Category Archives: Trades

Shorting Palladium… Again

It’s not often that one gets an opportunity to execute the exact same trade based on the same investment thesis after closing out the initial trade profitably. But that is exactly what I am facing and decided to take advantage of by shorting Palladium last Friday at $802.

My first trade was initiated on March 27, 2015 at $742 per ounce and closed on November 25, 2015 for $540 per ounce. My rationale for that trade can be read here, so I won’t rehash anything that was stated in that post.

I will only add that we are closer to the mass production of electric vehicles, with the Chevy Bolt EV just released and the Tesla Model 3 coming out later this year. A drop-off in gasoline-powered car sales will reduce a major source of demand for palladium.

It’s interesting to note that the Palladium market is the only commodity that has remained resilient in the midst of a commodity bear market. The recent improvement in global growth has helped palladium to rally back close towards its mulit-year high price of just over $900/ounce.

But when (not if) China experiences another slow down, global growth will weaken and palladium prices will come under pressure, falling towards $500/ounce.

Selling Bank of America (NYSE: $BAC)

I have sold out of my Bank of America (NYSE; $BAC) position yesterday at the close for a 94% gain. It was one year ago that I purchased BAC after it sold off hard due to recessionary fears. I believed there would be no recession and a major, profitable, and under-leveraged bank selling for 80% of tangible book with an earnings yield of 11% was a slam dunk.

With close to a double in a year, the share price reflects a fair amount of optimism about BAC’s business. BAC is now selling for almost a 50% of premium to tangible book and 14x 2017 earnings which is expected to grow a strong 15% due to higher interest rates and less regulatory burden thanks to the Trump White House.

However, any kind of a hiccup from China’s economy, which I believe is a decent possibility in the next 12 months, and BAC could give up a lot of its recent gains. Therefore, I think holding BAC at current prices entails a fair amount of risk.

Selling Alibaba Group Holding via Yahoo (NYSE:YHOO)

On Friday, I closed my position in Yahoo (NYSE:YHOO) at $41.85. I purchased the stock at the beginning of the year during the stock market selloff as a cheaper way of buying Alibaba (NYSE:BABA). At the time I bought Yahoo, China’s economic growth was slowing and investors ignored Alibaba as a play on Chinese e-commerce that could withstand, and perhaps benefit from a China slowdown as the economy shifts its reliance away from investment towards consumption.

After buying the stock, my hope was to see the Chinese economy begin the de-leveraging process while Alibaba maintains strong profit growth leading the market to award Alibaba a higher multiple for this decoupling.

Instead, the Chinese government responded to the economic slowdown in the same way it has in the past: credit-fueled infrastructure spending. Thus, the economy avoided a sharp downturn in exchange for more debt, a resumption in the real estate bubble in tier 1 cities and a deeper slowdown in the future. Alibaba’s valuation has risen from 22x 2017 earnings at the time of my purchase to 32x currently. I believe that once this latest stimulus wears off and China experiences another slowdown, Alibaba could get hit again.

Another reason for my sale is that the Yahoo user data breach that has been recently disclosed adds uncertainty to the Verizon deal. As a result, I am content with my 25% gain in less than a year and will look to redeploy capital.

Buying Bank of America (NYSE: $BAC)

The relentless selloff in US bank stocks continued today as several of them hit new 52-week lows intraday before staging a strong rally into the close. I believe the selling is unjustified and decided to buy Bank of America ($BAC) at $12.66. The current market reminds me of the 2011 market when fears of a Eurozone breakup caused European bank stocks to plummet. US bank stocks also got hit hard due to fears of European debt holdings, a possible recession, and falling interest rates.

The fears turned out to be misguided as the Draghi-led ECB introduced LTRO and the US economy continued to expand, which led to a doubling of the KBW Bank Index ($BKX) within two years.

