From WSJ Today

From article:

"Goldman Sachs, whose forecasters have been among the most downbeat about the strength of the recovery, said in a note to investors Wednesday that prospects for U.S. growth had "brightened significantly in recent weeks." The bank revised its 2011 growth forecast for gross domestic product to 2.7%, from 2.0%."

Translation:

While we try hard, we have no ability whatsoever to predict the future. Our forecasts are based on the prevailing sentiment of the day. Stay tuned for further revisions...

Futures Taxation

There are a few free lunches in this world. The Commodity Futures Modernization Act (CFMA) of 2000 provides a futures investor with a distinct tax advantage over the securities investor.

First let's understand briefly what the CFMA rules say. CFMA is a long, complex piece of legislation addressing all sorts of futures vs securities issues in the capital markets. In particular, it exempts OTC derivatives from being regulated as futures or securities. It also attempts to clarify taxation treatment of commodities. Prior to the CFMA, traders used "straddle" strategies to offset the risk of an appreciated position thereby deferring capital gains on one side and potentially realizing a loss on the hedge. The CFMA clarified rules around straddles and also specified tax on Commodities defined as any regulated futures contract, foreign currency contract, non-equity option, dealer equity option and dealer securities futures contract as per IRC Section 1256.

Under the new tax rules for traders electing mark-to-market accounting (ie, realizing capital gains and losses at end of each year) 60% of futures gains would be categorized long-term and 40% short-term. These would be taxed at the prevailing long-term and short-term rates (currently 15% and 35% for those in highest bracket). The blended rate would be 23% even if trades are entered and exited intraday.

This has all sorts of implications for those that are willing to make a mark-to-market designation on their tax return (note this has other ramifications that are important for those that have large unrealized gains).

For example, if you have the choice between owning Treasury bonds for investment income and bond futures, you probably want to choose the latter. While bond futures have some complexity due to the cheapest-to-deliver option, you earn the bond's coupon income through the forward price calculation. Given CFMA designates the majority of any income/gain as a long-term capital gain, you are advantaged by substituting futures for a long cash position all else equal.

The same holds true for futures on broad equity indices. The advantage vs index funds and index ETFs could be substantial for shorter term traders.

Wanna Be A Miner?

Now being stuck for sixty-nine days in a cramped, dank cave with thirty-two other sweaty men is probably not what anyone wishes for. However the exhilaration and joy of emerging into the fresh air probably was the sweetest breath taken for each of the famed Chilean miners. It also doesn’t hurt that they have a movie deal, various endorsements and designated hero status in pretty much every country around the world – except maybe North Korea where being kept underground is a form of punishment like everything else. In short, after more than two months of hell, the miners are consuming the most precious of all US exports – the American Dream. Good for them.

We live in a world of interconnected imbalances. Helped by rapid advances in broadband communications, the world has begun to resemble the Net itself – nodes and branches. The interconnections are everywhere. For example, the US depends on India for cheap customer service, and in turn India depends on the US for routers and other gear. The imbalance is driven by the US net trade balance relative to overall world trade. Or more simply, the US imports significantly more than it exports - so much more in fact that roughly half of the total trade surplus generated by countries running a surplus is generated from the US.



When a country runs large trade balances it is generating foreign currency. In today’s world this is seen in the large dollar reserves held by the world’s central banks most notably China. Once a country obtains the currency, they have to decide what do with it. They can leave it in cash (dollars), use the dollars to buy an asset, or convert the dollars to another currency. Since cash pays no interest, most holders of dollar reserves have elected to buy high quality US government guaranteed obligations or Treasuries. By doing this they earn a slight interest rate and maintain their reserves in dollars.

Dollar reserve accumulation has been the trend for many years as evidenced by the persistent negative US trade balances. Since dollars have been viewed as the preferred global reserve currency post WWII, central banks have been willing to accumulate them.



Many headlines predict catastrophe by the large foreign exchange reserves held by China worried that the US is being “bought”. This is the wrong way to think of it. The US is not like a corporation; there would be no bankruptcy, foreclosure or liquidation of the US in any circumstance. The country in a precarious position is China. They hold large amounts of US debt that is backed only by the US promise to pay (ie, “full faith and credit”). Remember if they want to change their holdings out of dollars, they have to sell the bonds and then convert the currency. But how can they do this? At $2.5 trillion, China cannot easily sell. Selling the Treasuries may be the easiest of the actions as the Fed is a committed buyer. What about converting out of the dollars? What would they buy and how much could they buy?

As a thought experiment, let’s assume they wanted to allocate 10% of their dollar reserves (assume $200bn) to another currency. If it’s the euro or yen, this can likely be done with minimal market impact over several weeks. But the euro and yen have their own issues. The euro is plagued by sovereign credit concerns and the yen is facing its own structural issues, so these may not be the best options. There are smaller currencies that may be better bets such as the Swiss Franc or Singapore Dollar, but these are too small to allow any meaningful percentage.

