation expense (killing two birds with one stone!). Worldcom accomplished this by capitalizing their excessive leased line costs (think of it as a rent expense on its leased networks).

Investors should be wary of companies that have suspicious or unexplained increases to capital expenditures accompanied with slowing receivable turnover numbers. These are signs the firm may be capitalizing normal operating expenses. If these changes cannot be explained to investors, just don't invest in those companies. 

Worldcom also booked small artificial revenues that wouldn't have met the standard revenue recognition tests. These were small in amount compared to the capitalizing of line costs. 

Enron: The more complex case
Enron's case was far more complex involving moving assets off the balance sheets to Special Purpose Vehicles (SPV) or Special Purpose Entities (SPE) and using mark-to-model accounting which allowed the company to book artificial profit numbers.

Rather than learning complicated structured finance, investors should stick to their basic investing knitting. A quick look at the financials will make you think you should look for another company

Table 1: Enron Financials in Millions   (2000 annual report released in early 2001) 

% Change
Operating Expense
Operating Profit
Net Income

It does not take a genius to figure out there is something fishy when you compare the revenue growth number (from 1998 to 2000) to the expense growth in table 1.Revenues grew 224% over the two years but expense grew much faster at rate of 231%.  Investors can merely stop here as there are plenty of better businesses that have revenues growth higher than expenses (this is called positive operating leverage). If investors want more warning signs, look at the growth rate of revenue to operating profit or growth rate of revenue to net income. Revenue grew 231% while operating profit grew 42% while net income grew only 31%. Normally firms with positive operating leverage is preferred. If investors need a final simple tests, look at the profit margins. In 1998, the profit margin is 2.2% while in 2000 it is a mere 0.9%.

Another reason to avoid Enron was the wording in its annual report, particularly to its footnotes. Management spend a lot more time on discussing the rise in the share price than actual business operations. (a company should not be a cheerleader of its own stock!). Also in 2000, there was a footnote that stated "Enron entered into transaction with limited partnerships whose general partner's managing member is a senior director of Enron". There is clearly a conflict of interest since the managing partner of the partnership would maximize his own interest which meant ripping off the shareholders of Enron. Clearly, it's better to look for another company than to investigate Enron further, which had all these complicated footnotes that are in another foreign language. In Buffett's famous quote: "I don't look for 7 foot bars to jump over, I look for 1 foot bars that I can step over".

Common cautionary signs
One lesson learned from the Worldcom's case is be wary of growth by acquisitions. It is easy for companies to capitalize inappropriate items or not capitalize appropriate items. For example, in the early 2000s, the pooling of interest method of accounting for acquisition  (no long allowed by IFRS or U.S. GAAP) allowed the acquirer to record the assets of the target at book value Thus, the assets are understated, which reduce amortization expense and overstate earnings. Acquisitions is preferred over organic growth because  goodwill write-down would be eliminated (no goodwill is recorded). Growth by acquisitions can be a good strategy but be wary when companies keep announcing "restructuring charges";  you don't want to be the shareholder that pays the corporate managers' tuition fees. 

One lesson learned from the Enron case is understanding the footnotes. If the footnotes are difficult to understand, the managers are probably hiding something or they don't want you to fully understand certain financial transactions. 

How to invest intelligently and avoid being a lemming
After reading all the negatives on accounting scandals in the past, investors must be extremely cautiously in the trusting company's reported financials and information. Investors should not completely take the financial data at their face value but they do provide valuable information when analyzed carefully. If anything looks fishy, it may be best to move on and find another company to look at. There are thousands of companies in North America investors won't have trouble finding a couple of good ones.

One final word, it very be easy to be a lemming that follows the latest fad in the market. To avoid this, always conduct considerable research on an investment before committing capital and stick with what you can understand. Aesop once said "a bird in the hand is worth two in a bushes" or Buffett's equivalent translation "a girl in a convertible is worth five in a phonebook". It's better to look for businesses (stocks) you can understand rather than invest in a company because you think another fool will come along to pay a higher price than you. The latter is pure speculation. Remember the following two quotes from Ben Graham and you'll be successful in your investing journey: "An investment is an operation where upon thoroughly analysis, promises safety of principal and an adequate return" and "in the short run, the market is a voting machine. In the long run, the market is weighing machine." 

Potash Cartel Crumbling Down

For those who follow fertilizer stocks such as Potash Corp (POT), Mosasic (MOS) and Agrium (AGU), the stocks are taking a big dive today after Russian fertilizer company Uralkali decided to pull out a potash cartel (Belarus or BPC) ending a cartel era of the Potash market where it almost controls 70% of the market. The other major play is Canpotex which sells Potash produced by POT, MOS and AGU. With BPC and Canpotex losing Urallkali as a partner, the two cannot effectively contain demands by emerging countries such as India and China for lower prices. Canpotex has been trying to finalize deals with the Chinese after old contracts (at ~$450/mt) already expired and India is not even in discussing as they want deals below $400/mt. With prices just at $900/mt just four years ago, the potash industry is seeing excessive inventories as companies expanded to boost capacity only to see prices tumble to current ~$400/mt range. Urallkali warned that potash prices may reach $300/mt or even lower as it tries to undercut BPC and Canpotex in pricing and supply the necessary potash to China and India. Just a quick review of the economics shows how Urallkali has a huge advantage vs Canpotex producers (POT, MOS and AGU). Marginal cost of production for Urallkali  is slightly below $100/mt while Canpotex is around $100-$150/mt so the Russian company definitely use pricing as a secret weapon given it is a low cost producer. Plus transportation by rail is much easier for Urallkali  than transporting via ships for Canpotex producers. 

