The First Leg of a (Hopefully) Long Drop

I have been waiting for this insane rally to peak, and I may finally get a nice Christmas present:

U.S. stocks declined moderately on Monday as weak data on holiday retail sales prompted questions about the consumer's ability to spend.

American consumers may finally be waking up to their new penury.

This rally has been spurred by overly optimistic investors (easily led along by Wall Street hype) and Fed liquidity pumping. Here's hoping that the Fed's desire to drain liquidity is more than just lip service. Goading investors into risky assets has been deliberate policy up for most of this year.

The Haiku of Finance for 11/29/09

Chinese gold records
Diversify from dollars
Middle Kingdom shines

China's Gold Isn't for You

China is now tops in gold:

China, the world’s largest gold producer, may have record demand and output this year as jewelry consumption soars and miners expand production after prices
reached all-time highs, according to the China Gold Association.

This supports the argument I made in my post on Nov. 27 that China's internal production is sufficient to soak up all of its internal demand. The spot price of gold on the world market is rising for many reasons. The unavailability for export of China's enormous gold production is certainly not the least of those reasons.

In my effort to avoid confirmation bias, note that the figures in the article are from an internal Chinese organization and thus subject to manipulation for reasons of the middle Kingdom's national pride.

Nota bene: Anthony J. Alfidi is long FXI, GDX, and ANV.

China's Net Effect on Gold‏

Here are some more of my thoughts on China and gold.

There's a lot to be said about how the average Chinese investor's rush into risky assets helps prop up a potential bubble in precious metals and other asset classes. Many Chinese are buying stocks, real estate, and gold with borrowed money. This may set China up for hard times in the short run if one of those asset markets has a downturn and your average Chinese investor has to sell other holdings to meet margin calls or loan payments.

China is now the world's top gold producer, so they are able to encourage gold investment domestically simply by restricting the export of bullion. This has little to no net effect on the world spot price of gold so long as all domestic Chinese demand for gold can be directed into the supply they withhold from the world market.

Diversifying away from the U.S. dollar is China's long-term goal and buying gold (in both individual and national accounts) is but one leg under that strategy. Every once in a while gold permabulls make a case for gold prices going into the stratosphere. Gold has appeal in uncertain times but I wouldn’t overdo it. It's just another asset class to me. Too many gold bugs make the classic mistake of falling in love with an investment rather than putting it into the context of a larger portfolio.

Nota bene: Anthony J. Alfidi is long FXI, GDX, and ANV at the time of publication.

The Haiku of Finance for 11/25/09

Turkey day coming
Cost of dinner declining
Eat the deflation

Not So Strong After All

Some time ago, I believe I predicted a downward revision:

The economy grew at a 2.8 percent rate last quarter -- less than originally estimated. And forecasts for the current quarter are for similarly slight growth before a drop-off next year.

That drop-off is coming sooner and harder than expected:

Major indexes were slightly lower Tuesday after the Conference Board said its Consumer Confidence Index rose to 49.5 in November from a revised reading of 48.7 in October. While better than expected, the report shows that consumers remain gloomy heading into the holiday season.

The markets are reacting sensibly, for once.

Alpha-D Portfolio Updates for Nov. '09‏

It's that time of the month again. Here's what I've done lately to try to make some money.

My shares of IAU finally went through the strike price of my covered calls. Wow! I've decided to walk away with several years' worth of capital gains and leave gold mining stocks as the sole "gold hedge" in my portfolio. I like bullion ETFs but I needed to free up some cash for potential equity purchases in the next few months.

Speaking of GDX, I did sell some off but I continue to write covered calls on the remainder.

I sold off some FXI and wrote calls on the remainder. I also sold cash-covered puts under FXI because I don't mind buying back what I sold at a lower price. I'm still bullish long-term on China but there may be a cause for concern behind recent talk of bubbles in Chinese stocks and property.