What about gold? How easy would it be to buy $200bn of gold? At a price, $1400/oz they would need to buy about 143mm ounces or 4400 tons. Given the annual production of gold is less than 3000 tons, this volume would be impossible. The same would hold true for almost every other store of value.

Adding to their woes, they are growing their reserve position by over 10% every year. When you add the fact that most of the world’s resources are owned, controlled or influenced by the West, you arrive at the simple conclusion that China cannot get out of their reserve position!

What is likely is that spurred by their ever increasing position and the new willingness by the US to debase the currency (ie., Bernanke’s QE2), China will become more aggressive in securing non-dollar assets such as mines, pipelines, ships, gold, silver and other goods in regions where the US has less sway (ie., Africa, Cuba, South America, Russia). China will also take a longer term approach to diversification and this will be supportive to commodity prices globally. The dual forces of continued development in emerging markets and the need to diversify reserves may bring about a commodity price boom that we have not seen in history.

Higher commodity prices will create the incentive to produce and extract more resources and this will have ripple effects on the demand for equipment, labor and logistics – which brings me back to wanting to be a miner. Chile with its massive copper reserves will likely be the preferred destination for Chinese delegates for a long time. Even with the risks, being a miner wouldn’t be so bad.

Japan Article

There was a great article in the NYT today discussing Japan's lost decade and societal decline.

While the article relays the basic facts and some anecdotes it fails to delve into why Japan continues to lean forward into a gaping abyss. It is not purely economic - that was just the catalyst. At its root, it was a cultural distaste for change - specifically a compositional change of the population. Had Japan opened its borders and allowed the influx of Asian immigrants to become a part of its economy, the country would not be in such dire straits. Japan is fundamentally a closed society and an open immigration policy runs counter to their very core.

Net migration in Japan is effectively zero while in the US this accounts for materially all of the population growth. Furthermore the immigrant population in the US accounts for a higher fertility rate. Japan maintains an active policy against immigrants particularly from other parts of Asia. The Japanese are intensely distrustful of Chinese, they look down on Southeast Asians and only barely accept Koreans, many of whom have resided there for generations.

While the recipe for reform is obvious (e.g., adopting English as main language, targeting 1% net migration rate), Japan will likely resist any opening of its restrictive ways. As the elderly dissave to sustain their spending, the nation will eventually need to import savings from abroad. Once this tide turns, Japan will face a reckoning manifested in default, devaluation and outright economic collapse. Is it then surprising that the Japanese elite need to drown their sorrows?

It is sad to see the train wreck happen with no way to stop it.

How to Find Bonds on the Web

TRACE is a pretty useful service for any bond investor. Here's a short blurb on what it is (source: FINRA):

"The Trade Reporting and Compliance Engine (TRACE) is the FINRA developed vehicle that facilitates the mandatory reporting of over the counter secondary market transactions in eligible fixed income securities. All broker/dealers who are FINRA member firms have an obligation to report transactions in corporate bonds to TRACE under an SEC approved set of rules."

For those of you who have a Bloomberg terminal, TRACE data is pretty easy to come by as is searching for any bond information. You get prospectuses, bond info and last traded prices all within a few pecks of the keyboard. How do the rest of us average folk do it?

Here are a few useful tips I have found:

1) What if I want to see all the bonds of a particular issuer?

http://www.investinginbonds.com/corporatebonds/(mut1qxnnahaztrigsfkxmi45)/searchissuers.aspx?flag=search&criteria=keyword1+keyword2+...

So for example if you wanted to find BP bonds you would type,

http://www.investinginbonds.com/corporatebonds/(mut1qxnnahaztrigsfkxmi45)/searchissuers.aspx?flag=search&criteria=BP

If there are two words in the name such as Sara Lee you would type,

http://www.investinginbonds.com/corporatebonds/(mut1qxnnahaztrigsfkxmi45)/searchissuers.aspx?flag=search&criteria=Sara+Lee

Click on the bond issue and you will get CUSIP and other details.

2) What if I have the CUSIP and I want to see most recent quotes from TRACE?

http://www.investinginbonds.com/corporatebonds/(cdgkcy45yesfqj45fsp05nm0)/cusip.aspx?action=all&cusip=CUSIP

Replace the bold CUSIP with the actual code

3) How do I see prospectuses from a particular issuer?

http://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=CIK Code&type=424&dateb=&owner=exclude&count=40

Replace the bold CIK Code with the actual code. You need to know the SEC's Central Index Key (CIK) to execute this search. Get that by going here http://www.sec.gov/edgar/searchedgar/cik.htm.

