"Let your performance do the thinking. "
-H. Jackson Brown
So there you have it - no matter where you are this morning, there your performance for March and Q1 of 2009 is. I have been getting some very exciting feedback from some of our clients already, and I'd like to congratulate all of you for differentiating yourselves. In the face of adversity, that's what winners do.
In The New Reality of Transparency and Accountability, marked-to-market performance will rule. While I doubt that the Nigerian government will be able to find a way to mark their stock market's YTD performance to "model", you can bet your Madoff that plenty of America's once vaunted private equity and "side pocket" fund superstars will do their best to have the US government sponsor that kind of accounting for them.
At down -37%, Nigeria was the worst performing stock market in the world in Q1. If my research team was able to properly "mark" the toxic liabilities (no, they aren't "assets") of some of the levered long investments we saw private equity make in 2007-2008, the performance of those funds anchored to those prices might be down more than Africa's biggest loser. Don't bother asking our fellow Yalie, Steve Schwarzman, about those Blackstone "marks" - the SEC already did - Stevie isn't into the transparency thing... yet...
I went through the math in yesterday's Early Look, so we all know how impressively China (and what China NEEDS) performed in Q1. But how about the things that the Chinese no longer need? Does China really need the wizardry of US Financial Services execs? Well, the scorecard for Q1 says US Financials (XLF) were down -30%. How about Technology? Sure, with the S&P Tech Sector (XLK) +1.4%, maybe they'll take a little more of that!
It's always fascinating to listen to populist politicians and underperforming corporate executives toe the line of excuse making, particularly when you overlay the rhetoric born out of their own incompetency with quantified performance results. While the SP500 being down -11.7% for 2009 to-date is by no means good, the major US index that isn't geared to what China doesn't need (US Financial Services), the Nasdaq, is only down -3.1% for the YTD. The Nasdaq was up +10.9% for the month of March! Great Depression??
Of course, unless you are going away without it bailing you out, government intervention scares the hell out of people - as it should. How else can we explain why the US weekly reading on consumer confidence this morning (ABC/Washington Post poll) remains mired at down -49? Well, America has voted... and Tim Geithner is not their American Idol?
Since our firm is dedicated to no banking, brokerage, or asset management, I don't manage other people's money anymore. Otherwise, I don't see how you can look The Client in the eye and tell them that your research isn't compromised, conflicted, or constrained. If you want the other side of that argument, I can get you the phone numbers of plenty of sell side shops who, for whatever reason, still believe you'll buy into the narrative fallacy associated with their horse and buggy whip Investment Banking Inc. structures.
The New Reality is that whether her name is China or Tiger Woods, The Client whose cash you are managing is the boss again - and we all must work together to prove that Americans are going to start doing the right thing with The Client's money when no one is looking.
While I'm not a big shot billionaire, I used to play "hedgie" with some of them - and I still like to keep score. For the month of March, my performance can be measured in two ways: 1. The Research Edge Asset Allocation Portfolio (only ETFs) and/or 2. Client performance allocated to every move I make in our virtual stock picking portfolio @ www.researchedgellc.com <http://www.researchedgellc.com> .
Following a +0.12% absolute positive return in February, the RE Asset Allocation Portfolio was +3.4% in March. Having a big position in Cash works both ways (you can beat the market in down tapes by a lot, and not get all of the juice in up moves). One client had our virtual stock picking portfolio up almost +10% for March on a gross basis. The difference between the two of these strategies is obviously the alpha my team generates on the stock picking side. Altogether, I'm very proud to be wearing the jersey that bears their name.
Where to next for the US stock market? I think we need to go lower before we go higher. Yesterday, those who had a great month on the long side tried their darndest to get that SP500 above my 803 line of resistance, but failed on the close. My immediate term downside support for the SP500 now moves to 764, which is -4% from the March 31st close.
After selling down exposure to US Equities to 6% into yesterday's last gasp of trading strength, I have hunkered the Asset Allocation Portfolio back down to a 70% position in Cash. With the US Dollar breaking out above what I see as the Shark Line at $84.95 on the USD Index, I have a very hard time seeing US Equities re-flate. If President Obama wants to fix this USA underperformance mess, he needs to get out of the way, and let Bernanke "Break the Buck."
Our 2009 call on that front hasn't changed. Only marked-to-market prices have - and no matter where you go in this market of winners and losers, there those prices are. Keep letting your "performance do the thinking."