I've decided that I like the possibility of going long a couple of transportation-related stocks. I think Kirby (KEX) and Tidewater (TDW) have good long-term potential, but I'm not ready to buy them just now as I expect the broader markets to correct in the near future. I wrote cash-covered puts under both KEX and TDW so that when Mr. Market does decide to disappoint most everyone else, I'll end up buying two stocks I like at a discount to today's prices. My holdings of KEX and TDW will be an application of my focused value approach. I did my homework on both of them.

I maintained my long position in ANV and my cash-covered puts under it. They've turned a corner and I still think they have tremendous upside potential.

I also decided to hedge two bubbles that I think have formed in defense spending and real estate. I bought puts against LMT and IYR in the expectation the markets for both advanced defense goods and commercial real estate will sink between now and 2011.

That's all for this month.

The Haiku of Finance for 11/21/09

Dollar carry trade
Pushing up markets worldwide
Prepping a big crash

Dr. Doom, Gold, Housing, and Unemployment

Gold used to be regarded exclusively as an inflation hedge. This made sense when the U.S. had a gold standard but made less sense after the gold confiscation of 1933. It made almost no sense as a philosophy after the closing of the gold window in 1973. Gold today is useful as just another asset class that's not closely correlated to equities; nothing less, nothing more. It helps diversify a portfolio when uncertainty plays havoc with other asset classes.

Meanwhile, Dr. Doom thinks gold is getting too big for its britches (through no fault of its own):

Nouriel Roubini said investors are “chasing commodities” and there is a risk of new asset bubbles emerging as stock markets and commodity prices surge amid record-low lending rates.

Okay. Who wants to be overweight an asset class that is getting frothy? Not me. My gold has done well but I'll probably begin pulling some money out of it soon even if it's still far from topping out. Why raise cash? Well, it pays to have some laying around in case I find something cheap to buy, like a foreclosed property:

The outlook for the home market dimmed this week as residential construction and mortgage applications fell and loan delinquencies reached a record.

“I don’t think the housing crisis is over,” Mark Zandi, chief economist with Moody’s Economy.com, said in a telephone interview. “I think we’re going to see another leg down.”

Okay. I'm also betting that worries over rising unemployment will keep home prices depressed for a while. This is good for patient investors like yours truly.

Full disclosure: Long IAU and GDX (with covered calls).

Fed Set to Pull Props From Mortgages

So what's been driving up stock prices? Insane buying activity like this:

The $5 trillion market for bonds backed by the housing finance companies Fannie Mae, Freddie Mac and Ginnie Mae is in for a shock when the Fed stops buying at the end of the 2010 first quarter.

The end of the Fed's mortgage buying means prices of mortgage-backed bonds will fall to a new market-clearing equilibrium. That means yields on new mortgages will have to rise to make them attractive to lenders. The resurgent mini-bubble in home prices - and stocks - thus has until April 2010 to run. Long-term investors may consider trimming their stock holdings before this hits. Me? I'll be looking to buy equities next spring, or even sooner if holiday sales crater.

The Haiku of Finance for 11/14/09

Burlington Northern
Buffett's century long play
But not a bargain

China Approaching Bubble Territory

China may be one of my favorite long-term bets, but articles like this make me think it's about to overheat in the short term:

China is doing what it can to expand domestic demand and rebalance its economy, President Hu Jintao said Friday, calling for renewed efforts to improve international financial oversight to prevent future crises.

There's other evidence that retail loan growth is getting to the point where the average Chinese consumer thinks they absolutely must max out their credit to avoid being left behind. That's the same mentality that inflated the U.S.'s housing bubble all the way until it burst in 2005-6.

I've been long FXI for a while, but soon I may start to take some money off the table.

3Com: A Special Situation

HP announced a buyout of 3Com (ticker COMS) for $7.90 cash per share. I see the appeal, as HP's brand strength can help it sell 3com's product line in markets where 3Com has failed to penetrate.

This was too tasty for me to ignore. I bought some COMS and I'll hold it until the deal closes. It's that simple. No options plays this time. The annualized gain will probably amount to only around 4%, but that's better than any bond of comparable duration.

