Tuesday, April 29, 2008

Pulp News

Two Pulp producers reported today- Canfor and Catalyst:
The announced price for April 2008 for Northern Europe is US$920 per tonne, an increase of $40 per tonne over the price in March. No price increases have been announced for the North American markets and prices are expected to remain steady at US$880 per tonne in the near term. Since there remains much supply uncertainty in the market, and demand is holding prices are expected to fluctuate in a narrow range over the balance of the year.
"Fibre constraints required us to curtail 65,000 tonnes of pulp and paper at our Elk Falls mill during the quarter," said Richard Garneau, Catalyst president and chief executive officer. "As a result our manufacturing costs and sales volumes were unavoidably impacted. As we look to the balance of the year, we expect the Elk Falls No. 1 paper machine will remain idled with our pulp business also likely to be impacted by the continuing fibre shortage."
The Company's pulp business is expected to take the remainder
of any fibre related downtime in 2008. Approximately 150,000
tonnes of pulp and white top linerboard production is currently
anticipated to be curtailed through the balance of the year
between our Crofton and Elk Falls pulp operations.

Sunday, April 27, 2008

From Fairfax's 2007 AGM Slides:

For those conservatively positioned, industry losses from MBS and Corporate bonds could be a blessing which forces stronger pricing/underwriting profits.

Recently, I ran across a small-cap California insurer. It was trading for 53 million with shareholder's equity of 70 million. It also generated 80 million in float, and its investment portfolio was almost completely invested in US treasuries. To top it off, their operations were generating an underwriting profit while also heavily re-insuring their business. That to me was a bargain which beats holding cash any day.

For The Housing UberNerds...

Here are some statistics from the New York Fed on Subprime and Alt-A loans in the country at December 2007. Some of the interesting US numbers (slightly rounded):

116 million total housing units
3.3 million sub-prime loans
300,000 non-owner occupied

3 million of owner occupied
1 million delinquent/foreclosure (of owner occupied)
(*32% delinquent or foreclosed on)

1.9 million variable rate loans
Resetting in: (keep in mind this was from Dec 07)

442,000 reset in 6-12 months
399,000 reset in 1-2 years
119,000 reset in 2 years++

682,000 + 306,000 Already reset + reset in 0-5 months

Friday, April 25, 2008

21st Century Economics

The best way I can explain the global economy today is from the perspective of the following equation:

Value of Production = Labor + Knowledge + Materials + Investment + Power

Now, remember the value is allocated across these factors based on the basic rules of competition. In that sense, the United States (and the developed world) has long had an advantage in three factors: Knowledge, Investment, and Power (think global brands or other forms of market power). And this advantage allowed them to bring relatively more value and wealth to their countries. Company X could invest in developing country Y. They could pay there employees next to nothing, and then send both the goods and the profits back to the home country. This wealth would then be dispersed throughout the population.

Everyone knows that globalization has greatly increased the working population, driving down the value of pure labor. (Supply goes up, returns go down) But other factors have also come into play. These workers have seen the developed world's living standards, and they see all the goods which they are producing, and they decide that they want these things too. And more importantly, they are acquiring the ability to do so without the developed world. First, they have developed modern financial systems, so they have the ability to raise capital and finance large investments on their own. Second, they are rapidly acquiring expertise and knowledge from us. Finally, their power over in the global economy is rising. As the competitive advantages start to deteriorate, then more competition takes place- and production can go up.

This sounds great for long term growth because the rest of the world is raising their living standards. The problem is there is now a new bottleneck. Demand for production has increased significantly, but the supply of materials remains static. So now there is a new advantage from the control over scarce materials. This is why we are seeing such large increases in basic goods- food, energy, raw materials, etc. In the short term, things seem surely to become more difficult and costly. But long-term optimists can take comfort that the solutions to these problems are going to have to come from scientific and technological progress (Or war... see post). And in that sense, the developed world still has a very large advantage in terms of the possession and acquisition of knowledge.

Feel free to critique.

Saturday, April 19, 2008

Brookfield Asset Management's 8 Investing Principles

Taken from Bruce Flatt's speech for the Whitman Day Keynote Address.

8. Buy great assets- pay more for great assets at great location with great fundamental characteristics. Rarely buy where land is cheap because it is easily replaceable.

7. Generally invest for the long term. Assume you will own it forever. Properly leveraged quality assets inherently appreciate faster than inflation. It also compounds your dollars tax-free.

6. Prudently finance your assets. Mis-financing the portfolio can lead to disaster. You might not be able to realize the full value of your assets if you can’t make it through a down market, liquidity crisis, etc. Even the best assets are absolutely worthless if you cannot hold them to see another day.