Best of luck to you and your respective teams in Q2 of 2009,
RSX - Market Vectors Russia-The Russian macro fundamentals line up with our quantitative view on a TREND duration. Oil has benefited from the breakdown of the USD, which has buoyed the commodity levered economy. We're seeing the Ruble stabilize and are bullish Russia's decision to mark prices to market, which has allowed it to purge its ills earlier in the financial crisis cycle via a quicker decline in asset prices. Russia recognizes the important of THE client, China, and its oil agreement in February with China in return for a loan of $25 Billion will help recapitalize two of the country's important energy producers and suppliers.
USO - Oil Fund- We bought oil on Wednesday (3/25) for a TRADE and are positive on the commodity from a TREND perspective. With the uptick of volatility in the contango, we're buying the curve with USO rather than the front month contract.
EWC - iShares Canada-We bought Canada on Friday (3/20) into the selloff. We want to own what THE client (China) needs, namely commodities, as China builds out its infrastructure. Canada will benefit from commodity reflation, especially as the USD breaks down. We're net positive Harper's leadership, which diverges from Canada's large government recent history, and believe next year's Olympics in resource rich Vancouver should provide a positive catalyst for investors to get long the country.
DJP - iPath Dow Jones-AIG Commodity -With the USD breaking down we want to be long commodity re-flation. DJP broadens our asset class allocation beyond oil and gold.
XLK - SPDR Technology-Technology looks positive on a TRADE and TREND basis. Fundamentally, the sector has shown signs of stabilization over the last several weeks. Semiconductor stocks, which are early cycle, have provided numerous positive data points on the back of destocking in the channel and overall end demand appears to be stabilizing. Software earnings from ADBE and ORCL were less than toxic this week and point to a "less bad" environment. As the world stabilizes, M&A should pick up given cash rich balance sheets in this sector and an IBM/JAVA transaction may well prove the catalyst to get things going.
EWA - iShares Australia-EWA has a nice dividend yield of 7.54% on the trailing 12-months. With interest rates at 3.25% (further room to stimulate) and a $26.5BN stimulus package in place, plus a commodity based economy with proximity to China's H1 reacceleration, there are a lot of ways to win being long Australia.
GLD - SPDR Gold- We bought gold on a down day. We believe gold will re-assert its bullish TREND.
DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.
UUP - U.S. Dollar Index - We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. The Euro is down versus the USD at $1.3201. The USD is down versus the Yen at 98.9400 and down versus the Pound at $1.4380 as of 6am today.
EWL - iShares Switzerland - We shorted Switzerland for a TRADE on an up move Wednesday (3/25) and believe the country offers a good opportunity to get in on the short side of Western Europe, and in particular European financials. Switzerland has nearly run out of room to cut its interest rate and due to the country's reliance on the financial sector is in a favorable trading range. Increasingly Swiss banks are being forced by governments to reveal their customers, thereby reducing the incentive of Switzerland as a tax-free haven.
EWJ - iShares Japan - Into the strength associated with the recent market squeeze, we re-shorted the Japanese equity market rally via EWJ. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. Japan has experienced major GDP contraction-it dropped 3.2% in Q4 '08 on a quarterly basis, and we see no catalyst for growth to return this year. We believe the BOJ's recent program to provide $10 Billion in loans to repair banks' capital ratios and a plan to combat rising yields by buying treasuries are at best a "band aid".
DIA -Diamonds Trust-We shorted the DJIA on Friday (3/13) and Tuesday (3/24).
EWW - iShares Mexico- We're short Mexico due in part to the country's dependence on export revenues from one monopolistic oil company, PEMEX. Mexican oil exports contribute significantly to the country's total export revenue and PEMEX pays a sizable percentage of taxes and royalties to the federal government's budget. This relationship is unstable due to the volatility of oil prices, the inability of PEMEX to pay down its debt, and the fact that PEMEX's crude oil production has been in decline since 2004 and is down 10% YTD. Additionally, the potential geo-political risks associated with the burgeoning power of regional drug lords signals that the country's economy is under serious duress.
IFN -The India Fund- We have had a consistently negative bias on Indian equities since we launched the firm early last year. We believe the growth story of "Chindia" is dead. We contest that the Indian population, grappling with rampant poverty, a class divide, and poor health and education services, will not be able to sustain internal consumption levels sufficient to meet targeted growth level. Other negative trends we've followed include: the reversal of foreign investment, the decrease in equity issuance, and a massive national deficit. Trade data for February paints a grim picture with exports declining by 15.87% Y/Y and imports sliding by 18.22%.
