Portfolio Note: Buy EUFN @$21, A Trade on the EU Stress Test

This is a note of a trade on the European banks on the ensuing EU bank stress test result, an event-based trade, if you will.

The rationale behind the trade is that uncertainty is the nemesis of the market, and more so in the banking business where the asset values float in line with the macro. A stress test, which puts into light the prospectus of safety and soundness of the financial institutions, would hopefully clear the cloud over the investors and increase the market valuation of the tested along the way by diminishing perceived risks.

The idea came to me earlier this week when the news of the EU stress test was all over the business media. The result set to come to the open Friday, I have since been contemplating buying EUFN (iShares MSCI Europe Financials Index) throughout the week. A delay of action has cost me, when EUFN’s suddenly jumped 5% from $20 to $21 Thursday. Standing behind my expectation on what the stress test could do, however, I decided to put significant weight into EUFN in my portfolio, purchasing at $21.

The U.S. Stress Test and its Market Impact

What inspired me into such a trade is the bank stress test conducted by the Fed in the U.S. last year— in my opinion a highlight stroke out of the arsenal in the all-out war against the financial crisis by the regulators.

In February 2009, still lingering deep in the woods of the crisis, the Fed organized the bank stress test, called Supervisory Capital Assessment Program (SCAP), in an effort to gauge the collective health, and in some cases the viability, of the top 19 big U.S. banks, which consisted aggregately of 60% north of all U.S. bank assets. The test simulated under two what-if scenarios—one normal and the other more adverse, with more dire macroeconomic assumptions—the credit losses and the subsequent capital adequacy of the tested for 2009 and 2010. Those who failed would set out to raise capitals.

As the result showed by the Fed on May 7, 2009, the accumulative credit losses under the more adverse scenario would hit $599.2 billion for the 19 towards the end of 2010, on a basis of risked weighted assets (I don’t know what it means) of $7.8 trillion. After offsets by earnings and government support, $74.6 billion of additional capital needed be raised—$33.9 billion for BofA alone, and another $13.7 billion for Wells.

I was puzzled, however, looking into the market movement in the two-week span on both sides of the May 7 publication of the stress test result.

• During the trading week before, May 1 - May 8: S&P500 +2.42%, IYG (Dow Jones U.S. Financial Services Index Fund) +9.93%, BofA +36.51%, Citi +25.62%, Wells +16.21%;
• The week after, from May 11 – May 15: S&P500 -2.9%, IYG -6.47%, BofA -17.54%, Citi -9.84%, Wells -6.26%.

If you stretch the time zone back from the March-9-2009 low till today, IYG’s +116.91% beat by miles SP500’s 61.66%. BofA was up 264%, and Citi 298%.

If the time frame started from the May 7 result publication, however, S&P500’s +20.28% outperformed huge of IYG’s +10.33%. BofA gained a meager 5.6%, 6% for Citi.

All these wild swings mean different things to different people. What is clear is that my thesis of a short-term trade on the EU stress test breaks down, according to what I observed in the U.S. theatre. There was no observed correlation between the stress test result and the market performance—if anything, the market tumbled upon it.

The Reading of the EU Stress Test

The Committee of European Banking Supervisors (CEBS), mandated by the ECOFIN of the European Council, in cooperation with the European Central Bank (ECB), the European Commission and the EU national supervisory authorities, conducted a bank test similar to the U.S. one in 2009 on 22 cross-border European banks.

The EU bank stress test of 2010 is a second-run, only on a larger-scale, expanding into all banks whose assets should cover at least 50% of total bank assets in every of the 27 EU member states. Such a new rule drew in total 91 banks with total assets of €28 trillion, or 65% of the EU banking system.

The 50% coverage rule also resulted in an even distribution of number of banks from different countries. On the two ends of the extremes, there is only one bank from Poland, but 28 from Spain. Although the names of 20 countries on the list seem familiar (7 are inexplicably missing), skimming through all the 91 names of the banks, I found myself not knowing most of them.