5. Never become too positive or too negative in the markets. In the longer term, assume asset appreciate will always revert to the mean.

4. Invest against the common trend. Significant opportunities arise when things are negative. This is where great value investments can be made. 99% of business transactions occur inside some band of reasonable valuation. 1% of business transactions occur outside of that band, and that's what you should be looking for. In the 99% area, just try to avoid the mistakes.

3. Build with quality people. Business and life are about doing things you enjoy. If you don’t enjoy them, you likely won’t become successful. Finding good people, who are competent and willing to work in a team, is one of the most important organizational factors. Very important during the turbulent times.

2. Execution. Strategy is important, but without execution it is worthless.

1. Never deviate from the first 7 principles. It is very seductive to invest when everyone is making money. It is easier to buy low quality assets because they look like they are better starting off. But higher risk more than offsets it in the end.

Tuesday, April 15, 2008

Johnson & Johnson Overview

Let's begin with a ten year operation history for Johnson & Johnson:

The company has a long history of double digit growth, with sales growing annually over the last 10 years at 10.5%, and operating income at an even faster 11.95%. It generates tons of free cash flow that is really "free". It has a great position in the worldwide health market, meaning it can benefit from the falling US dollar. Finally, it is a 4 trillion dollar per year industry which is bound to keep growing.

But can we show it is cheap? I think you can if you look at the breakdown of their businesses:
(*these are operating incomes)

There are three segments: Consumer, Medical Devices, and Pharmaceutical. The first two are solid businesses with great brands. For example, the Consumer brands include Band-Aid, Listerine, Neutrogena, Aveeno, and Nicorette. And 80% of the Medical Division's products are number 1 or 2 in their markets. These are also stable and consistently growing businesses:

Then you have the Pharmaceutical business, with 2007 Operating Income of $6.5 billion. My understanding is this industry has been heavily discounted because analysts have become nervous about expiring patents and the limited possibilities for new breakthrough drugs. Now, I don't claim to have any insight or expertise with regards to their actual drug pipeline. But I do know that of the company's 2007 Research & Development expenses of $7.7 billion, $5.3 billion was for the Pharmaceuticals segment. So, if you applied a rich multiple to the company's Consumer and Medical divisions, and then assume that the Pharmaceutical business stopped research and was simply "ran-off", then you can likely justify Johnson and Johnson's current price. ( 185 billion) And their Pharmaceutical business, with its large resources and the abundance of human capital in its employees, is likely worth much more than a "run-off" type scenario.

Monday, April 14, 2008

What Warren Thinks...


How does the current turmoil stack up against past crises?

Well, that's hard to say. Every one has so many variables in it. But there's no question that this time there's extreme leveraging and in some cases the extreme prices of residential housing or buyouts. You've got $20 trillion of residential real estate and you've got $11 trillion of mortgages, and a lot of that does not have a problem, but a lot of it does. In 2006 you had $330 billion of cash taken out in mortgage refinancings in the United States. That's a hell of a lot - I mean, we talk about having $150 billion of stimulus now, but that was $330 billion of stimulus. And that's just from prime mortgages. That's not from subprime mortgages. So leveraging up was one hell of a stimulus for the economy.

If that was one hell of a stimulus, do you think the $150 billion government stimulus plan will make an impact?

Well, it's $150 billion more than we'd have otherwise. But it's not like we haven't had stimulus. And then the simultaneous, more or less, LBO boom, which was called private equity this time. The abuses keep coming back - and the terms got terrible and all that. You've got a banking system that's hung up with lots of that. You've got a mortgage industry that's deleveraging, and it's going to be painful.

The scenario you're describing suggests we're a long way from turning a corner.

I think so. I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that.


Saturday, April 12, 2008

Joseph LeDoux: Putting Emotions Back into the Brain

(hat tip to Arpit)

Twenty years ago no one cared about emotions and the brain, but it seems in the last couple of years there's been a flurry of activity. One reason for this may be that the topic was ignored for so long, and the vacuum is being filled. Another, though, is that there have been some successes in approaching the problem, and these have changed peoples' minds about the feasibility of studying emotions in the brain...

I've come to think that emotions are products of different systems, each of which evolved to take care of problems of survival, like defending against danger, finding mates and food, and so forth. These systems solve behavioral problems of survival. Detecting and responding to danger requires different kinds of sensory and cognitive processes, and different kinds of motor outputs, different kinds of feedback networks, and so on, than finding a mate or finding food. Because of these unique requirements, I think different systems of the brain are going to be involved in the different kinds of emotions…

Emotional reactions that occur in this quick and dirty way are really reactions that are important in survival situations. The advantage is that by allowing evolution to do the thinking for you at first, you basically buy the time that you need to think about the situation and do the most reasonable thing. For example, freezing is often the first thing people and other animals do when sudden danger appears. Predators respond to movement, so freezing is overall probably the best single thing to do first, at least it was for our distant ancestors. If they had to think about what to do first, they'd have been so caught up in the thought process they'd probably fidget around and then get eaten.