Reaction to the News:
POT and MOS are down more 20% so far today. AGU is down less at 8% because of its retail operations and much lower production of Potash. Given the news today shows a major shift in the Potash market, I would avoid POT and MOS for at least rest of the year and until late 2014 when current excessive potash inventories sold off at lower prices. POT and MOS has large exposure to the Potash so lower prices will materially impact their operating results and underlying earnings. On the other hand, I would look for opportunity to pick up AGU thanks to this news but may wait until later this year. AGU is still trading at lower multiples (9X) vs. POT(10X) and MOS (9.5X) and has much lower exposure to Potash. AGU may be a target of further activist campaign as Jana Partners may either build its 5% stake or others may come in which could be positive for the stock price. Unlike MOS or POT, AGU faces less multiple contraction risks given its diversification. 

*mt = metric tonne
** I am not 100% on the stats but  I am sure there is at least 10 million metric tons of excessive potash (supply >demand) with demand around 45 million metric tons. I will check the numbers and update this post.

Thursday, July 25, 2013

Bank Capital Ratios

This is one of the most hottest topic for bank investors and financial regulators. After reading the new leverage proposal from Basel committee and reviewing the U.S. bank's Q2 results, I will share some of my thoughts


General Review of Capital Ratio Framework: 

For those that need a refresher on bank capital or new to the subject, banks generally need to keep a stack of capital to absorb losses when some assets go sour. The banking model is designed in a way that leverage is needed to boost returns. With return on assets averaging only about 1%, a financial leverage ratio (total assets to total equity) of let's say 20X is needed to achieve the rich 20% ROE reported by most banks.

During the 2008 financial meltdown, many banks found themselves in trouble as many of their assets (mostly in securitized  mortgages or other structured finance instruments) went sour. After the crisis, new capital rules called "Basel III" was implemented to prevent bank failures. Under Basel III, banks need to meet certain capital ratios calculated using a risk-based framework. These ratios are calculated using a capital number in the numerator and the risk-weighted assets (RWA) as the denominator.

RWA is a total asset number based on sum of assets multiples by their risk weights. This calculation is done usually by the bank itself and could be subjective given different banks can use different risk weights on the same assets (see below)

Here some definition of capital under Basel III (for those who wants a quick review):
Tier 1 common: Capital in forms of common shares, retained earnings. This is the most reliable source of capital
Tier 1 capital: Tier 1 common with addition of preferred shares
Tier 2 capital:  Subordinated debentures and certain loan loss allowances
Total capital: Tier 1 + Tier 2 capital

As of July 2013, Canadian banks are already reporting capital ratios under Basel III while U.S. regulators are working to implement Basel III according to the phase-in schedule set out by the Basel committee. For all banks under Basel III, banks are required to hold a Tier 1 common equaling or greater than 7% of RWA. Canadian banks are required to hold 8% or greater due to a new rule by OSFI (Canada's financial regulator)

The problem with the risk-based approach is that Basel regulations allows banks to use their own internal risk models to evaluate the risk weights. This approach is often called the Internal Ratings Based (IRB) or advanced-IRB (A-IRB). A recent study by BIS committee illustrates how risk-weights to account credit risks in their banking books differ materially. See BIS study on the significant differences in risk-weights in bank's book (http://www.bis.org/publ/bcbs256.htm). Fun fact: There is a reason that European banks lack capital, their risk weights applied in their banking book is too lax.

New Leverage Ratio: 

As many regulators found out, banks can cheat a little when they calculate their capital ratios because of the loopholes in the IRB or A-IRB approaches to calculate risk-weights and thus impact the calculation of risk-weighted assets (RWA). Given capital ratio (such as Tier 1, or Tier 1 common) is using RWA as the denominator, a lower RWA will make a bank appear more healthier than it is. A new proposal under Basel III is use of a leverage ratio as a supplementary capital ratio. This leverage ratio is calculated as a capital number in the numerator and a "total exposure" number in the denominator. This new leverage ratio will take account banks' leverage which include off balance sheet numbers in the calculations. Notice that the leverage ratio is less subjectively calculated compared to risk-based capital ratios although the total exposure number could be subject to some ambiguities.

The capital number currently proposed is the Tier 1 capital. The total exposure number is a sum of on balance sheet items (adjusted for secure financing transactions and derivatives) and off-balance sheet items. Off balance sheet items include:  commitments (include liquidity facilities), unconditionally cancellable commitments, standby letters of credit, trade letters of credit, unsettled securities etc.   For those interested to learn more on the calculation, see the link below on the Basel committee's leverage ratio proposal.

The Basel committee's plan is to have banks report leverage ratio by January 2015 and have banks meet a minimum leverage ratio requirement of 3% by January 2018.

