Friday, 16 September 2011

Green Energy, Red Ink: Prospects of Solar in a Recession

It is an undisputed fact that green energy and alternative energy will have to be fully integrated in a world that is quickly running out of fossil fuels as its primary source for energy. Yet despite this obvious premise, there is no guarantee about the short-term profitability of the industry. Especially for a nascent industry, growing pains could be quite high. Add to this the fact that economics of solar still requires subsidies that depend on governments which are facing big financing woes themselves, the short term is set to be painful for solar stocks.

Solar has been an industry driven by subsidies. We see that stock performance and the trading multiples have correlated strongly with positive policy developments. Therefore, with the key growth driver being subsidies, the current political environment makes the outlook on the sector weak. With bulk of the market emanating from European demand, a Euro area crisis is the elephant in the room. The market expects, at varying degrees, that non-European demand (primarily US, China and India) will pick up the slack. However, this assumes that contagion will not spread and if it does, the periphery will not be affected (Read this for a fantastic read on periphery and the core). With budgets under strain, governments have been/are revisiting their subsidy levels (see Germany, Italy, Spain, France, UK). Furthermore, other countries that are jumping on the bandwagon are doing so at a much lower rate.

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Investing in Solar Stocks: What You Need to Know to Make Money in the Global Renewable Energy MarketInvesting Books)

Thursday, 15 September 2011

Seeking Yield in Industrial REITs – Opportunity for Growth and Income Investors

The warehouse space, along with other real estate sectors, went through a very deep recession in 2008. As a consequence, the supply/demand situation of the sector is now exhibiting interesting properties. Supply has been constrained for over two years. Growth has been less than 1% per annum and has not been able to cover obsolescence. Meanwhile demand continues to see plans for growth due to reconfiguration of distribution systems in order to achieve greater efficiency and lower costs. Eastgroup Properties (EGP) is a player that stands to benefit from this.


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Income Investing Secrets: How to Receive Ever-Growing Dividend and Interest Checks, Safeguard Your Portfolio and Retire WealthyInvesting Books)

Investment Themes in a Low Growth, Zero Rate, Deleveraging Economy

Recent Euro zone crisis that arose from sovereign worries, spread quickly around the globe that wiped off over $9 trillion in value from equities globally. This strong sell-off, initially triggered by the resurfacing of the Greek debt problems is in fact nothing more than the discovery of skeletons that the global policymakers were hiding in the cupboard. Following unprecedented and coordinated monetary and fiscal stimulus that the governments poured over the burning markets in 2008, the equity markets naturally reacted positively to the wall of liquidity.

However, rather than going to the root of the causes and fixing the problems, the order of the day was to sweep the problems under the carpet. Instead of trying to address the issues at hand, politicians and policymakers in the Western World cheered the markets on, as if prices of a handful of asset classes and thus the confidence in those assets could reverse the fundamental problems of the western world ridden with overleverage and excessive consumption. It was a simple overplaying of one’s hand in a poker game. It was taught that liquidity would be the panacea, yet while it is an undisputed fact that confidence is the key underpin of a strong and healthy economy, diverting attention from the main problem by artificially inducing confidence through inflated asset prices can only lead in a bigger down when the drug gets cut off.

Now we are left with three main themes that are interconnected: low growth, zero rates, and a deleveraging economy. 

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The Ultimate Dividend Playbook: Income, Insight and Independence for Today's InvestorIntroduction to Investing Books)

Wednesday, 14 September 2011

2 Stocks that are Falling from the Good Graces of the Street

Both Zion's corp and FedEx have recently seen negative analyst feedback. ZION's woes include TARP exit, NIM squeeze and low-quality profit sources, forcing the company to a level where it may not be able to earn its cost of capital. Meanwhile, FedEx is a victim to the economic slowdown. A fixed cost base makes EPS highly sensitive to change in volumes (1% decrease in volumes affects EPS by 5%)

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Tuesday, 23 March 2010

Margin mana for the market?

Following the January correction, the market rallied in the last 1.5 months to reach new highs. But a wide range of players continue to feel ambiguous about the future direction: will the markets topple off as the bounce fizzles out in H2? will the Fed act too soon, freaking everyone out? Are we to stay in an extended period of easing, hence creating another bubble? or have we reached the sweet spot and this is 1921 all over again?

Amidst this confusion, several charts from Citi research team caught my eyes. Tobias Levkovich has been drumming about on the lag of credit to industrial production (which in turn is a driver of the stock market itself).

That infamous chart (above) continues to suggest buoyant industrial activity (the caveat being is what if this is an atypical period compared to the last 20 years, which can then be challenged by “this time is different” has never really worked – don’t you just love economic dilemmas?!?!)

Now amidst a positive activity backdrop (which many argue is already priced in) the key question shifts to upside in margins. Having shed 6mn jobs ($240bn of “savings”) a bounce back in activity levels will drop down to profitability. (Now I hear you objecting: who will buy if the consumer is dead and out of a job? can we really sustain such high productivity levels – wouldn’t companies have to hire back all those people?) But lets concentrate on this one partial derivative for now. With 2/3 of company costs being labor, the importance of the labor savings become highly pronounced, even trouncing the commodity pressures that we so much fret about. The chart below shows how margins are correlated with labor costs (note that the RHS is inverted scale)

So with the spread between small businesses saying they will increase prices to small businesses saying they will increase wages going up, the higher margin argument becomes more plausible. (see chart below). Of course this dynamic will not be sustainable ad infinitum, but at least the 2010 margins could see a nice pop upwards given the slack in the employment market.

Sunday, 28 February 2010

Growth vs. Return on Capital: The Chinese Dilemma

At times it is instructive to go back in time and read some of the seminal pieces which describe the mood of that day. Worst case, you get a reminding glimpse of the prevailing thoughts (and giggle at their naïveté), but if you are lucky, you uncover a long forgotten treasure that provides you with timeless insight.