Thursday, April 10, 2008

How International Is This Housing Bust?

Some anecdotal evidence to show that it wasn't just the US that got out of hand. From the New Zealand Herald:
Mr Bowie, 30, and his fiancee Charlene McFarlane, 29, have just taken out a mortgage for 100 per cent of the cost of their modest home in Birkdale, Auckland, which cost them $397,000.
The couple are among a growing number of first home buyers who are willingly taking on huge financial burdens by borrowing 100 per cent of the cost of their homes.

"Going back three or four years, 100 per cent mortgages were only available through non-conforming type entities and second-tier lenders," says Mortgage Brokers Association chairman Geoff Bawden.

"Now you have a situation where most, if not all, of the mainstream bank players are able to offer 100 per cent funding on reasonable terms."

Most brokers put 100 per cent loans at around 5 to 10 per cent of all new mortgages...

Easier financing has helped to push up house prices. Although brokers say they aim for mortgage payments of no more than 30 to 35 per cent of household incomes, the Reserve Bank says the average is now nudging 50 per cent (see graph)...

"We are not good savers," says Ms McFarlane.

And in England...

A collective shudder ran down the spines of British homeowners on Tuesday April 8th when Halifax, a part of HBOS and the country’s biggest mortgage lender, revealed that house prices fell in March by 2.5%. The monthly decline recorded by the Halifax house-price index was the biggest since September 1992, when the housing market was enduring an agonisingly prolonged bust.
Mortgage lenders are reluctant to talk down the market, so it says something that both the Halifax and Nationwide are predicting “modest” declines in house prices this year. Forward-looking indicators suggest a gloomier picture. The number of mortgages approved for house purchase was almost 40% lower in February than a year before. According to the Royal Institution of Chartered Surveyors, estate agents have been grappling with the worst conditions—measured by the ratio of completed sales to unsold stock—since September 1996.
Last week a study by the International Monetary Fund found that Britain’s housing market was the third most over-valued of 17 developed economies, narrowly behind Ireland and the Netherlands. House prices were almost 30% higher than could be explained by fundamental factors such as disposable income, interest rates and working-age population.

These findings are not shocking given the extraordinary house-price boom of the past decade. Between the first quarter of 1997 and the first quarter of 2007, house prices rose by 214%. This was the third highest among 20 countries covered by The Economist. It contrasts with a rise of 135% in America up to its peak in 2006.

The housing bubble seems to have been a global occurrence.

Update*- Great article from the comments.

As Mr Greenspan pointed out in his response to his critics in the Financial Times on Monday, the housing bubble was not unique to the US. On the contrary, as the background chapter on housing in the International Monetary Fund’s latest World Economic Outlook shows, US experience was far from exceptional. On the contrary, the biggest apparent overvaluations occurred in Ireland, the Netherlands and the UK.

The chart shows the proportionate increase in house prices between 1997 and 2007 that cannot be explained by the fundamental drivers: affordability (the lagged ratio of house prices to disposable incomes); growth in disposable incomes per head; interest rates (short- and long-term); credit growth; changes in equity prices; and changes in working-age population. Thus, the rises reveal the extent to which a country has experienced what seems to be a bubble. The US is in the middle ranks.

Tuesday, April 08, 2008

"Permenently High Home Prices?"

Paul Krugman comments:

Brad Delong is of the belief that home prices won’t fall back to pre-bubble levels, because “America is filling up” and “we will wind up with higher prices for scarce positional goods–chief among which is location, location, location.”

The trouble with this argument is that it’s an argument for rising rents as well as rising prices — and if you believe the BLS data, that just hasn’t happened nationally. Below are the Case-Shiller home price index and the BLS index of “rent of primary residence”, both adjusted for overall CPI and expressed as indexes with Jan. 1987=100. Bottom line: rents have hardly risen at all in real terms.

Now, maybe the BLS is wrong. But for what it’s worth, the data say that essentially all the rise in real home prices came from a rise in the price-rent ratio, which suggests that things will go right back to where they were.

I would add one other thing: that real risk-free yields have also fallen over that period, and that should also be accounted for.

Monday, April 07, 2008

Poetry Corner

THERE was a time when meadow, grove, and stream,
The earth, and every common sight,
To me did seem
Apparell'd in celestial light,
The glory and the freshness of a dream. 5
It is not now as it hath been of yore;—
Turn wheresoe'er I may,
By night or day,
The things which I have seen I now can see no more.