U.S. Banks Leverage Ratio (Sources: Company Reports) 
Citigroup: 4.9%
Wells Fargo: >5%
Bank of America:  between 4.9% and 5%
Morgan Stanley: 4.2%
JP Morgan: 4.7%
Goldman Sachs: Not given

During the Q2 U.S. bank reporting session, many banks reported consolidated leverage ratios. This is due to a new proposal from U.S. regulators that U.S. banks must meet a 5% leverage ratio at the bank holding level and 6% for each banking subsidiaries. Given most U.S. large banks are quite close in meeting these new tough rules, it shows how much U.S. banks have improved since the financial crisis. Most U.S. banks are still trading near book value compared to Canadian banks that are still trading at 2X book.

A report by CIBC World Markets puts the average big six (RY,TD,BNS, BMO,CM, NA) bank's leverage ratio at ~3.5% vs. the near 5% for most average U.S. banks. For Canadian bank investors, don't feel alarmed. This is because of the different business mix and the fact Canadian banks hold insured mortgages (essentially risk free because guaranteed by CMHC which is a government entity) while U.S. banks usually securitize or sell their mortgages off.


Capital is very important for bank. Basel III raised the capital requirement to 7% of tier 1 common (old rules were so lax that banks needed only 4% of tier 1 capital) and introduced various new measures such as the leverage ratio as discussed above. I find the new liquidity ratios introduced through Basel III such as the stable funding and liquidity coverage ratios will further assist investors in evaluating bank's solvency and liquidity. The downside to investors is the need to understand these new complex rules and they will impact banks' operations. Banks are profitable businesses but they are also very complex businesses for investors to understand.  

Similar to Warren Buffett's opinion on GAAP accounting rules, I have a similar sentiment towards Basel III. I find Basel III far from being perfect, but would hate to be the one tasked to find a better alternative method.

Basel III capital: http://www.bis.org/publ/bcbs189.htm
OSFI Capital Requirement: http://www.osfi-bsif.gc.ca/osfi/index_e.aspx?ArticleID=5050
Leverage Ratio Proposal: http://www.bis.org/publ/bcbs251.pdf

Monday, July 22, 2013

Financial Reporting and the use of non-GAAP measures

After reading the CFO Journal on WSJ on the topic of "non-GAAP" measures, I would like to share my views financial reporting and the use of these non-GAAP measures.

Everyone is probably familiar with the accounting scandals in the early 2000s. SEC passed the Sarbanes-Oxyley Act to enhance financial disclosures for public companies. Nonetheless, 11 years after, there are still many companies taking advantage of loopholes in SEC's regulation G, which allows companies to report non-GAAP measures when they report results.

What are non-GAAP measures? These are operating and financial metrics that do not comply with Generally Accepted Accounting Principles (GAAP), hence the name "non-GAAP". Companies argue these non-GAAP are more representative of the financial position of the company for investors than traditional GAAP measures. Examples of non-GAAP measures include EBIT, EBITDA, adjusted EBITDA, Free Cash Flow, Funds From Operations (FFO). Although measures such as EBIT and EBITDA can be strictly calculated from GAAP financials, companies often make discretionary adjustments. Free Cash Flow may sound easy in principle but there are many companies that exclude working capital investments in their definition of Free Cash Flow, absurd in my view! 

As an investor, I think non-GAAP measures were created with good intentions but management took advantage of the lax regulation regarding non-GAAP measures and often  paint a much more rosier picture of the company. I gave some brief example below but I am certain that there are many company out there giving misleading non-GAAP measures.

Manipulating non-GAAP Financial Measures:

Be very careful when assessing the financial healthy of a company based on non-GAAP measures like adjusted EBITDA or adjusted earnings. Although the company claims that these measures exclude "one-time" (often called "nonrecurring" or "unusual") items, be wary of the claim. Under SEC regulation G, companies must reconcile non-GAAP financial measures with a comparable GAAP financial measure. Investor must conduct their due diligence to make sure that companies are not mis-classifying one-time items. Often, companies try to stuff regular expenses in unusual items so that their adjusted numbers look much more cleaner. Maintenance expenses, bad debt expenses and advertising expenses are NORMAL costs of operating a business. Excluding them in the adjusted earnings calculation inflate the profitability of the company and goes against common sense of doing business.

Another non-GAAP measure is revenue growth metric like same-store-sales. This is a commonly used metric in the retail sector. This metric is dependent on the definition of how many stores were active during a period. Many companies exclude results from stores that just opened and are less than 1 year old. Nonetheless, investor must pay attention to the how company defines active stores. A clever trick used by management to mask poor sales performance is to re-fine active stores. Krispy Kreme tried this trick in 2004 to mask the poor performance of its new stores.