The Limerick of Finance 11/08/09

China knows Africa has it rough
And offers to help them build stuff
There's resources galore
A lot left to explore
With new wealth they'll all soon have enough

The Haiku of Finance for 11/06/09

Job losses no joke
"Create or save" didn't work
Misspent stimulus

Job Losses Have NOT Peaked

All of those fake jobs "created or saved" by the stimulus aren't showing up here:

The unemployment rate in the U.S. soared to a 26-year high of 10.2 percent in October and employers cut more jobs than forecast, underscoring why Federal Reserve policy makers say interest rates will remain near zero.

Things aren't getting better here in the U.S. Even Berkshire Hathaway is cutting jobs, probably to raise cash to pay off all of that BNSF debt they'll assume. Monetary stimulus remains in place but the fiscal stimulus will soon wear off. When it does, stocks will probably (hopefully?) start to pull back to a lower level that reflects the true condition of the economy.

Allied Nevada's Positive Earnings Surprise

Lo and behold, my one truly speculative gold play is finally paying off. ANV has reported its first profitable quarter:

Allied Nevada Gold Corp. ("Allied Nevada" or the "Company") is pleased to report its financial and operating results for the three and nine months ended September 30, 2009, including its first quarter of positive earnings in the third quarter of 2009. The results presented in this press release should be read in conjunction with the 10Q (third quarter report) filed with SEDAR and Edgar and posted on the Allied Nevada's website at http://www.alliednevada.com/. The financial results are based on United States GAAP and are expressed in U.S. dollars.

Of course, it's just one quarter's numbers, but now there's a factual basis for the faith that I (not to mention George Soros) have placed in ANV. I bought ANV as a new-venture bet on its founders, but now I think I can put my thinking on firmer footing. My confidence in my ability to value established stocks (confirmed by Warren Buffett's purchase of Burlington Northern) leads me to believe I can construct a similar valuation for speculative mining companies.

I will soon begin constructing a formal valuation methodology for mining stocks. The principles are simple: The company's intrinsic value should be the dollar value of recoverable ore in the ground minus the cost of extracting and processing that ore for sale. The details can get complex, so I've got a lot of thinking left to do. I'll let you know when my model is ready.

Nota bene: Anthony J. Alfidi is long ANV (with short puts covered by cash) at the time this post was published.

Buffett's Big BNI Buyout Bets On Buoyancy

Tuesday brought big news on Berkshire Hathaway's proposed buyout of Burlington Northern Santa Fe (BNI) railroad at $100/share, cash and stock. This transaction is a textbook window into Warren Buffett's equity valuation model.

Uncle Warren has dropped hints over the years on how he values a stock. Buffettology books (particularly those by Mary Buffett) have done an excellent job outlining his calculation of "owner earnings" (net income plus depreciation minus average capital spending), his use of the 10-year Treasury yield as a discount rate, and his preference for companies that consistently grow retained earnings per share over long periods.

I built an equity valuation model using these principles and got an interesting result. Discounting BNI owner earnings for the past four quarters at a discount rate of 3.5% (approximately the prevailing 10-year Treasury yield in recent weeks) results in a share price of slightly more than $150. Warren Buffett doesn't buy anything unless he can get a severe bargain, so paying $100 for a stock he believes is worth around $150 represents a 33% discount.

I believe Uncle Warren's key insight is his tweaking of the growth factor used in traditional DCF models. In place of the "b" retention rate for net earnings not spent on dividends, he substitutes the average long-term growth rate of retained earnings on the balance sheet. Multiplying this modified "b" by his version of ROE (owner earnings divided by shareholder equity) gives us the annualized growth factor "g" that he uses to estimate those future owner earnings.

I'm intrigued that Uncle Warren chose to assume BNI's relatively high long term debt load onto Berkshire's balance sheet. Apparently he thinks the cash flow from Berkshire's finance and insurance lines will be sufficient to pay that off. If this gamble works, it gives Burlington the operational freedom needed to continue investing in technological innovation.