The methodology of the test stayed more or less the same: the estimation of capital adequacy under one base-line scenario, one adverse scenario, with an additional sovereign shock in light of the recent sovereign debt crisis in Europe.

The Friday result showed that 7 banks from the 91—five Spanish, one Germany, and one Greek—failed under the worst case scenario the threshold of 6% tier 1 capital ratio, a standard seemingly lower than the U.S. one. In all, a mere €3.5 billion needs to be replenished. It is a result better than expected, as it should have been. The final estimate, also under the worst case scenario, is €565.9 billion in total credit and trading losses until 2011.

What is more striking than the outcomes is the property price assumption used. Even in the base-line case, property prices run flat in all countries, with those in Spain and Ireland down 5-15%, commercial doing much worse. Under the adverse one, property prices are assumed to be down 10% across the board.

The Trade

I have to say that I made the purchase Thursday on EUFN intuitively, with more an intention for a short-term ride on the momentum.

Now with the stress test result refresh at hand and the time for after thoughts, I believe there is value in the medium term nonetheless. Despite of the complexity of the issue (United States of Europe, macroeconomic forecast, FX, housing, banks, ETF) and information deficiency, I see on the iShare website that EUFN trades at 1X book value, while its U.S. equivalent IYG trades at 1.6X, and EMFN (MSCI Emerging Markets Financials Sector Index Fund) at 2.5X. I may be comparing apples to oranges here—think aggregated asset books kept on quite different accounting standards and you lose all sense of accuracy—but the valuation gap is stark and in my personal opinion more than reasonable, despite the sovereign debt crisis, deteriorating real estate market and decelerating growth in Europe.

At any rate, the game is on.

Stock Portfolio’s One-year Anniversary

Today is one-year anniversary of my stock portfolio. The gain is 38.99%, outperforming S&P 500 by 23.44%. Not bad. I think I will take it.

Fannie Mae @ $2.04

This is a quick valuation of Fannie Mae (FNM).

Stock Performance

The market value of Fannie has been almost wiped out by the Great Recession (who dubbed it?) .

Recent performance has been strong however and it caught my attention – usually I like seeing plummeting stock prices because ascending price of stocks I don’t own feel like a loss. Greed…

The market cap was $2.4 bil as of last Friday.

What It Does and How It Makes Money

The short answer is I have no idea, but this is what I will tell you if I try: it buys mortgage loans from 1,000 banks, thrifts, credit unions, and other mortgage originators, packs them into MBSs (mortgage backed securities), and then distributes them back into the market (the so-called securitization process) as well as keep some on its own book.

It makes money in primarily two ways:

1) for the mortgage loans/securities it keeps on its own book, it earns the net interest yield, i.e., the interest spread between the interest it collects from the mortgages and the funding interest it pays.

2) for the MBS securities it distributes out, it collects a guaranty fee by presumably guarantees the return, as in an insurance policy.

In both cases, it has to face the default risk when borrowers cannot repay its mortgages.

The above is a 5-year financial summary.

What’s worth noticing first is the sheer size of its mortgage book – around $800 bil held on the B/S and another $2.2 tril guaranteed, or $3 trillion in total. It represents earning power as well as risks, so that if 1% is written off, it’s $30 bil loss.

The next thing is the net interest yield and guaranty fee rate, both of which have been trending down before trending up. It’s a long story to explain the swing. But anyway, the 2008 net interest yield was 1.03%, and guaranty fee rate was 31 bps (or 0.31%).

2008 Losses

A key question of the valuation is how much losses Fannie would incur before the mortgage market normalizes. It’s hard to define what the norm is, but we shall look into the $60 bil loss in 2008 for some clues.

A break-down of the big item 2008 losses: $7 bil in Investment losses, $20 bil in Fair value losses and $30 bil in Credit-related losses.

The 2008 A/R says that the $7 bil investment losses was all due to sub-prime and Alt-A. I will assume it would not happen again in the recent future.