Another actual example is Groupon when it filed for its IPO two years ago. It included a measure called "adjusted consolidated segment operating income" or adjusted CSOI. Adverting and acquisition expenses are not fully expensed in CSOI; instead they are treated like capital assets and only a portion of them gets expensed into CSOI. Treating marketing and acquisition expenses as capital assets is absurd in my opinion. Groupon or any company that uses CSOI as a non-GAAP measures assumes that the expenses will have future benefits but that's only IF those expenses bring in future customers or revenue. On the other hand, purchasing a machinery that can produce X amount of products is much more likely produce future benefits than advertising expenses. Therefore, it is obvious that the machinery should be capitalized [put on the balance sheet] while marketing costs should be expensed. [put on the income statement]

In the end, GAAP measures still matter: 

Most investors are focusing less on GAAP numbers and more on these pro-forma numbers. Nonetheless, GAAP measures still matter and investors should still pay attention to the reported GAAP income. As an investor myself, I understand that GAAP numbers are volatile and may be inappropriate to use in ratios such as P/E. Nonetheless, I average the earnings (as suggested by Ben Graham) and still utilize GAAP earnings for ratios such as P/E. Given that GAAP numbers are audited (companies still pay millions in annual audit fees after all), I can feel safer using GAAP numbers than use non-GAAP measures like "adjusted earnings".

Non-GAAP measures are helpful, but be wary when using them. Always double check what the measures actually mean and that the definition stays consistent over time.

Wednesday, July 17, 2013

Update on Major Central Bank Policies for Investors

Today (July 17th) is a big day for central bank announcements. We have the July minutes coming out of the BoE, Stephen Poloz's issuing his first BoC meeting communique  and of course Bernanke's testimony to congress. 

Bernanke's Testimony to Congress:

In his prepared remarks, Bernanke started by outlining the improvements in the economy in particular with references to the improvements in the housing sector and the recent strong payrolls numbers. The important part of his address was on future course on monetary policy. With regarding to future policy, he emphasized that the course is not "preset" and is dependent on future financial and economic developments. It is also important to link future policy with the goal of achieving the Fed's dual mandate of maximum employment and price stability. In discussion of the two unconventional tools, he tried to distinguish between forward guidance on rates (federal funds rate) and asset purchases (QE) by stating the two has "different roles".The asset purchases were used to improve "near term momentum in the economy" while the forward guidance is use to provide a "highly monetary accommodation for an extended period of time even if the economy strengthen" 

On tapering, the Chairman reminded everyone that the tapering plan introduced in the June press conference is highly dependent on the outlook for economy and financial market stability. The assumption of that plan was continued payrolls growth as seen in recent months (200K per month on average) and inflation (as judged by the PCE which is only at 1%) moves closer to the Fed's 2% inflation target. If these assumptions are proven false, then a change in the original tapering plan must be ratified. The pace of future moderation (tapering) of QE will depend on future course of job growth and inflation outlook, which can change dramatically from what is being forecasted now. 

On forward guidance, the Chairman stated it is important to pay attention to the phrase "at least as long as" in the rate guidance. He added that even though the guidance stated rates will remain low at least as long as the unemployment rate is above 6.5% and inflation is not more than 0.5% above the 2% target, the 6.5% unemployment number is a threshold, not an automatic trigger point. When the economy reaches 6.5% unemployment rate, the FOMC will re-assess the economy to see if it is appropriate for a first rate hike (of the federal funds rate). If the drop in the unemployment rate is due to lower labour participation, then rates will likely remain at the zero bound longer than what the 6.5% threshold suggest. Also, when the 6.5% threshold is reached, an outlook of inflation must also be assessed to see if the committee's 2% medium term inflation goal will be achieved; low outlook for inflation will also mean zero bound interest rate will remain for longer than what the 6.5% threshold suggest. All in all, Bernanke remind investors that even if Fed end QE, the federal fund rates will likely remain at 0% and is unlikely to rise in the future unless economy improves substantially.  

Overall, he stuck pretty much with his old script but repeating and keep repeating the same thing assures traders and investors he will not diverge from those remarks he made on tapering and future course of monetary policy. 

Source: http://www.federalreserve.gov/newsevents/testimony/bernanke20130717a.htm

Poloz and the BoC:

Looks like Poloz has made his mark at  the BoC with a slight change in the last part of the April meeting statement: "AS LONG AS there is significant slack in the Canadian economy, the inflation outlook remains muted, and imbalances in the household sector continue to evolve constructively, the considerable monetary policy stimulus currently in place will remain appropriate. OVER TIME, as the normalization of these conditions unfolds, a GRADUAL NORMALIZATION  of policy interest rates can also be expected, consistent with achieving the 2 per cent inflation target", the caps are intended to put additional emphasis on the changes Governor Poloz made. It is clear that he is putting on a more dovish tone with adding "As long as" the weakness persist in the Canadian economy, the considerable monetary policy stimulus (i.e. a low 1% overnight rate) is appropriate. This tone is considerably more stronger than Carney's. In addition, he watered down the statement on returning to a more normalized policy by stating that it will be more "gradual" and it will be done "over time". 

The change in the statement reflected his June speech when he predicted the return to full capacity in the economy will be more gradual since consumer and business confidence takes time to build. 