I recently stumbled upon Krugman’s 1994 piece, “The Myth of Asia’s Miracle.” Brushing aside the discussions surrounding the honesty of the statistics of the Eastern block, a perceivable faster growth rate in these economies was a worry to the West in the 1950s/1960s. Similarly, the contemporary thinkers were fretting about the Asian growth in the 1990s (when Krugman was writing). Yet one should not forget that it is the nature of production: the more inputs you throw at it, the more you will get out. Yet the basic law of economics, diminishing returns, start setting in. This means that there is a limit to input driven growth. On the other hand, we know that natural and sustainable growth path of per capita income is driven by a rise productivity.

As Krugman describes:

The immense Soviet efforts to mobilize economic resources were hardly news. Stalinist planners had moved millions of workers from farms to cities, pushed millions of women into the labor force and millions of men into longer hours, pursued massive programs of education, and above all plowed an ever-growing proportion of the country's industrial output back into the construction of new factories. Still, the big surprise was that once one had taken the effects of these more or less measurable inputs into account, there was nothing left to explain. The most shocking thing about Soviet growth was its comprehensibility.

At this point, it is instructive to dive into the slightly more technical paper of Alwyn Young, “A Tale of Two Cities.” In this seminal paper, Young compares the growth rates achieved between Hong Kong and Singapore over a 30 year period. The striking observation is that thanks to several factors such as a more educated postwar population and a government that took a laissez-faire attitude, Hong Kong was able to achieve this growth primarily through increases in productivity growth, while Singapore’s GDP growth came primarily through the increasing use of factors of production (for example, the employed share of population increased 2 fold to 51%, while investment as a percent of GDP rose to 40% - chart below):

Yet throwing in factors of production under a state driven growth program (forced savings and massive surpluses being recycled into the economy) is not the most efficient way of achieving growth. Young argues that “driving the economy ahead of its learning maturity into the production of goods in which it has lower and lower productivity” is detrimental to the efficient growth of the economy. This is because “the costs of production are higher the further beyond the economy’s cumulated learning experience one tries to move.” The cost curve beyond the cumulated learning experience of the economy increases, which makes the new products increasingly costly and unprofitable to manufacture. To prove this point in real life, Young presents us with some striking data: a look at Singapore’s real return on capital to be one of the lowest in the world!

And this is exactly what is happening now in China. By government decree/policy, China is aiming to become the “capital of electronics” or some other industry. But it is at the same time pushing itself beyond its learning maturity. A recent analysis by Thomas Mayer and Michael Biggs of Deutsche Bank shows this very clearly. What DB finds is that the growth in GDP achieved via massive investment in factors of production does not yield “good returns”. They show this historically 1990-2009 and also what it would look like going forward:

What we see in these charts is that Developing Asia (from 1990-2009) and both Developing Asia and China (in the next 5 years) have achieved lower return on invested capital than implied by the iso-returns line (which is merely showing the same returns to capital over different combinations of GDP and Investment as & of GDP. In the charts, all countries to the north of the line have lower returns to capital).

From the perspective of the investor it is the return on capital that matters. On the other hand if you can increase the level each period, you will have sequential growth, even though this is not an endogenously sustainable method (i.e. it is not the natural growth path of the economy if left on its own). But when level effects are so large, as was in the case of Singapore (and now in the case of China), you obviously have a political incentive to push that. But as per the argument above, this political push is detrimental to the return on capital.

In the end, it is the return that matters. By giving low adjusted return on capital, China and the Developing Asian countries are not creating as much value. One can, therefore, look at less sexy, non-growth developing countries for a “good” return on capital. This is like investing in a company that has a good yield but no top line growth, vs that which has good revenue growth but not generating return on capital. So the concentration of the argument should not necessarily be around GDP growth but on the return on invested capital.

So going forward, the issue is not whether China can sustain this growth level. It can achieve this by playing around with the level effects whereby they continue to increase factors of production given that they still have much to achieve on that front but as long as this does not come from a genuine increase in productivity, returns on invested capital will continue to disappoint.

Wednesday, 24 February 2010

A Quick Look at Qualcomm

One of my friends has brought Qualcomm to my attention based on a valuation agreement...

Qualcomm is a play on smartphone space through their large intellectual property on 3G technology (there are six interfaces for this of which three are based on Qualcomm’s CDMA technology and one on Qualcomm dominated OFDMA technology, with the other two based on GSM – i.e. TDMA of which the most prominent is EDGE). Up to now, many GSM based operators were using a bridging technology 2.5G (like GPRS) but proliferation of smartphones and explosion of data services means that the push to WCDMA (including HSDPA, HSUPA) will materialize, proving a big boost for the company.

Royalties make 2/3 of profits while manufacturing chips makes 1/3 of profits (with ratios switched for revenues). Having settled over the past 2 years all outstanding license agreements with the big guys for a 15 year period, they only have one license renewal coming up in the next 7 years. This has obviously de-risked the business substantially. With +10% growth expected for the next 3 years with EBITDA growth of over 15% in the same period, the company is poised to reverse the flattish performance of the last year. Generating $1-1.2bn per quarter in the next couple years (which is $4bn of cash on top of the 19bn cash pile), the valuation seems out of whack with such an appealing profile for a large cap play. The company currently has a market cap of $67bn while the EV is $48bn. Ex-cash, you are getting the company at around 12x free cash flow multiple (or 14x P/E), on top of a modest 1.8% dividend yield.

The chart looks a bit eery as the stock hovers around the major support level at $37. With a potential back up to the $47 area (gap fill), risk rewards seems compelling at this level with a tight stop.