The $20 bil fair value losses was primarily due to interest rate swap, in which Fannie locked in the funding rate to mitigate interest rate risk before the market rate fell. It’s a loss on opportunity cost and it can be factored into the valuation through net interest yield.

The true loss came from the $30 bil credit-related losses, caused by the recent housing market turmoil and reckless lending/borrowing. Though it was about 0.83% of total guaranty book, the 20.76% nonperforming loan ratio was frightening.

2009 1H Losses

Fannie lost another $38 bil in the first half of 2009. Brutal as it was, the glimmer of hope is that the net interest yield improved to 1.69%, and credit-related losses stabilized in the second half.

Conservatorship

Fannie Mae is currently under conservatorship. Financially, it means that the Treasury Department owns $35 bil senior preferred along with warranty to purchase 79.9% of common at zero cost ($0.0001 to be exact).

Though I think the B/S allows Fannie to handle the senior preferred without too much difficulty, the warranty takes away 80% of the market value.

A Quick Valuation

Here’s a ballpark calculation of Fannie’s fair market value.

As you can see, it is the worst case scenario. I assumed 1% net interest yield, 0.25% net credit loss rate that unfortunately cancelled out all of $2.2 tril mortgage guaranty business, and 2% earning growth.

Even under such circumstance, it would stand 2% net credit loss from the $3 tril mortgage book, the advantageous credit condition and a turning housing market notwithstanding.

Here’s a blog link for the U.S. historical foreclosure rate. And historically, 2% net credit loss seems high.

Fannie or Freddie?

Good question. I’m too tired to figure out.

Conclusion

Loading up!

http://icecurtain.blogspot.com/

Bear Rally?

Did I once mentioned that stock markets work the same way as inflation does – meaning higher demand would drive up price?

The above is the new accounts opened weekly for Shanghai Stock Exchange A-shares.

If you compared to the index, they are almost of the same shape.

The above is mutual fund flow data.

You may have guessed it.

I see few reasons for euphoria, but you should consider stock market for now – stay near the door though.

http://icecurtain.blogspot.com/

GE: An Electricity Company @ $10.78

If you have a long investment horizon (i.e., many years before being eligible to receive social security checks), get your money out of money market and load up on General Electric.

“But GE has just been downgraded!” Stop! Listen to me and I will tell you why.

Share Performance

Its share price dropped 70% in last year, a clear winner vs. S&P 500 in the race to the bottom. The market value is $114 bn, or 6X earnings.

The Business

Here’ a summary of last five years’ income statement by segments.

A caveat emptor first: I don’t know anything about the business of General Electric, except than I was using a GE microwave oven and that it owns GE Capital, which is a bank.

The Valuation

Anyway, tell you how I put up with a price.

The company has five segments – energy infrastructure, technology infrastructure, NBC universal, capital finance and consumer & industrial. The capital finance part is the bank.

Banking business is quite fishy these days, so I will give the capital finance segment ($8.6 bn profit ‘08, 10X leverage) out for free; The consumer & industrial part ($365 mn profit ‘08) is small compared to the other segments, I will also give it out for free.

The rest three segments (again, I don’t know what they are doing) had a combined profit of $17 bn ‘08. By the current market value, it gives a P/E of 6.7.

Now suppose that the economy is really bad in the next two years (C’mon, even Google is laying off people), and those three segment makes zero profit in ‘09 and ‘10, then return to the ‘08 profit level in ‘11 and grow in line afterwards with the U.S. GDP at 3.5% (2.5% real growth plus 1% inflation).

If you discount the earning stream at 10%, the P/E would be 1/(10%-3.5%)/(1+10%)^2 = 13X, or a market value of $221 bn, about 200% of the current.

You may say that “hey wait a minute, that’s not cash.” Let me tell you this: GE had a historical dividend payout ratio of 80%, or so I heard. Take a 80% discount if you wish to.

Besides, I seriously think the growth rate is underestimated. Here’s a part 10-year summary: The CAGR of earning growth was a solid 6%.