Source: http://www.bankofcanada.ca/2013/07/publications/press-releases/fad-press-release-2013-07-17/
Carney and the BoE 

Mark Carney in his first policy meeting at the BoE managed to convince his fellow members to stick with a "mixed approach" with forward guidance and tried to strike a balance between doves that wanted an increase in the Bank's quantitative easing program (current at 375 billion pounds) and those who wanted to keep quantitative easing unchanged. Carney had everyone on board with his new policy with vote of 9-0 (most expected 7-2 vote as the 2 doves were predicted to vote for more QE). The Bank's trial run at forward guidance was successful as the added phrase in statement managed to push down gilt yields, push up equity prices and the pound depreciated against most peers. With a full introduction of forward guidance in the next month's meeting, BoE is on course to continue to provide a very accommodation monetary policy to the U.K. economy.

Source: http://www.bankofengland.co.uk/publications/minutes/Documents/mpc/pdf/2013/mpc1307.pdf

Overall Conclusion: 

All three events today signaled that global monetary policy will still remain accommodative  The most influential one, the U.S. Federal Reserve, provided more clarity on their intention to reduce the pace of their asset purchases (QE3). Although Bernanke did not provide additional new information, the assurance he made in his prepared remarks that monetary stimulus is still needed and repeating that tapering is NOT monetary tightening helped to alleviate fears especially among the traders who interpreted incorrectly his previous statement on tapering. The huge rise in fixed income yields after tapering talk surfaced was pretty much a over-reaction. U.S. 10 year are down below 2.5% from a 2.74% reached after the June job report. Rates may continue to drop further in the short term but in the long term (2.3-2.4% for 10-year treasury) , investors shouldn't forget we are in a rising rate environment

Thursday, July 11, 2013

Abstract: H2 2013 Investment Outlook

Below contains the summary section of my H2 2013 Investment Outlook which contains discussion on major investment themes in the equity, fixed-income, currency and commodity markets. The full copy can be found HERE


Main Investment Thesis Going into the second half of 2013:

The second half 2013 should provide modest returns for equities, and further losses for fixed income assets. In the global currencies market, the reversal of the carry trade will likely boost the value of the USD against other major currencies. In the commodities space, energy and industrial metals should perform relatively better compared to precious metals.

The search for yield theme is starting to wind down after the U.S. federal reserve signaled to the market that it is ready to reduce the size of its asset purchase program (nicknamed QE3). Investors must be careful when basing investment decision solely on yield levels because high yields does not guarantee safety and high yield assets are likely to face further losses in a rising interest rate environment. In the equities space, investor should avoid bond-like equities such as utilities and telecoms. Instead, investor should prefer companies with exposure to the stronger U.S. economy or benefit from a rising USD. Sectors that benefit from a stronger U.S. economy include industrials, consumer staples/discretionary and U.S. financials. Companies that benefit from a higher USD include Canadian industrial companies or Canadian material companies that sell commodities priced in U.S. dollars. 

Focus in fixed income is on quality rather than absolute yields. Corporate bonds are better choice than overpriced sovereigns. Investors should reduce duration in their portfolio to mitigate interest rate risk. A laddering approach is more appropriate in a rising interest rate environment.

For currency investors, U.S. dollar is likely to appreciate further due to the perceived tightening in monetary policy and tightening of interest rate differentials.

Major risks to the outlook include slower than expected recovery in the U.S. economy, a hard landing in China and additional negative news out of Europe. 


The post is for informational purposes only and does not constitute an offer to buy or sell any securities discussed in the post. The recommendations made in this post are subject to change without notice. Investors are recommended to conduct due diligence before committing capital to any investment.  

Tuesday, July 9, 2013

Reflection of BlackBerry Annual Shareholders Meeting (Prelim Version)

Disclosure: The author intends to hold his shares in BlackBerry (BB.TO). This post summarize Thorsten Heins (CEO of BlackBerry) address to shareholders on July 9, 2013. All opinions presented are in the opinion of the author and this post is for informational purposes ONLY. 


Besides the boring process of going through the voting of directors and passing a couple of special proposals (such as the one changing the legal name from Research in Motion Ltd. to BlackBerry Ltd.), the most interesting part of the meeting was the CEO address to shareholders, which contained more colour on future strategy of the company, although most major themes were repeats from past conference calls.

A 3 stage process for the restructuring process was presented : 
1. Refocus the company (reduce cost, re-position products)
2. Build + Invest
3. Return to profitability

Stage 1 was declared complete in the last fiscal year as the company managed to launch its brand new BB10 products (Z10 and Q10 in January and Q5 in May). The Cost Optimization and Resource Efficiency (CORE) program was implemented early last year to cut operating cost by about ~$1B a year (based on Q4/2012 run-rate). The company also restructured its board and management adding 3 new BoD with wireless industry experience,  a new marketing chief and chief legal officer. Finally, the balance sheet was strengthen through the reduction of working capital and leaner supply chains (reduced manufacturer providers from 4 to 2 and reduced manufacturing site from 10 to 4). Cash & investments is up $1 billion from $2.1 billion at fiscal end 2012 to $3.1 billion in first quarter 2014 (last quarter).