$BKX vs $TNX 2011-2016

Interestingly, interest rates continued to fall until 2012 before rising in 2013. However, the US 10-year yield now is at the the same level as in late 2011. The fact that the US banks have much higher share prices than 2011, shows that prices then were irrationally low and were pricing in more than low interest rates. Perhaps those low prices could be partly explained by forced technical selling. In any case, once it was clear that the US economy was not falling into a recession, it made little sense for bank stocks to be trading below tangible book value.

I believe the same realization will dawn on the market over the course of this year. Therefore, buying Bank of America at 80% of tangible book value represents compelling value, particularly if my expectation of the economy strengthening over the next couple of years plays out. Even if the Fed does not raise interest rates much, banks should benefit from higher credit growth and buying back stock at below tangible book value. I will track the performance of my Bank of America holding here.

Buying Goldman Sachs (NYSE: $GS)

Financial stocks have been hit hard in recent days due to concerns about an economic recession and declining interest rates. Financials are leveraged to the economy so it is no surprise that they are underperforming the market. Since I do not believe that the global slowdown will infect the US, I am taking advantage of the recent decline in equity prices to buy high-quality names. One attractive opportunity that I am taking advantage of is buying Goldman Sachs ($NYSE).

Goldman Sachs is an incredibly well-run investment bank, as is evident in its ability to navigate through two recessions and be profitable every year since its IPO in 1999. Prior to the financial crisis, Goldman’s stock traded above 2x tangible book value (TBV).  However, in recent years its valuation has wavered between a slight discount to TBV and 1.5x TBV.

Goldman Sachs Tangible Book Value

Bears on the stock justify a low valuation by pointing out that the large banks are under enormous regulatory scrutiny which requires them to hold unnecessarily high levels of capital that impedes their ability to earn a high return on equity. I would counter that the requirements for high levels of capital make them safer and better able to weather a downturn. Therefore, their utility-like returns are deserving of a utility-like valuation of 2x TBV. I believe that the steady  profits that the banks earn over time will eventually cause the markets to revalue them.

In the meantime, Goldman Sachs offers a 1.5% dividend and is buying back 5% of its outstanding shares each year for a total cash return yield exceeding 6%. Moreover, by buying Goldman at TBV, investors can get the Goldman Sachs brand name and the intellectual capital of the smartest minds on Wall Street for free. I will track GS here with an initial price equal to Wednesday’s close of $159.00.

Buying Alibaba Group Holding via Yahoo (NYSE:YHOO)

During the recent market volatility, I decided to build a position in Alibaba Group Holding (NYSE: BABA). This might be surprising to those who are familiar with my long-standing bearishness on the Chinese economy. Aside from buying one Chinese stock 5 years ago (which turned out to be a fraud), I have always traded China from the short side.

That being said I am always searching for companies having market leading positions in large industries with secular tailwinds and being run by highly successful operators. These companies tend to be easily identified by investors, and consequently trade at rich valuations. However, during market corrections and economic slowdowns, the baby is often thrown out with the bathwater. I believe the recent stock market correction along with an economic slowdown in China has presented a compelling investment opportunity in Alibaba.

Alibaba is synonymous with e-commerce in China. The company’s platform provides the fundamental technology infrastructure and marketing reach to help businesses leverage the power of the Internet to establish an online presence and conduct commerce with consumers and businesses. Given the scale it has been able to achieve, an ecosystem has developed around its platform that consists of buyers, sellers, third-party service providers, strategic alliance partners, and investee companies. Much of Alibaba’s effort is spent on initiatives that are for the greater good of the ecosystem and the various participants in it.

The popularity of Alibaba’s platform has resulted in rapid revenue growth and high profitability as shown in the table below.

BABA Financials

Although China’s economy is facing a significant slowdown, the weakness is likely to be confined to fixed asset investment as investing slows after outpacing the overall economy for the past several decades and being artificially stimulated during the recent global financial crisis in order to revive growth. As shown in the following chart, the growth in retail sales has been fairly stable and now exceeds investment spending.

Chinese Economy Rebalancing

Within China’s retail sector, e-commerce will continue to take a greater share of total retail sales, which is to the benefit of Alibaba.