XLP - SPDR Consumer Staples- This group is low beta and won't perform like Tech and Basic Materials do on market up days. There is a lot of currency and demand risk embedded in the P&L's of some of the large consumer staple multi-nationals; particularly in Latin America, Europe, and Japan.
SHY - iShares 1-3 Year Treasury Bonds- On 2/26 we witnessed 2-Year Treasuries climb 10 bps to 1.09%. Anywhere north of +0.97% moves the bonds that trade on those yields into a negative intermediate "Trend." If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yield is inversely correlated to bond price, so the rising yield is bearish for Treasuries.
"Let your performance do the thinking. "
Starwood’s Maximum Consolidated Leverage Ratio calculation simply divides gross debt at the end of the period by Adjusted EBITDA (Reported Adjusted EBITDA less JV interest expense add-back plus adjustments for asset dispositions). We estimate that HOT’s leverage ratio at the end 4Q08 was 3.6x, giving the company a 21% cushion on its EBITDA at its current debt balance of $4BN.
Given Starwood’s reduction in capital expenditures and IRS refund, and a likely timeshare note securitization, we believe that the company will be able to reduce gross debt by $400MM by 4Q 2009. However, the debt reduction alone will not be enough to offset our projected 35% decrease in Adjusted EBITDA. At 4.9x Leverage, HOT will violate the leverage covenant by $70MM or $320MM of debt capacity. In other words, in order to make the 4.5x covenant, Starwood must generate reported Adjusted EBITDA of $820MM or reduce gross debt to $3.3BN on our EBITDA number.
We believe, barring an asset sale, that Starwood will seek a credit amendment to increase leverage to 5.5x or (more likely) completely re-do its credit facility. Since September 2008, there have been three relevant credit facilities amendments in the lodging space: Ashford 12/24/2008, Strategic 2/25/2009, and Interstate Hotels: 3/30/2009. Based on the comps, we believe that such an amendment would increase Starwood’s cost of borrow by approximately 150 bps. We also believe that the banks will ask HOT to discontinue its dividend in 2010 and seek to reduce the facility size by a $200-$500MM.
However, given that the revolver matures April 2010 (including an extension option to Feb 2011), with a $500MM term loan maturing this June and another $500MM term loan maturing in June 2010, HOT will probably seek a complete refinancing of its bank facility. A new credit facility is likely to be smaller in size ($1.25BN), and is likely to cost closer to 7% all-in (LIBOR Floors), which would represent $40MM in incremental annual interest expense or $0.15 in EPS.
As we wrote about in past notes (“HOT: THE CREDIT IMPLICATIONS OF OUR FORECAST”, 01/28/09), we don’t see this as a big concern for the credit – but equity holders tend to get skittish on bad credit news.
Sheldon Adelson and his wife each purchased 7.8 million shares of LVS for a total of around $45 million. This is not chump change. He and Miriam met with investors at an investor conference last week and by all accounts the meetings were positive. In this space, we’re used to managements selling stock after they talk their stock up. To his credit, they bought stock after the conference. Bravo.
Are they throwing good money after bad? It’s hard to believe that Sheldon would be buying that much stock if LVS was on its way to a major covenant breach and bankruptcy. At the current price, the stock implies that bankruptcy is a realistic probability.
The takeaway here is generally positive. However, one note of caution is in order. The purchase of stock diminishes the possibility of a near-term transaction announcement. We still expect LVS to pursue the sale of the Macau malls and possibly casino assets but we can safely assume that nothing is imminent. Nevertheless, it’s hard to find much negative in a Chairman doubling (not quite) down.
Based on our numbers, Starwood is trading at 8.5x 2009E EBITDA and 9.5x 2010 EBITDA. Putting these multiples into historical context, HOT’s average EV/EBITDA multiple from 2000-1Q09 was 10x. However, if we exclude the 2007 multiples which were predicated on take-out speculation and 2008 prices that factored in a much higher 2009 EBITDA estimate, the average EV/EBITDA multiple falls to 9.0x. For those looking to bottom feed, the duration of that fishing expedition will be longer. As can be seen in the following chart, HOT’s EV/EBITDA multiple troughed at 6.5x in 2003, which is well below the current trading range. While the company is certainly less asset intensive than in 2003 and arguably deserving of a higher multiple, the gap to trough remains very wide.