Stage 2 is underway. BlackBerry is ready to invest its high cash balance to deliver the BB10 experience. As Thorsten explains, BB10 is not just a new product, it is a entirely new mobile computing platform. It'll take time for consumers and businesses to get familiar and be comfort enough to buy a new platform. Along with new BB10 devices, the new BlackBerry Enterprise Service (BES) 10 for enterprise device management is gaining traction among corporations with 19,000 servers  installed or in testing stages. The attractive feature of BES 10 is that it is a cross-platform  device management system and it offers a secure environment for transferring of data no matter which device employees use.  This shows that BlackBerry is embracing, not ignoring the Bring-Your-Own-Device (BYOD) trend. BES 10 is likely to add  more service revenues for BlackBerry, which will offset the lost service revenues from consumer customers.  New launches for BB10 devices are still coming up and even a new BB7 device launch aimed at maintaining its market share in emerging markets. Calling BB10 a fail now without seeing the full product line may be premature especially for a more work-oriented device like a BlackBerry. If an iPhone launch had five months of lackluster sales, it may be a sign of trouble. However, a BlackBerry device is positioned entirely different from an iPhone and five months is too early to call BB10 a failure even in an industry where products have shorter than average life cycle.

Although stage 3 is far away from today, this is a stage where BlackBerry will be a leading mobile platform and the company will return to profitability. Thorsten stated it is important to leverage BlackBerry global secure data network (connected in over 175 countries and 654 carriers are connected to the network) in stage 3.

Long-Term is in Mobile Computing

As Thorsten mentioned in the past, he wants to position BlackBerry to meet the ongoing trend towards mobile computing. Mobile computing is the increase use of mobile devices for work related tasks. We seen the big move from PC to laptops and then from laptops to tablets. Judging from Thorsten's comments, he is betting on the continued interest in smaller computing devices to meet the needs of the typical multi-tasking worker. This also includes leveraging the QNX system which is used in cars and hospitals.

Thorstens elaborated on his decision to open up Blackberry Messenger (BBM) to iOS and Android devices because it will position BBM to be the leading messaging tool. An interesting observation he made was that the usage of e-mails has been decreasing and usage of instant messaging has been on the raise especially for work. To take advantage of  this trend, opening up BBM allows BlackBerry to build a larger BBM user base and provide the opportunity for new users to experience BBM. Monetizing this decision may be difficult but Thorsten stated that this strategy is similar to the strategy of many other social networking companies. Getting a bigger user-base is key and then it may able to implement service fees later on.

Our Job is not pleasing the  analysts 

Thorsten repeated that it is not his job to meet the irrational short-term expectations set out by Bay/Wall analysts. After all, he did roughly guide the analysts that BlackBerry will "approach break-even" in Q1/2014,  although street consensus for EPS was at $0.09 with one analyst at $0.72 going into the Q1 earnings report. Although results are difficult to forecast in a competitive industry, investors should not forget that BlackBerry is currently in its  investment stage and Thorsten reminded everyone that Blackberry is guiding for another operating loss in Q2/2014.

Author's Take

Execution and re-building its reputation are key to BlackBerry's turnaround. As a shareholder, I was obviously disappointed with a large 35% drop in share price since their Q1/14 earnings report but short term volatility needs to be ignored. Now that BlackBerry has new devices and the new BES 10 system, they need to get those products/services to market efficiently and effectively. It may not be easy as consumers still have a negative perception of the BlackBerry brand and rumors of BlackBerry's death may scare enterprise customers.  The increase in BES 10 servers installed and tested of 19,000 (up from 18,000 reported in Q1 earnings report) is positive and shows that BlackBerry's strength in enterprise reminds strong. It may take a few more quarters to judge the success of BB10 products and the BES 10 system. BlackBerry handsets are mainly work devices; hence,  sales may not be clustered near the initial months after a launch like an iPhone or Samsung device. More time is needed for work devices as planning cycles are longer for businesses than for consumers.

All in all, I believe BlackBerry will rebound in the future. The share price is volatile in the near-term with more declines likely in the short term but I am taking a longer term view. With the stock trading significantly lower than tangible book of ~$11 ($0 assign to patents and intangibles), a cash pile of $6 per share and the worst-case break-up value of $8-$9 (assumes zero value  for hardware), shareholders have ample of margin of error at this point. I picked a few cigar-butts before in the past and all worked out pretty well. A good example was Manulife (MFC) when I bought back in late-2011 and it was most hated stock on the street. The reason was because everyone thought interest rates were going to zero and the stock would soon be worthless with billions of guarantees on its books.  However, with economy improving, interest rates are now raising and MFC stock is constantly touching new 52 week highs recently.  As I learned from the MFC experience, patience is needed for BlackBerry investors.

The future for BlackBerry is definitely uncertain, but in my opinion, where there is uncertainty, there will be opportunities. With everyone looking only at downside risks, the upside potential is now completely ignored. Those upside potential should not be discounted as there is a real possibility for BlackBerry to have a solid positioning in Mobile Device Management (MDM), and enterprise secured services. As Thorsten reiterated in his remarks, BlackBerry is not just a device only company.  Even on the hardware side,  sales of Q10 may surprise to the upside in Q2 with over 96 counties (320 carriers) offering it worldwide and current sales expectation  for Q10 is low after a disastrous Q1 (Q10 was only available in selected countries such as U.K and Canada for 1/3 of Q1) . Overall, if you buy or own BlackBerry, you better exercise extreme patience. One positive fact often overlooked is that the majority of investors are already extremely negative on the stock. This is reflected in the 182 million (35% of float) of short interest and the high trading volume on declining days. With investor sentiment extremely negative, prices are likely stabilize soon (not guaranteed to)  and may surprise to the upside later on.

