Photo: Poulopoulos Ioannis, Flickr
The list of issues facing the market grows ever longer. A Greek default, slowing U.S. GDP, possible games with the debt ceiling, reduced Chinese demand for commodities, the Arab Spring.It’s endless, and on top of all this almost 50% of Americans in a recent poll believe we’re heading back into recession. The top-down view often provokes worry but right now seems unusually bleak. Let’s take a closer look at some of these:
Greece. It seems as if everybody except the EU politicians have assumed a restructuring of Greece’s debt. The austerity imposed on Greece by its EU neighbours doesn’t seem to be generating the improved fiscal outcome so desired.
Meanwhile, many Greeks understandably feel that higher taxes, reduced pensions and all the other prescribed medicine is not getting them anywhere. It’s looking increasingly as if Germany will be writing a check to solve the problem; either to Greece to help them reduce their debt burden, or to their own banks to help rebuild their capital once they write down the Greek bonds they hold. And this is entirely reasonable. Germany’s exporters have benefitted both by selling to Greece but also by selling outside the EU in a currency made more competitive (weaker) by sovereign debt fears. Meanwhile, the banks that hold too much Greek debt have only themselves to blame.
It’s unclear to me, and evidently to the rioting Greeks, why a default would be worse for them than the current austerity. Many countries have defaulted and quickly returned to the markets – notably Russia and in recent years Argentina.. In fact, new Greek bonds would be a safer investment following a default on the old ones.
Much as it will irritate the more prudent north Europeans, Greece’s problem is their problem too and the cost of solving it is unlikely to be borne solely by the Greeks. However, it’s also looking increasingly as if the EU will not resolve this issue without a crisis. The possibility of a substantial drop in the Euro as it faces an existential threat is looking more likely. In our hedge fund where we have a number of risks which generate long equity exposure, we are starting to go short the Euro to hedge against a potential European sovereign debt crisis.
Slowing U.S. GDP. This has crept up on us, with high energy prices and the Japanese earthquake causing slower income growth and reduced consumption. We don’t alter our equity exposure based on GDP in our long only Deep Value strategy, but we have recently been adding to investments in the retail sector. Sears (SHLD) continues to produce disappointing earnings.
Just about every measure of performance shows sequential deterioration. Meanwhile, Eddie Lampert continues to buy back stock, and in reviewing financials as well as his commentary one can’t avoid feeling that he likes for the stock to be unloved, since he can buy more of it at lower prices. While their income statement provides little to love, their real estate provides some type of downside protection in combination with several leading brands (Kenmore appliances, Kraftsman tools) which could all be sold if Sears ultimately decided they weren’t going to make it. Meanwhile the stores are starved of capex in order to provide cash to buy stock. Presumably signs of strength in U.S. consumption would induce store refurbishment and improved sales. We’ve been adding to SHLD.
We’ve also started investing in Family Dollar (FDO). So-called Dollar stores have the appealing quality of performing well during a recession as consumers trade down. FDO was recently the subject of a takeover bid from Nelson Peltz which management declined, adopting a poisoned pill defence that expires next March.
The company’s list of shareholders includes several activists and well known hedge funds, including William Ackman’s Pershing Square. Ackman recently made a presentation comparing FDO with a close competitor Dollar General (DG) and noted how DG’s performance had improved dramatically following KKR’s acquisition in 2006. If FDO can close the gap with DG on operating margins and sales per square foot the stock has plenty of upside. The company has virtually no debt, and given the comparisons with DG, activist interest and expiring poison pill next year it looks appealing to us.
Slowdown in China. Glencore apparently noted that commodity demand in China was weakening. Developing an insight into Chinese growth isn’t easy. Glencore is better situated than most to have an informed view. We are invested in the shipping sector which has not been particularly enjoyable of late. The industry suffers from years of future oversupply through exuberant ordering of new ships during better times. Consequently, shipping stocks are cheap and the industry’s fundamentals stink.
We own Overseas Shipholding Group (OSG), which is more conservatively run than most and trading at what we think is a substantial discount to intrinsic value. They operate VLCCs (Very Large Crude Carriers) and so are exposed to volumes of shipped crude oil. Increased OPEC production would undoubtedly help them.
We are also invested in Aegean Marine Petroleum (ANW). They provide bunker fuel and so are presumably well positioned to benefit from the growing global shipping fleet. Their business model is driven by the spread they can earn on bunker fuel, and while a weak industry has put pressure on their margins their most recent quarter saw a reversal in this trend. In addition their volumes are set to grow sharply; they will be the exclusive provider of bunker fuel at each end of the Panama Canal starting next year, and are also opening a new terminal in Tenerife. It seems quite plausible that they could earn $0.80 per share next year, which puts their forward P/E at 9X. We were early – its current low price is a mystery to us.
Debt Ceiling. One thing almost everybody agrees on is that long term treasury yields are unappealingly low. It’s perhaps the least contentious view in investing today, which is probably why bond yields continue to confound everybody and head lower. We are uncomfortably in the majority on this one, and our Fixed Income strategy is currently invested 35% outside the U.S., in short dated emerging market instruments as well as Canadian $. U.S. interest rates are too low to justify investing here for income; growth, inflation and rates are all higher elsewhere and fiscal balances are mostly better too.
Canada has managed its financial affairs far better and has vast amounts of raw materials as well. The other 65% of our Fixed Income portfolios is in two year investment grade corporate bonds, earning a modest yield while avoiding the duration risk of longer maturities. Brinkmanship over the debt ceiling has the potential to go a step too far. But more fundamentally, we don’t yet believe the conditions are set for meaningful fiscal reform.
Popular support is extremely shallow – polls show conceptual support for deficit reduction but not for the tangible steps needed to achieve it (reduced entitlements, higher taxes and so on). A meaningful plan will likely die a death by a thousand cuts – more likely is an agreement on substantial but unspecified future reductions with the hard decisions deferred once again. Until higher bond yields alert popular opinion to the growing problem, it will remain as hypothetical as global warming.
Disclosure: Author is Long EUO, OSG, ANW, SHLD, FDO
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