Ecommerce Growth by Country

E-commerce as a Percent of Total Retail Sales

With 386 million annual active buyers and 346 million monthly active users on mobile, it is inevitable that Alibaba’s China e-commerce growth will slow. However, investors are overlooking some of Alibaba’s other businesses which are experiencing hyper-growth and have the potential to significantly add to the bottom line down the road, while strengthening the company’s platform.

BABA Revenue by Business

Aliyun is Alibaba’s cloud computing unit which was started in 2009. Restrictions on foreigners investing in the online services industry gives Chinese companies a significant advantage when competing against Amazon and Microsoft. Aliyun has become a world-class cloud computing service platform and is the market leader in China. While holding a 23 percent market share in its home market, Alibaba has set its sights on the cloud computing space beyond China, eager to tap into a market that according to researcher IDC could grow into a $100 billion industry by 2017. With only about 10 percent of IT budgets spent on cloud computing in Asia, there is plenty of room for growth outside of China. Cloud Computing can be a highly profitable business as disclosed by Amazon’s AWS unit which had 21% operating margins last quarter. The chart below shows that Aliyun is registering exponential revenue growth.

Alibaba Cloud Computing Revenue

Alibaba is also disrupting the financial services industry in China through its 37.5% ownership of Ant Financial which raised money last year at a $45 billion valuation. Ant Financial’s Alipay platform is China’s largest Internet payments platform.

Alipay Dominance

When it comes to mobile payments, China is years ahead of the rest of the world. Traditional noncash payment methods such as credit cards, debit cards, and personal checks never really caught on in China meaning that until recently cash was king. This has allowed China to leapfrog traditional payment systems. In the US, mobile-payment providers rely on the traditional infrastructure of bank-card numbers. However, in China  Alipay only require user accounts to be linked to a traditional bank account. Alipay charges small merchants just 0.6%, which amounts to very little profit. One way Ant Financial can increase profitability is to cross-sell other financial products, including loans and investments. But new regulations in China make this difficult.

To get around these restrictions, Ant Financial created an online bank, called MYBank, which has a license to provide loans and other financial services, though regulations still limit its scope. It is only a matter of time before restrictions are eased because China desperately needs to reform its banking sector by providing more competition to China’s state-owned banks. The state-owned banks tend to favor state-run firms, while underserving individuals and small businesses. MYBank and other online lenders can fill this void by doing away with brick-and-mortar branches to keep costs low and reach more users. Ant Financial has an advantage over other online banks because it can use its huge trove of user-behavior data from Alipay to  assess creditworthiness.

In addition to cloud computing and financial services, Alibaba is establishing an Internet-based entertainment ecosystem for domestic households by delivering of a variety of video content over the Internet using set-top boxes and online video website Youku Tudou; operating online music platforms that offer music streaming services through websites and mobile apps; and producing films and television programs via Alibaba Pictures.

Alibaba has spent over $6.3 billion on logistics-related deals in the past three years because there are signs that getting packages to consumers quickly and reliably is an increasingly important battleground. JD.com offers same-day and next-day services for over 80 percent of orders it delivers while Alibaba aims to have next-day delivery available in 50 cities by the end of the year.

Another notable investment that Alibaba has made is a minority stake in Didi Dache-Kuaidi Dache, the leading and most widely used mobile taxi booking app provider in China.

In the coming years, I believe Alibaba founder and chairman, Jack Ma, will integrate all these businesses to strengthen Alibaba’s ecosystem resulting in double-digit annual  revenue growth over the next decade. At 29x this year’s EPS and 22x next year’s EPS, I believe BABA is trading at an attractive valuation given its growth prospects. I am adding BABA to my Trades page with an initial price equal to Monday’s closing price of $76.69.

