Friday, January 31, 2014

Why the Japanese Debt Doesn't Affect the Yen

There is a pretty dreadful argument going around that the Japanese Yen will go to zero like Zimbabwe's currency recently. The reason is the crippling Japanese government debt. Right now that debt is running at over 200% of GDP. The argument can certainly get attention and makes great headlines. But the facts fly in the face of this, at least in the short term.

Japan has struggled with deflation — not inflation — for more than a decade. Deflation is a dreadful situation that governments try to avoid at all costs. An infamous example of deflation was the Great Depression. Also, the puny rates on Japanese bonds shows that the market doesn't remotely believe in a bond default.

Japan recently summoned the political will to take drastic measures against deflation. This is called Abenomics. But removing deflation is like pushing a huge boulder up a hill. If you let up for just a bit, the gains are undone. But the Yen detractors say pushing inflation is difficult only now. Wait till they get inflation going, then it is game over. Inflation will go on forever. See figure below.

The detractors even know where is the hump in the figure. It will be the point when annual tax revenues cannot pay for the annual interest. They say we aren't at that hump only because the Japanese government can finance this debt with unusually low interest rates. And this rate will rise. I will spare you the details of why interest rates will rise. But based on this theory, people like Kyle Bass have setup funds that bet against the Yen, Japanese bond rates and the Japanese economy as a whole.

But I am very skeptical of this argument because the reality does not match the theory, at least in the short term.  It reminds me of people who believe in the efficient market theory. EMT all makes sense because as information and capital is more readily available, stocks should be less volatile. But crash after crash in the last two decades simply flies in the face of this argument.

At the extreme, why is the tipping point when the interest rate equals the tax revenue? Even when that happens, in theory the Bank of Japan can still print more money to pay the interest. Yes, it's a giant Ponzi scheme, but governments can do that with their own currency.  Also, the bond purchasers are overwhelming Japanese, so this is an internal issue of Japanese owing Japanese. If the debt is a problem, it will show up when the Japanese cannot fulfill their obligations to their old and needy. That's a very gradual process.

In the global markets, Japan bond holders won't dump their bonds for other country's bonds. The world wants Japanese goods, so demand for Yen is healthy. And even if there is a small amount of flight from the Yen, Japan has $1.3 trillion USD in foreign exchange. Nobody thinks there will be a run on the Yen. For evidence of this, simply look at what happened last week. When the world became pessimistic about emerging markets, investors converted their capital to Yen, causing the Yen to appreciate. This is market reality!

I believe a prolonged Yen decline will be caused by structural problems of the Japanese economy. The very things that Abenomics is trying to fix. The Japanese, with the dwindling population, must fix their inefficient industries, such as agriculture. When and if that happens, I think they will recover from prolonged deflation and their malaise. In the meantime, the markets think the Yen is a safe haven that is only matched in size and safety by the Euro and USD.

Saturday, January 18, 2014

My Current Reading List

Keys to Reading an Annual Report by George T. Friedlob and Ralph E. Welton. This is an excellent easy-to-ready guide which I will keep always as a reference for reading 10-K's.

Two very bullish investing gurus on weathtrack: Ed Hyman and Bill Miller. These two seem to me to be over-the-top bullish. And I am skeptical but also praying that they are right! You can view the two parts here and here.

Understanding Michael Porter by Joan Magretta. Michael Porter wrote the seminal book on the topic of business competitiveness called Competitive Strategy. He wrote that book more than 30 years ago, and it is very dry. That book and all of his works up to now are summarized in this book by Joan.

I found a treasure trove of data supplied by Aswath Damodaran of the Stern School of Business. It contains spreadsheets with individual company statistics for tens of thousands of companies all over the world. I intend to use this as the basis for making a global stock screener. And hopefully, I'll find some new neglected undervalued smallcaps.

Tuesday, January 14, 2014

Japan Hits Record Current Account Deficit

Just ten months ago, I opened a global trading account and began investing in Japanese stocks. I current own three Japanese small/microcaps: Tachibana Electech, Riken Keiki and Fujimak. If you want to read more about them, click on their respective labels on the right column.

I was luckily investing in the wake of multi-year lows for the Japanese stock market in 2012. Shinso Abe then began Abenomics. Abenomics' most drastic effect to me is the depreciation of the Yen. The Yen needs to depreciate to make Japanese companies profitable. But one year of Abenomics has brought a very bad downside. The Japanese current account hit an all time monthly low in November 2013. The following shows the monthly current account in units of ¥ 100M. The current account is the net outflow of a nation's currency versus the net inflow of foreign currencies. A positive number in the chart indicates a surplus — more outflows than inflows. Note the chart is very seasonal for reasons I don't yet fully understand.