The rainbow comes and goes, 10
And lovely is the rose;
The moon doth with delight
Look round her when the heavens are bare;
Waters on a starry night
Are beautiful and fair; 15
The sunshine is a glorious birth;
But yet I know, where'er I go,
That there hath pass'd away a glory from the earth.


From Ode: Intimations of Immortality by William Wordsworth

Wordsworth basically says: remember back when the smallest things gave you such joy? You can remind yourself about it just by spending some time watching children and seeing how easily they amuse themselves. But the now mature Wordsworth asks where has that feeling gone?

Now, the first time you read this poem, the prognosis looks pretty bleak. He seems to say that this childhood delight and freedom is gone, and that we have to settle for just our memories and "find strength in what remains behind" (180). He uses a metaphor to of a vast sea and land to sum up this point. We start off in birth in the ocean. As we age, we make it to shore and then further move inland. Once there, we are left only with what we remember of that vast immortal sea.

Yet starting from stanza nine, you can make an entirely different interpretation as well. For he says he has found "perpetual benediction" not in "delight and liberty, the simple creed of childhood." Rather, he finds it in his "obstinate questionings of outward things," or the innate curiosity within him. Why? Well if you think about it, curiosity may be directly linked with our childhood delight and liberty. After all, life begins with an empty conception of the world. So much of the world remains inexperienced in the eyes of the child, and nearly every moment leads to some new experience. All of a sudden, the reader has come across an explanation for “those first affections, those shadowy recollections” of our childhood joy. Why did everything once raise such great feelings of interest and joy within us, yet now seem ordinary and boring? The great affections we felt for these things arose because we were experiencing them for the first time. Yet as these things were “the fountain light of all our day, … [and] of all our seeing,” they have become habitual experiences and cease to amaze us. (151)

Now I'll leave it to you to decide whether you want to see how this interpretation is carried into the rest of the poem. But the argument itself is an interesting one that you don't often think of. In the end, the reader learns that there is nothing so enviable about childhood. Our peaceful attitude is simply the result of a life filled with experiences in a complex world. And although maturity takes us far inland in Wordsworth's analogy, we would not choose to give up our "calm weather" and stability for the vast unknown of the sea.

Of course, the second part of this argument is that it is the satisfaction of our curiosity which leads to happiness. So break out of the routine and keep asking questions: the world is big enough to always learn or experience more, if you take the time to notice it.

P.S. Reader's of The Black Swan may also enjoy thinking about how that argument relates with this.

Wednesday, April 02, 2008

Clearing Up Some Housing Uncertainty

There is risk, and then there is uncertainty. The distinction was first made by Frank Knight in his popular work Risk, Uncertainty, and Profit. Risk exists when a probability can be attached and an expected value can be derived. Uncertainty exists when there is no objective way to place a probability on an event and so an approximate outcome can not be made. The word 'uncertainty' seems to characterize the state of the housing market today. The predictions for how bad it will end up being seem to be all over the charts because no one is quite sure about the extent of the problem.

Well today, the New York Fed posted up a new dynamic mapping and data tool which gives some valuable information towards clearing the uncertainty. The site provides many statistics on sub-prime and Alt-A mortgages, including:

• Loans per 1,000 housing units
• Loans in foreclosure per 1,000 housing units
• Loans real estate owned (REO) per 1,000 housing units
• Share of loans that are adjustable rate mortgages (ARMs)
• Share of loans for which payments are current
• Share of loans that are 90-plus days delinquent
• Share of loans in foreclosure
• Median combined loan-to-value ratio (LTV) at origination
• Share of loans with low credit score (FICO) and high LTV at origination
• Share of loans with low- or no documentation
• Share of ARMs with initial reset in the next 12 months
• Share of loans with a late payment in the past 12 months

The one I found most interesting though is the first one: "Loans per 1,000 housing units". If I'm understanding this correctly, this gives us the percentage of homes in a market which are backed by subprime or Alt-A mortgages. So let's take a look at two states which are supposed to be the worst housing market offenders: Florida and California.

Subprime loans per 1000 units: 39.40
Alt-A loans per 1000 units: 20.40
Total = 5.98%

Subprime loans per 1000 units: 38.60
Alt-A loans per 1000 units: 48.60
Total = 8.72%

These numbers are far from great; they also do not include many poorly underwritten home equity loans. Still, the risk of housing causing a doomsday type scenario seems pretty small to me if the share of houses with shaky loans is not even in the double digits. Some new problem will have to step up if the doomsayers are going to be proved right.