Valuation is just one of the compelling reasons to be cautious on this stock. Estimates are too high, industry occupancy needs to stabilize, and barring an asset sale or amendment, HOT will surely trip its 4.5x leverage covenant in 3Q09.
I’m convinced that supply chain pressure of the past 2 yrs will ease. Perhaps temporarily…but it will ease. And Soon. Add SG&A/capex cuts, positive sales delta and cheap stocks… You get the picture.
This might be the longest note I’ve ever posted, but the narrative must be spelled out in every detail. To ignore this will be to ignore a potentially meaningful second leg of a retail rally (but this time driven by fundamentals – augmenting my 3/5 call).
China accounts for 87% of US footwear consumption, and 30% of apparel (and growing). Let’s think about history for a minute…
1) From 2000-2007, margins for Asian manufacturers went down by 8 points. Margins for the brands went up by 8 points. Retail margins have been flat. There's only so much margin to go around, so the direct inverse correlation is no coincidence.
2) In the early 2000s Asian manufacturers had around a 15-20% gross margin, which was more than enough to offset the roughly 10% in SG&A and capital costs to turn a profit. This was especially the case given that the Chinese government rebated the VAT tax, which added between 3-7% in net profit for the manufacturers. All said, life was good as a manufacturer, which is why capacity grew at a mid-single-digit clip. Excess capacity = more pricing leverage on the part of the front-end of the supply chain.
3) Starting in early 2007, factory gross margins approached the break-even hurdle, Chinese VAT tax rebates were phased out to stimulate local consumption as opposed to export, and costs headed higher across the board.
4) The result? Capacity growth slowed meaningfully, and was flattish by the end of the year. This meant that the pendulum swung back into the hands of the US supply chain with $3-4bn annually to pad the supply chain.
Then came last year, which caused a massive reversal in the Asian side of the equation – and came alongside (and intermingled with) the US Great Recession.
1) 2008 started out with the biggest snowstorm in China in 100 years. It completely shut down the Eastern provinces and the logistical infrastructure of the country was put to (and failed) the stress test. Factories were boxed into a corner.
2) The tragic earthquake in the spring was a double whammy. Not only did this test the infrastructure once again, but the ‘human factor’ prompted migrant workers – that account for about a third of production in the Pearl River Delta factories – to simply not show up. Migrant workers that don’t migrate? Yes, that’s a problem.
3) A third important point is that in advance of the Olympics, the Chinese government cracked down on sweat shops, and started to mandate that factories pay employees back-pay for unused vacation time. You know how Americans take 2-3 weeks of vacation per year at best? And how the Brits will commonly ‘go on Holiday’ for a 5-week clip at a time? Trust me; compared to the under-vacationed US workforce, the Chinese factory-worker culture makes us look like Americans are on permanent vacation.
4) What does all this mean? Natural disasters stressed output and tightened prices for exports in aggregate. Then the government decided to wipe out the ‘sweat shop’ factor to appease human rights activists. You might say ‘the Chinese don’t ‘appease’ anybody.’ Well, in the months alongside the Olympics – otherwise known as China’s coming out party – I’m willing to bet that China reigned in its pride and cleaned itself up a bit.
5) Oh yeah…did I mention that not only did the VAT tax rebate come down, but absolute export taxes went up at a steady clip in 2007/08 as China changed its tax system to encourage local consumption over export?
6) China went through a 2-year capacity tightening phase, which pressured pricing in the US supply chain for this industry (and others). Using footwear as an example, there were 12,000 factories in the Pearl River Delta 2-years ago. Now there are about 6,000.
Ok smarty pants…so now what?
1) We’re looking at a teens rate of import taxes…that has been recently reduced to zero. Yes, a donut.
2) Today China announced that its VAT (Value Added Tax) tax rebates on garments go up to 16%. Yes, this means that local factories are incentivized again to export product as the government funds enough of their P&L so they can sell product at a break even rate and still be cash flow positive.
3) Within hours of China’s announcement, Vietnam proposed to cut its Value Added Tax (VAT) on VAT on yarn, fabric, and garments, as well as reduce the corporate income tax rate by 30 percent for textile, garment and footwear industry.
4) As a kicker we see Nike pulling out of four Asian factories – three in China and one in Vietnam. This is part of Nike’s restructuring, but is pretty darn well timed given geo-political events. I guess Nike ‘does macro.’