The approximately ¥ 5 billion ($5 billion USD) outflow at the last point in the chart has gotten quite a bit of press lately. So, I gave it a closer look. I took five random months in the last five years and looked at the current account breakdown.

Units of 100M Yen

The huge swing between April and November of 2013 was due to 1) foreign profits repatriated to Japan and 2) a cheaper yen. And the difference between 2013 and 2010 was due to 1) cheaper yen and 2) nationwide nuclear power shutdown, which required oil imports to make up for the energy shortfall.

In any case, the Japanese foreign reserves stand at $1.3 trillion USD. So November results isn't even a rounding error. But, if this downtrend keeps up for a long long time, then the Japanese will have to make up for it somehow, maybe by restarting the nuclear plants, or by allowing more foreign investment. Otherwise, the yen could fall to a point of damaging the economy. But right now I am more relaxed after digging into the facts behind the headlines.

Friday, January 10, 2014

Why I Own ITIC

Lately, I have been busily searching the internet for my next smallcap. And the work paid off. The stock I found is Investor Title Insurance Company (ITIC:NASDAQ). And I first heard about it on this this twitter feed.

ITIC provides title insurance and associated transaction services in real estate transactions. I have always thought this is a lucrative industry. Any bank requires title insurance as a condition of a housing loan. It protects the buyer from defects in the title purchased. But there is rarely any issues as (almost) all deeds are recorded at the local city hall. And verifying the deed is a simple process in the computer ago. So, title insurance rarely pays out claims. Who wouldn't want get in on this industry.

ITIC is a smallcap company in an industry dominated by two giants, First American Financial and Fidelity National Financial. I summarize their key financial numbers below. Note they are based on the first 9 months of 2013 projected to the full year (which actually overestimates the PE).

As one can see, ITIC is more attractive than its two bigger peers because it has a lower earnings multiple, greater profit margin and a better balance sheet. ITIC has retained a lot of earnings. When I see that, I feel as if the person who sold me stock has given me the previous earnings, his earnings, to me for free! The two larger competitors don't have such a good balance sheet because they have a considerable amount of goodwill and intangibles.

Now a person new to this stock may be a bit gun-shy because it depends on the housing sector. Title companies have benefited from the recent increase in housing activity, no doubt. But housing sales have still some ways to go to return to pre-recession levels. After that however, there will be minimal growth for the industry as a whole. This is a classic no-growth value investment.

I also like the company's management. The company's is 42 years old yet is run still run by the original founder, J Allen Fine. His two son's are also executives with the company. This shows a good management continuity, dedication and track record, which is a key criteria for Warren Buffett. The Fine family owns 30% of the outstanding shares. They collectively earn less than $1 million in salary.

So, my investment thesis is simple. The company has a low PE for such a lucrative industry. The company has a great balance sheet, it is almost a netnet. And revenues are bound to go up in the near future.

Wednesday, January 8, 2014

WLP Sells Division

Wellpoint has announce that it will divest its eyeglass business in order to focus on its core business. The company said that this will cause an approximately $0.55 charge in the coming quarter.

So, Obamacare has begun and we have 2.1 million people enrolled. The initial goal is 7 million by the March deadline for enrolling without incurring a penalty. I think worse case is 4 million and if it is significantly above that I expect WLP will easily hit new highs.

So I'd like to, once again, summarize my thesis for WLP serving Obamacare.
  1. Obamacare does not socialize or nationalize health care
  2. The public, the politicians for Obamacare and the politicians against Obamacare are all either neutral or very sympathetic to insurance companies who are simply caught in the middle of this issue.
  3. Obamacare is adding 7 million to the insured pool. Insurance companies like WLP know the risks and are voluntarily going in with their eyes wide open
  4. I feel Obamacare is part of an overall consumer trend towards more "luxuries" as our standard of living rises.
In other news about my portfolio, I have closed my KCLI position. I feel Kansis City Life is a well-run company with minimal exposure to risky annuities. However, it has run up along with the rest of the stockmarket, and the price is now 75% of book. Still, if the market corrects and KCLI drops, I will certainly consider buying.

Monday, January 6, 2014

My Current Reading List

Starting today, I will regularly post links and reading material that I am reading. Hopefully you will find something interesting.

A series of posts by the late Doris Dungey. It is all about the insides of the mortgage industry. They were written before the 2008 crash, but still worthwhile to read today.