Besides, don’t forget that I gave you GE Capital and Commercial & Industrial for free. Besides, I wiped the rest’s earnings out for two years.

A Comparison

Admittedly, there are many earning-depressed quick picker-uppers out there these days, but GE is obviously one of the worst (see above).

When Gaming Becomes Culture

You may or may not have never seen this.

It’s from the ‘08 annual report of Sohu.com. The number is simply crazy.

Remember when the dot com boom crashed, the big three Chinese Internet portal (Sina, Sohu, Netease) almost got delisted from Nasdaq?

You may also like to take a look at Netease [PDF], or Shanda [PDF].

It produced fat-cat CEOs – sometimes really wild, and world-class. Grandpa Deng once said “let somebody get rich first.” His vision has been well realized, but I guess he himself would be surprised seeing what’s happening.

Maybe we should find kids better things to do.

http://icecurtain.blogspot.com/

Shenhua: SOBs, Corporate Governance and Market Economy

This post is on China Shenhua (01088.HK), an energy company and one of the FT/Xinhua 25 index. It’s more about things to consider in investing in Chinese state owned businesses (SOBs) than a stock recommendation.

Introduction

It operates coal mines, power plants, railroads and ports. It mines coals in central China, transports them via own railroads or national railroads to market for sales, or to power plants (most in eastern China) for power generation.

Here’s a list of assets owned.

It’s a really really profitable business. Its 2007 revenue was RMB82 bn (including coal segment RMB56 bn, power segment RMB 24 bn), 50% growth from 2006. Net profit was RMB24 bn. See income statement below.

Ownership

This is the interesting part. The listed company was part of the Shenhua Group, which is a coal energy mammoth with dozens of subsidiaries. Below is part of the org chart.

The group owns 74% of the list company.

The group itself, with RMB411 bn in asset and RMB 141 bn in revenue in 2008, is one of the most profitable state owned business.

Implications

Here’s an excerpt from the 2007 annual:

“The Company’s standard of corporate governance has been recognized in the capital market and the Company has won various awards such as the award of “2006 Best Corporate Governance in Asia” («Finance Asia»).”

To me it’s an oxymoron. For an individual investor, if it’s owned 3/4 by the parent company which is in turn owned by the Chinese government, why is corporate governance even relevant? All you can do is to trust that the parent company (hence the government) will keep it profitable. The good news is such company would rarely bankrupt.

Several implications of the story:

• Market economy

the market economy is this case would hardly work. Suppose you are one of the Shenhua managers (BTW, most of them held government positions) trying to maximize profit for shareholders, you won’t know what to do when the group tells you to pay above-market price for coal purchase, or hold longer for receivables, etc. They won’t do that being responsible, but it’s hard to know.

Or the governments says that you should sell coals to steel plants or power plants for less to help them overcome the economic downturn, since they are also owned by government. It’s socialism at its best.

• Stock market

this also illustrate why some guys advocate government supporting the stock market (though the premise is absolutely false). The Chinese stock market is government-driven, because the government has a lot in it. For stock pickers, it takes a quite different skill set.

• Environment issue

China is short of oil and natural gas but coal abundant and uses a lot of coals for power generation. The immediate issue is carbon emission and global warming, which is also a petroleum problem.

In a market economy, the government would have to adjust the incentives for the economics of the clean energy to work. For example, I seriously think the U.S. should hike the gas consumption tax, like Demark, besides the cap & trade.

The Chinese government, with its immense and somewhat skewed market power, can take a different approach. It’s a much simpler process in China to allocate land for wind and solar sites (the government, hence the people, owns the land collectively), maybe also biomass for incremental power generation. I didn’t do the math, but it would be worth it even with some heavy subsidies to begin such a national industry of tomorrow.

 

P.S. for investment decisions, look here.

http://icecurtain.blogspot.com/

What Mr. Market Says about Citigroup (C)

I did a ballpark (oversimplified) valuation on Citigroup, saying C should be worth more than last Friday’s closing price $1.50. Today C dropped 20% to $1.20, worse than other major banks.