All issuers have to file SEC forms 424 for any offering (stocks, bonds, etc...) and you should be able to see all of these on the SEC's EDGAR site.

I am sure there are more elegant ways to do this, but hopefully this helps

Quick Thoughts on Google

(Chart from Yahoo Finance)

Google has come under strong selling pressure after (1) confusion around Google’s status in China and (2) their recent miss in Q2 earnings. I thought I would give a short valuation analysis.

First how does Google make money?


Well the answer comes directly from their website:

- “Today, the majority of our revenue comes from advertising… Google AdWords, our auction-based advertising program, enables advertisers to deliver relevant ads targeted to search queries or web content… and advertisers pay us either when a user clicks on one of its ads or based on the number of times their ads appear...”

and

- “We distribute our advertisers' AdWords ads for display on the Google Network through our AdSense program. We share most of the revenue generated from ads shown on a site of a Google Network member with that member.”

What is AdWords?

In short it is the world’s largest ad exchange:

- Advertisers are on one-side while Google and cooperating operators (ie, Google Network members) are on the other

- Advertisers bid $ amounts for their ad’s position. The $’s go to operators which host the ads on their webpage (you know on the side of website)

- Google uses its algorithms to determine a “quality score” of each ad. This quality score reflects relevance and is a key determinant of “cost-per-click” (CPC)

- The trick is how does Google get enough traffic on its site so that advertisers are willing to pay. Well first, they have sites that attract huge volumes of traffic (ie, searching on Google.com or Gmail). But there is more.

The brilliance of the business model is that they pay others for traffic through AdSense.

AdSense

AdSense is the Google service which places ads on willing partners sites and pays for the privilege. As a web site creator you sign up for AdSense and depending on your site’s popularity, Google sends you monthly checks. The amounts are a function of the content as some advertisers are willing to pay more for certain types of keywords (ie, car > snot).

Amounts are also a function of how many people come through your site (ie, traffic). This service is in addition to their traditional means of making money – ads on their own Google.com and Gmail sites.

So to summarize:

Google revenues are a function of,

1. Overall willingness of advertisers to pay for ads
2. Volume of internet traffic (search + content)
3. Google’s share of this traffic

The more Google can do to capture share of a given traffic (ie, start free email services) or create a new type of traffic (ie, YouTube, mobile), the more money it will make all else equal.

Now let's look at it as an investment.

First let's make some simple assumptions:

- Internet growth will continue to grow rapidly

- Traffic will expand at significant rates across variety of content

- Search will remain primary driver of traffic and Google will continue to dominate the category

- Over time new projects such as YouTube will be profitable and add to traffic growth

Company Details

Google TTM Revenues (ie, after traffic acquisition cost) = 26.2bn
Cost of Revenues = 36%
R&D, Sales & Marketing, and G&A = 25%
Operating Margin = 39%
Tax rate = 22%
Net Margin = 30% or ~7.8bn
CFO = ~9.3bn
Capex = ~1.8bn (assumed)
FCF = ~7.5bn
Fully diluted shares = 322mm
FCF/share = $23

For purposes of valuation we will assume FCF grows to $40/share by the end of 2015 (~15% growth)

Then we will assume 5% growth in perpetuity and run valuation levels using 10, 12 and 15% discount rates

Current cash/share is $93. Assuming growth of FCF/share to $40 by year-end 2015 we assume cash/share will grow by (40+23)/2*4.5 years or $142/share. That is we assume year-end 2015 cash/share is $235/share.

If cash is distributed prior it will only change valuation through time value of money assumption

Let's look at the case of a discount rate of 10%.

Let’s assume $40/share in year-end 2015 FCF

We use 10% discount rate and 5% growth rate to get a multiple of 20x FCF or $800. Add cash of $235 and we get a value of $1035 at year-end 2015

We then discount this back to today at 10% and get an NPV of 674.

Equation is:
[FCF per share/(Disc Rate – Growth Rate) + Cash per share]/(1+Disc Rate)^Time

Now we can look at different scenarios for the "fair value"

Using the previous equation,

NPV @ 10% is 674
NPV @ 12% is 484
NPV @ 15% is 339

Also using current market price of 459 we can compute alternate rates of returns for these discount rates

ROR @ 10% is 19.8%
ROR @ 12% is 13.3%
ROR @ 15% is 7.5%
ROR @ 12.4% is 12.4% (In this case the NPV = 459 so the ROR is just the IRR)

Obviously the “right” value depends on discount rate. We won’t get into a debate on what is the appropriate rate, but let’s say that to compensate for the risk of obsolescence or regulatory intervention we probably need a discount rate between 12% and 15%.

At 15% discount rate the stock clearly has further downside which is probably a reasonable worst case (of course, 0 is the worst worst case).