Uprising by George Magnus: A very easy-to-read, thought provoking book on emerging markets.

100 Minds that Made the Market by Ken Fisher: A easy-to-read biographical history of US finance.

Friday, January 3, 2014

PetSmart Performing to Expectations

I have owned PetSmart for six years and it has tripled in that time. My earlier writeup was a year ago, so I think an update is in order.

PetSmart is the the largest pet retail chain and it owns 40% of the US market. The pet industry is a $53 B industry. About 62% of household have pets and I estimate that Americans spend about $250 on each cat and dog annually. I think our pet owners can and should do better than that!  The pet industry has been growing at about twice the rate of GDP, and trend should continue. Although I don't believe we will have much more pets in homes, I do feel that as a wealthy society, we will gradually spend more than $250 on each pet annually. So even if PetSmart does not grow market share, which it has done successfully in the past, earnings should still outgrow the GDP. The following supports this point.

Revenue and Earnings (mil)

Div yield1.2%
P/E18x .
Note that the chart shows the total earnings growth. Per share earnings growth is even greater due to regular share buybacks.

The downside to this stock is the relatively high earnings multiple. I generally stay away from anything with a multiple above 20. And PetSmart is close. But I am keeping it for two reasons. One is that I hope PetSmart will do what Coke did for Warren Buffett. Buffer bought Coke in the 80's and it has returned about 12% annually for 30yrs. He also bought Coke at a high multiple, but the company's moat was worth it. PetSmart doesn't have quite a moat, but it is the leader in a superb industry. The second reason I am keeping the stock is I want to avoid capital gains tax.

In other news, we have just ended a memorable year with the US markets up 30%. Who would have predicted that twelve months ago! But 2014 is another year and another chance for the pundits to redeem themselves. The following by Tren Griffin is the funniest though.

CNBC will continue to lose viewers by trying to make its programming similar to ESPN’s Sports Center, even though that approach is *exactly* what sends ordinary investors to their financial doom and *ensures* that ordinary investors will stop watching CNBC (i.e., the CNBC ratings death spiral will continue).

That does make me a bit sad. Now that is one less media outlet to goad suckers to take the other side of my trades *sigh*. Well, I hope Jim Cramer will find another network to hire him on after CNBC dies!

Wednesday, January 1, 2014

Arbitrage with Sterihealth and Stericycle

Recently, I was thinking new places to look for smallcap gems, and I decided to try Australia. There I found a candidate with a colorful past.

The company is Sterihealth (STP:ASX). It deals in hazardous medical waste disposal. The company was known in 1999 as Cutters Ridge Resources. I guess it's business in resources was a failure so the company's management decided to change the company name to Stericorp and try the medical waste business. However, it appears that the management initially didn't know the business.

The company initially tried waste disposal in Argentina, which failed. Then they bought a plant from Stericycle (SRCL:NASDAQ) in Canberra, Australia, but that was also written down to zero in 2004. Then in 2005, with new CEO Daniel Daniels, Stericorp sued Stericycle for breach of contract to try to recover some of the losses. They eventually won $18 M in that suit. I think the company has stablised with Daniels at the helm. Stericorp turned over a new leaf by changing its name to Sterihealth and it bought 100% interest in ADX, a company started by Daniels.

I think it is interesting to compare Sterihealth and its much bigger former partner Stericycle. The two are both in medical waste, but Sterihealth only operates in Australia while Stericycle is a global player. The following table shows their stats.

In my view medical waste is a profitable and growing industry. Companies in the industry should easily earn returns above their cost of capital. I think that is why Stericycle commands a 37x earnings multiple. But Sterihealth couldn't be more different, it trades at only 6.6x earnings! So, does this mean Sterihealth is a severely mispriced stock? The company history should give some clues.

The company has had a troubled history up to 2005. At that time, the stock reached less than $1 from a high of around $12, and for good reason. The company had accumulated losses of more than $30M! By 2006 they had turned a corner I feel with the new CEO and had raised $15M over three years to shore up the balance sheet. By 2007 Sterihealth got another $18M from settling with Stericycle. The following shows the company's earnings.

Sterihealth Earnings (Mil $ AUD)

Note, that the above results excludes the one-time $18M gain from the Stericycle settlement. So, one can see the company is in a good industry with consistently growing revenue. Therefore, I think the company deserves a higher multiple. Or, looking at it another way, the earnings multiple of Stericycle and Sterihealth should not be as dramatic as it is today. Stericycle must either fall or Sterihealth must go up, or both.

I am long Sterihealth.