The bottom line: I am convinced that the supply chain pressure we’ve been feeling over the past 2 years will ease. Perhaps temporarily…but it will ease. Add on SG&A/capex cuts, a positive sales delta and cheap valuations… You get the picture. Names I like best in retail include BBBY, RL, LULU, LIZ, UA, and DKS. I don’t like those who are cutting into bone to print profit, such as Ross Stores, Iconix, Sears, Carter’s, Jones and Gildan. The challenge here is that this latter basket of companies will also show a reversal in cash flow trends, temporarily masking the damage they are doing to their base business.
I’ll be working closely with Keith to game the sizing and timing on these fundamental ideas when the group looks more ‘shortable’ and/or when the near-term fundamentals for each of these names present an opportunity.
As market practitioners, we wake up every day with a hunger to find order in the markets. And to Benoit Mandelbrot’s (the Father of Fractals) point above, order does not come by itself. Global markets are complex and to some seemingly unpredictable.
In the Early Look today, we wrote:
“Across asset classes, global markets have revealed themselves as being as interconnected across a multiple of interacting fundamental factors as they have ever been. Mathematicians call this chaos theory.”
It is our fundamental belief that while markets are complex, they are neither random, nor uniformly unpredictable.
Our idea of applying chaos theory to markets was probably first and most widely used by Bruce Babcock, a Yale graduate, former State attorney in California, and prolific trader of commodities. He wrote as it relates to chaos theory and markets:
“According to respected authorities, the markets are non-linear, dynamic systems. Chaos Theory is the mathematics of analyzing such non-linear, dynamic systems. Chaos analysis has determined that market prices are highly random with a trend component. The amount of the trend component varies from market to market and from time frame to time frame. A concept involved in chaotic systems is fractals. Fractals are objects which are "self-similar" in the sense that the individual parts are related to the whole.”
As outlined in Bruce Babcock’s quote above, chaos theory is used to describe the behavior of a system that is constantly evolving, a dynamic system. The stock market is, for its ever evolving nature, the perfect system for utilizing chaos theory as a framework to analyze and forecast.
When we make a market call, it is based on a proprietary 27-factor model, in which the primacy of the factors evolve, much like a chaotic system, with time. But the basic organization, the 27-factors, remains largely constant, even as certain factors become more important over different market periods. While we don’t disclose our proprietary methods, or all 27 factors, clearly we are focused on both the US dollar and volatility currently as primary deterministic factors.
In some sense, the term chaos is at contrast with the theory. Chaos suggests disorganization, while chaos theory itself implies that there is a pattern, or initial deterministic conditions, behind the seeming randomness. That is, there is actually a method and reason to the madness.
In 1890, while studying the three-body problem, Henri Poincare found “that there can be orbits which are non-periodic, and yet not forever increasing nor approaching a fixed point.” As result of this discovery, Poincare is considered the father of chaos theory. If Poincare is considered the father, then Edward Lorenz would have to be considered the person most responsible for inserting the theory back into modern scientific thought.
Lorenz was studying weather prediction in 1961. He was using a basic digital computer to run his simulations. In an attempt to see a prior sequence of data, he started a simulation in the middle by entering data from a print out. In contrast to the prior simulation, this simulation produced a completely different set of data outputs. The key difference was that the revised simulation used only printouts, which had 3-digit numbers versus the original simulation which used 6-digit numbers. The key conclusion was that small changes in initial conditions can lead to large changes in the long-term outcome.
As a start-up business, we have also applied chaos theory to internal organization. When Keith, Michael, and Brian started Research Edge over a year ago now, the Company was much less complex, in fact it was a concept on a whiteboard. In less than a year’s time, we have evolved to three offices and over thirty full and part time employees, and a great client base of savvy investors who continually keep us challenged and add to our research network.
A key way in which we try to differentiate ourselves is to be first to market with information that is meaningful on the margin. As we say repeatedly at Research Edge, when the things change that matter, they change on the margin, so this is where we want to focus. Marginal changes will predict much larger changes in the future, which is consistent with chaos theory.
Only time will tell whether we will be proven right on the ability to make stock market calls based on a foundation of chaos theory or whether our internal organization based on a fractals is as effective as we expect it to be, but as the Father of Fractals also said:
“When the weather changes, nobody believes the laws of physics have changed. Similarly, I don't believe that when the stock market goes into terrible gyrations its rules have changed.”
Daryl G. Jones
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