Current undervaluation @ 12% is ~$25/share.

The important thing to remember is whatever you assume as the discount rate is what you are assuming the "asset" compounds at over time. So even though the stock is $100+/share overvalued at 15%, we actually see rapid growth in the share price at that rate. So the year-end 2015 target share price over time is still above today's ($635/share in the 15% example).

So the question is would you like to own a company with as stable revenues as Google with its pipeline of growth at a return trajectory somewhere between 7-20% per annum? Is it worth the obvious risks of obsolescence and regulatory intervention? That's for you to decide...

Revenge of the Nerds

Some time back: Wall Street lucrative compensation lures hordes of top engineering and math students (aka Nerds)

Not too long ago: Nerds create programs and products that help propel Wall Street profits to gargantuan levels

Somewhat recently: Fooled by their own contrived complexity, countless nerds and non-nerds alike propel asset markets to new heights

Seems like yesterday: Realizing that the models grossly underestimated reality, investors rush for the exits and markets crumble

The present day: Blamed for the financial crisis, Nerds are rounded up and made to walk the plank. However non-Nerds get lambasted for lack of sufficient oversight and are thrown overboard instead. Nerds are elevated to the top spot

More State Doom and Gloom

This blog was not supposed to be solely about state finances but the situation is so overwhelming and dire that I cannot help comment.

Read this.

In short, there are only three ways out:

1) Rapid economic growth balances state budgets
2) States make dramatic spending cuts and/or tax hikes
3) Additional federal stimulus (eg, ARRA)

Hmmm... What do we have behind door #2?

Just Cannot Catch a Break

From the WSJ:

"A year after enacting the largest increase in the state's personal income rate in generations, Albany is about to further raise taxes on wealthy New York City residents.

New York City's personal income tax rate for taxable income above $500,000 will grow by 6% under a plan advanced by lawmakers this week. The change, to take effect this year, would raise the city's top rate to 3.88% from 3.65%.

Combined with the state's income tax, higher-earners in New York City would pay a top rate of 12.85%, excluding federal taxes. New York City already has the highest combined local and state income tax rate in the nation.

State and city officials estimate that the increase would generate $100 million to $167 million a year in revenue for Albany. The hike is buried in a budget bill containing about $1 billion in taxes, fees, and other revenue changes.

The increase comes as a result of a plan to shave away some of the cost of the state's School Tax Relief program, the bulk of which pays for reductions in schools taxes paid by homeowners. A portion of the program also pays for a reduction in the city's personal income tax rate.

This year's state budget would eliminate that reduction for taxable income above $500,000, in effect, leading to a broad-based increase within New York City.

The increase comes on top of another soon-to-be approved plan in Albany to shrink in half the amount of charitable contributions that New Yorkers earning more than $10 million may deduct from their state taxes.

"It's here we go again. This is what happened last year. When the Legislature needs to be cutting spending, they're raising taxes," said Kenneth Adams, president of New York State Business Council, a business lobbying group based in Albany. "Their failure to bring spending under control leads to tax increases that stymie growth."

"Given that just one half of one percent of personal income tax filers in New York City pay half of the city's personal income taxes, Mayor [Michael] Bloomberg continues to be very concerned about any tax increases that could drive the people who pay for our police, fire, and other City services out of the five boroughs," said Stu Loeser, a spokesman for the mayor, in a statement.

A spokesman for Assembly Democrats declined to comment on the measure. Asked about the proposal, the Paterson administration also declined to comment.

Gov. David Paterson in January proposed a similar measure that would apply to taxable income above $250,000.

Last year, after a concerted lobbying effort by major labor unions and the Working Families Party, Albany raised the state's personal income tax rate by the largest percentage amount in nearly 50 years.

Individual filers earning between $200,000 and $500,000 and married couples with incomes totaling $300,000 to $500,000 now pay a top rate 7.85%, up from 6.85%. All filers with taxable income of more than $550,000 now pay a flat rate of 8.97%. They used to pay a flat rate of 6.85%.

Generating about $4 billion a year, the hike helped Albany to reduce deficits without imposing steeper cuts to public education and Medicaid. The increase, termed a "temporary surcharge," is scheduled to expire after 2011.

New York Attorney General Andrew Cuomo, a Democrat running for governor, and his Republican rival in the race, Rick Lazio, have said they would block any attempt to resurrect the tax after the sunset date."

SF Fed Economic Letter on State Fiscal Crises

For those who think tax-exempt bonds are cheap to taxables this is a worthwhile read.

Setting up the blog

This pre-inaugural post is to help me see if the blog is working. I am doing this (blogging) for the first time and I don't have the faintest idea how it works. If you are reading this, welcome to Hot Flat Nickels!