Friday, July 5, 2013

Investing Series Part 2: Intelligent Investing for the Average Investor

Author's Note: This article mainly serves as a guide for active investing (stock picking) for the average investor. Stock picking/active investing is not suitable for everyone. For those who want a more passive approach, I suggest a balance mix of ETFs (50% stock/50% bond ETF division and then re-balance annually).  However, if you want to learn the basics of stock pick, read on.... 

To succeed, one must have a mind-set of an investor, not a speculator:
The statement above took the author over 5 years to learn properly. It is very easy to pay attention to the stock ticker and the current price than to think about the underlying business. Everyone needs to be reminded from time to time that a stock represents an ownership of a business, not just a paper (or electronic ticker) with a price on it. If the business does well, your stake in that business should increase in value and vice versa. It's simple as that.

Investors need to be patient as owners and must ignore short term fluctuations of the stock market. Imagine if you buy a house, will you check with a real estate broker what is the price of your house every morning at 9:30am? What about at 9:35am? The answer of course speaks for itself but unfortunately, many investors will likely check the price of their stocks at 9:30am, 9:31am....all the way till 4:00pm. Now that's speculating.

Understand Mr.Market but don't listen to him
Mr. Market is an allegory of the stock market made up by Ben Graham, the mentor of Mr.Buffett. Mr.Market is a fellow who comes to you daily to quote prices of many businesses and he is happy to buy your interests in those businesses or sell his interests at the price he quoted. Mr.Market is very emotional. He sometimes quotes a ridiculously high price because he only sees the positive sides of those businesses. He sometimes also quotes a ridiculously low price because he thinks the business is worthless.

Warren Buffett reminds investors of two important facts about Mr.Market investors need to know and remember at all times:

1) You don't have to transact with him every day. Only do so if you can take advantage of his quotes. If he quotes a low price, you buy from him. If he quotes a high price, you sell to him. Most of time, it is simply better just to IGNORE him.

2) It is Mr.Market's pocketbook (pocketbook describes the book traders use to keep track of their stock inventory back in Graham's days), not his opinions that should interest you. Many investors think Mr.Market is correct on the valuation of businesses and follow his opinions.

Basic skills needed
Although investing is a game the average Joe can succeed at, there are some of the skills that are essential for an investor: 
  • Basic accounting knowledge (understanding of income statement, balance sheet and cash flow statements). Accounting is the language of business; therefore, investors need a basic understanding of accounting
  • Have patience. As Peter Cundill used to say, "patience is patience is patience"
  •  A basic understanding of the business model of the underlying company. If you don't understand how the firm actually makes money (i.e. Enron), you have no right to be the owner of that company
  • Able to differentiate between "price" and "value". Remember "price" is what you pay, "value" is what you get
  •  Have the attitude of an owner, not a speculator. If you buy a stock and not worry if the stock market closes down for the next 10 year, you are truly thinking like a owner.

Order of Operations:

1) Have an understanding of the industry and business. Pull up its annual reports from either SEDAR (for Canadian companies), EDGAR (US companies) or on the investor relations site and start reading. Understanding characteristics of the underlying business is important. What are the key successful factors in a particular industry. Does the company possesses those key success factors? Does it have a competitive advantage vs. other competitors. In this step, it is beneficial if the investor has worked in or has a good understanding of that specific industry.  Never ignore a section in an annual report just because it looks long. The risk-factors (Section 1A of 10-Ks) section should never be ignored.  The management discussion & analysis (MD&A) section is an important section of the annual report where the management explains its outlook for the company and industry.

2) Listen to a few recent quarterly conference calls (most companies have webcast links on their investor relations). This will give you a recent update on the company and industry.

3) Take a look at its financial statements in the annual report. Don't forget to read the footnotes to the statements! Analyze them using techniques such as common-size, trend analysis and ratio analysis will help investors generate a good picture of the company's financial trends. It may be helpful to remove the effect of one-time items such as a goodwill write-downs or other asset impairments.

4) Analyze the key operating or financial ratios relevant to the industry that the company operates in. i.e. banks investors need a careful look at lending margins (Net Interest Margin), loan losses (Provisions for Credit Losses) and capital ratios (Tier 1 common equity ratio, leverage ratio). For life insurance companies, interest rate levels, swap spreads and corporate bond spreads are analyzed. For retail companies, same store sales (SSS) growth and sales per square foot/meters are analyzed. For telecoms, average revenue per user (ARPU)  and the churn rate are analyzed. For oil and gas companies, focus is on the growth in reserves (such as 2P) and production (production in barrels per day). Don't worry if you do not know the key ratios above. Just read the annual reports of the companies and you'll slowly learn what those ratios mean. 

5)  Figure out the intrinsic value of the company (see next section)

A basic framework for valuation:
Investors can either use a cash flow based approach or a earnings based approach. A cash based approach takes all future cash flows generated by the company and discount them to calculate the present value of the company. An earnings based approach uses an average earnings multiplied by an appropriate long term multiple.