It's almost a done deal pending regulatory hurdles. Anti-trust scrutiny will probably force Berkshire to divest its other rail holdings, namely Union Pacific (UNP) and Norfolk Southern (NSC). Forced selling of those large stakes might make them attractive plays for other value-oriented transportation sector investors. It would also give Berkshire additional cash if they need to sweeten this deal.

My play? I immediately sold a few short puts under BNI at 95 on the premise that Buffett's bid establishes a firm floor for the stock and will be approved without any glitches early in 2010. The worst-case scenario for this special situation would be a market dislocation that tanks Berkshire's own share price, forcing it to further dilute its own shareholders to maintain the agreed mix of cash and equity for this buyout. If my puts are exercised against me, my own worst-case scenario is that I end up owning a long-term position in either BNI (if the deal collapses) or Berkshire, two companies that the greatest investor of all time thinks are terrific to have.

Full disclosure: Anthony J. Alfidi is short Jan 2011 puts on $BNI at 95 (covered with cash) and holds no position in any other stock mentioned in this post.

Alfidi Capital Publishes Report on Put-Call Parity

Here's a short report I've created describing a way to find an arbitrage opporunity in a stock. I call it "Put-Call Parity Analysis of Market Ignorance." Read and enjoy.

Burlington Northern Santa Fe: A Special Situation

I haven't done much special situation investing lately, but today presents an opportunity that's too good to pass up. Rarely does one have the chance to ride the coattails of a master.

Warren Buffett has decided to go whole hog and buy BNI for $100 per share:

Warren Buffett's Berkshire Hathaway Inc. on Tuesday agreed to buy Burlington Northern Santa Fe Corp., making a $34 billion bet on the future of the U.S. economy.

The offer comprises both cash and Berkshire Hathaway stock. I'll have more to say about this tomorrow as I believe I've succeeded in deconstructing Uncle Warren's valuation methodology. I played this by selling Jan 11 puts at 95 on BNI. This is slightly under the $100/share acquisition price, with the transaction expected to close in about 3 months.

Thank you, Uncle Warren, and not just for this opportunity to make some quick cash. Thank you for discussing your investment philosophy in public over these many years, because I think I finally understand it.

The Haiku of Finance for 11/02/09

Stocks jump on Ford news
Cash for Clunkers paid them well
But that program's done

Dollar Weakness Driving U.S. Manufacturing?

Declines in consumer spending haven't curtailed growth in manufacturing output:

Manufacturing in the U.S. expanded in October at the fastest pace in more than three years, a sign that factories will be the main drivers of the economic recovery in coming months.

The article uses tortured logic to ascribe the jump in manufacturing to stimulus spending. The claim that "rising sales led to a record plunge in stockpiles" contradicts the data showing the inventory index rising to 46.9 from 42.5; that number indicates that stockpiles are rising, not plunging. Maybe the plunge claim refers to data from earlier in the year.

I can only hypothesize that a weaker U.S. dollar is making U.S.-made goods cheaper in foreign markets. Let's see some trade data to confirm whether U.S. exports are rising, as indicated by the rise to 55.5 from 55 in their gauge of export orders.

Let's not forget that manufacturing comprises only about 12% of U.S. GDP. Any growth there is welcome if it makes us a nation of builders and producers once again.

Effective Chinese Stimulus Needs Other Stimulators Too

China continues to grow (according to them, ahem):

The Purchasing Managers’ Index rose to a seasonally adjusted 55.2 in October from 54.3 in September, the Federation of Logistics and Purchasing said today in an e-mailed statement in Beijing. An index of export orders climbed to 54.5 from 53.3.

How reliable are their figures? I wish I had more time to delve into that, as I'm kind of busy. At least China stimulated something important - manufacturing - whereas the U.S. stimulates transfer payments from one constituency to another. China also wants other stimulators to keep stimulating into infinity. So much for the de-coupling of emerging markets from the developed world.

Nota bene: Anthony J. Alfidi is long FXI (with covered calls) at the time this post was published.