I have to say I don’t understand what Mr. Market is thinking. The dialogue between the conversion scheme and the market goes like this:

The conversion: “We shall convert the preferred shares to $3.25 per common share.”

Mr. market: “It’s a bad deal for common holders. The per common share value should be worth more than the conversion price ($3.25), so that I decide to adjust the market price down to $1.20.”

Dah..

Either the conversion is expected not to go through, or something drastic will happen.

 

http://icecurtain.blogspot.com/

Save Mr. Market

If you are in the stock market, I think you should read or should've read this piece:

"[..] you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who [..] appears daily and names a price at which he will either buy your interest or sell you his. Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. [..] If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."

- Warren E. Buffett

Value vs. Greater Fool

I learned in the Corporate Finance course that there're two approaches toward the stock market.

One is by fundamental values. Say you wanna save an amount of money. You checked the CD rate: it's 5%. at the same time, you're considering buying the stock of the ABC company: the closing price of the day is $10, and it's paid 6 cents dividend per year for 2 years. You figured that despite the risks, the stock yields more thus is the better option. Congrats! Call yourself a value investor, like Buffett.

The other is the Greater Fool Theory. It says that there's no price too high, as long as you can sell it at an even higher price to the next fool. If this is your thing, and you're confident that you can time the market well, congrats to you, too. This is the index used a thousand times to show the U.S. housing bubble that destroyed the world economy. You'll know when you see it.

Recent events and my plumbing portfolio value made me believe that the GF Theory fits better. But to be a money winner, you have to be a bit of a gambler and an excellent mob psychologist.

Something Weird

Which theory you believe is your choice - it's your money after all. End of story, until I read this: 十教授上书建议扩大内需把提振股市作为切入点. If you own stocks (A or H), it absolutely worth your time reading it.

Some best part below:

"激活股市的关键是锁定当前股市下跌的主要原因，对症下药。中国股市一年来下跌幅度超过了70%，远远超过美国股市近40%的下跌幅度，我们认为我国股市下跌的主因是内因而不是外因；内因的宏观政策原因目前已经解决，而股市自身的“大小非”和“大小限”等制度性缺陷却至今仍未消除。目前股市“大小非”和“大小限”合计高达1.18万亿股，比两市流通股的两倍还要多。大小非的问题不仅极大地改变了沪深股市的供求关系，而且改变了市场的估值体系，即使股市跌到1000点，这些一元钱左右的低成本股票仍然有利可图。无论1.18万亿的限售股在现实中是否会流出，对于投资者而言都是悬在头上的一把“达摩克利斯宝剑”，对于市场信心和流动性都是致命的威胁。"

(老师们好！06至07年间，中国股市上涨300％，美国股市上涨30％。请问，上证指数突破6000点大关的时候，我在习读《马列主义》和《毛选》，“大小非”和“大小限”原地不动，老师们在哪儿混哪？）

“建议国家外汇投资部门和公司把战略重点从美国转到香港，购买当前质优价廉的H股公司，动用500亿美元左右的外汇在香港市场吸纳H股，其意义：(1)化解外汇储备风险；(2)知根知底，风险可控，加上手中的政策工具，可确保国有资本保值增值；(3)围魏救赵，履行国际承诺，进退自如；(4)守住了香港“桥头堡”，就堵住了外部金融危机对A股市场传输恐慌，有利于A股市场稳定。”

（顶！可惜我不炒股，能不能把我那份（30美元左右）还我？我特想筹钱买台数字电视）

In short, their suggestion is: the government should be the Greatest Fool.

Alas, if there's an argument, I guess they're right and I'm wrong. This is a concluding remarks: 尚福林:努力提高各类机构入市资金比例. It's a great article: everything he said sounds so right, only I can't remember a thing of what he said as soon as I closed the link.

Damn, my digital TV!

But still, I don't think I will send my kids to where those profs teach.