For the cash based approach, the measure investors should use is Free Cash Flow (FCF). As an approximation, FCF = Cash from Operations (from cash flow statement) - capital expenditures (often a line in the cash from investing section). Investors need to estimate future FCF and then discount them back to the present to figure out current value. The definition of FCF used here is cash flow to the whole company (firm) so the equity value is calculated by subjecting total net debt value (short term debt + long term debt- cash) from the calculated present value of the FCF values. 

The earnings based approach is very similar to a P/E multiple approach. However, investors should use an average earnings number in the "E" instead of forward earnings (next 12 month) used by most Wall Street analysts. Many companies are cyclical or have large swings in earnings so an average number will smooth out those fluctuation to provide a better picture of the long term earnings power. Using an average earnings number also implies the multiple must represent a fair long term multiple for that company. (most are in range of 10-15 times earnings). This approach was practiced by Buffett's mentor Graham since 1930s and he calls it the "earnings power" approach. 

Conclusion and the "Margin of Safety Principle"
In Chapter 20 of the Intelligent Investor, Ben Graham summed up sound investing in 3 words: "Margin of Safety". What does that mean?

Because there is uncertainty regarding the future and it is likely your calculation of intrinsic value is very different from the actual value, a margin of error is needed. This margin of error is an investor's margin of safety.  If the stock price is at $25 and you think it is worth $30, the $5 difference does not offer a large margin of safety. For a DCF model, a small change in discount rate will likely change the intrinsic value. For an earnings multiples model, a change in the multiples will impact  the calculated value significantly.

How does an investor guarantee adequate margin of safety? Graham suggested that the intrinsic value should be at least 50% higher than current price to provide that safety cushion. Some deep value investors even suggest that calculated intrinsic value should be at least 100% higher than current price. From the author's own prospective, he wouldn't consider putting any money unless the upside is at least 33%, preferably 50% or more. 

All in all, investing is a marathon, not a race. Investors should purchase a stock when it is cheap enough justified by its fundamentals, not because you heard a rumor that the company may go up at a cocktail party. Investing, as Warren Buffett would say, is simple but it's definitely not easy. For anyone wants a superior return, hard work is needed. No pain, no gain, it's that simple.  

Appendix: Collection of quotes investors should know:
Aside from the ones already mentioned above, below are some of the quotes every investor should be aware of.

"If a business does well, the stock will eventually follow" Warren Buffett
Comment: The stock price may fluctuate day to day but it is ultimately the underlying business that matters. If current stock prices are depressed for whatever reason and the business is still doing well, expect stock price will rise in the future.If the company, on average, earns 20% (return on capital) per year, then the stock price should rise by 20% per year in the long run.

"Be fearful when others are greedy, be greedy when others are fearful" Warren Buffett  
Comment: Buffett did not earn billions by luck. This is one of his important principles. Investors have to realize when others are very fearful, it is a sign of opportunities. Buffett took advantage of many panics such as 1962 salad oil scandal to buy American Express (AXP), the 1974 panic in Washington Post (WPO) stock due to a political threat, and 1990 S&L crisis to buy Wells Fargo (WFC).

"Invert, always invert" Charlie Munger
Comment: This quote was actually from algebraist Jacobi. Many investment decision can be improved by looking at the problem backwards. i.e. To find good investments, the direct method is to search for excellent stocks to buy. The inverted approach is to avoid all bad stocks and the remaining choices will be good. 

"If I have to identify one factor to successful investing, it's cheapness" Howard Marks
Comment: No matter what asset you buy, if you buy it at a reasonable and cheap price, you'll do well. A great example Mr.Marks likes to point out is that if you bought the nifty-fifty stocks (a group of high growth blue chip stocks), you would have lost money in the 1970s. However, if you bought a group of junk bonds (bonds of financially distressed companies), you return was fantastic. It may counter-intuitive that risky junk bonds actually performed better than high quality blue chip stocks, but the reason was price. Junk bonds were ridiculously cheap before the 1980s LBO boom but blue chip stocks were highly overvalued (some traded near 90X earnings). Marks always made fun of the definition of junk bonds in the old Moody's manual  "a bond that does not possess the characteristic of an investment" 

"Bull-Markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria" Sir John Templeton
Comment: A very concise sentence to describe market cycles. You want to buy when everyone pessimistic (i.e. 1933,1938,1970,1974, 2002, 2009) and be wary/sell when everyone is caught in euphoria (1929,1937,1968,1973, 2000, 2007)

"Those who do not remember the past are doomed to repeat it" George Santayana
Comment:  For a successful investor, a study of past market cycles (bear/bull market) may help them understand market cycles and improve investing decisions. Those who neglect to study the past, is likely to  repeat past mistakes. One common mistake was leverage. Leverage always caused problems. Mr.Marks summed it nicely in a good equation: Volatility + Leverage = Dynamite 

"History doesn't repeat itself, but it does rhyme" Mark Twain
Comment: Adding to Santayana's quote, investors need to remember every market cycle may be different but the underlying factors of greed and fear that caused those cycles will always be the same.