Update (2/3/16)
Due to the significant relative underperformance of YHOO as compared to BABA, I am replacing my holding of BABA with YHOO. Yahoo has become so cheap that if you strip out its holding of BABA (assuming a modest tax hit for selling), Yahoo Japan and cash, the core business is selling for nothing. The core business is on track to generate nearly $1 billion in adjusted EBITDA in 2016 and has 600 million monthly mobile users. The board’s statement that it is willing to sell the core, should unlock several billions of dollars. Therefore, YHOO is a cheaper vehicle for owning BABA. I will adjust up my cost basis on YHOO on the Trades page to reflect that I am currently down around 13% on my BABA long.

Shorting Palladium

A lot of my financial wealth was created riding the great commodity super cycle during the previous decade. In 2004, when I first had enough money to invest, it was apparent to me that the industrialization of China, the underinvestment in mining, and easy US monetary policy would create an ideal setting for commodities to rally. To speculate on this, I bought a basket of Junior gold exploration companies and watched their value multiply several-fold.

But in 2010, short seller Jim Chanos opened my eyes to the growing fixed asset investment bubble occurring in China. Fearing that a popping of the bubble could lead to a drop in demand for commodities and a stronger US dollar led me to believe that the great commodity super cycle was about to end.

Sure enough, commodities have been a house of pain for investors since then.

Commodities Price Performance

Most commodities have declined by 30-50% during the past 4 years with one exception: palladium. Palladium has been resilient while even platinum (a fellow PGM metal) lost 35%. Why did the palladium price decouple from the rest of the commodity complex in 2014?

Early 2014 saw the rise of tensions between Russia and Ukraine leading western countries to slap sanctions on Russia. That spooked the palladium market because Russia is the world’s largest palladium producer supplying 40% of mine supply annually.

Palladium 20 Year Price

In the late ’90s, western countries implemented stringent auto emissions restrictions requiring car companies to fit their cars with catalytic converters which require palladium. This caused a surge in palladium demand that Russian mines could not fully supply. The Russian government, desperate to build up foreign exchange reserves after their debt default, sold off its palladium stockpiles to meet the increased demand until it ran out of inventory. To rebuild its inventory, the government delayed issuing palladium export licenses causing a spike in palladium prices.

That experience has made market participants worried about any sanctions that may affect Russian palladium exports. In addition, mine workers in South Africa, the second largest palladium producer, were on strike during the first half of 2014. However, a resolution was reached last June and palladium prices topped out shortly thereafter.

Fears of western sanctions that block Russian palladium exports appear overblown to me because they would hurt western auto manufacturers, while Russia could still sell their supply to China and India. The global automobile industry consumes almost two-thirds of annual palladium supply.

As a side note, I believe the rise of electrical vehicles (which do not have catalytic converters), could cause a significant drop off in palladium demand down the road. But it will take a few more years for battery technology to be price competitive with and as efficient as internal combustion engines.

Nonetheless, I still believe that the palladium price will soon join other commodities and experience a significant decline. My confidence is based on chart analysis.

palladium price

From 2010 to 2013 palladium prices were tracing an alternating series of lower highs and higher lows – a pattern that chartists call a triangle. When the price eventually breaks out of the triangle, it could lead to a sharp move in the direction of the break. However, a false break could arise where the price fails to move quickly and reverses to fall back inside the triangle. This would signal that a sharp move could be forthcoming in the opposite direction of the false break.

In my experience, a well traced out triangle pattern in a widely followed market such as palladium often leads to false breaks. Sure enough, the Russian invasion of Crimea in 2014 led to a breakout, but the price failed to rise much and made only a marginal high before falling back below the lower trend line of the triangle.

I believe that palladium has experienced a false breakout and shorted it on Friday at an average price of $742. The beauty of this trade is that I can stop myself out if the price rises back above the trend line to approximately $775 on a weekly closing basis and take a small loss. Alternatively, I may add to my short position if the price breaks the downward sloping support line at $700.

I will be tracking the trade here.

 

Closing Fiat (Italy: FCA)

Today I sold out of my position in Fiat Chrysler at a price of €14.10. I established the position on July 28th of last year and enjoyed an 80% gain in 7 months. The company is benefiting from an improving European economy, a weaker euro, and the upcoming spinoff of Ferrari.

Although I see nothing wrong with the stock other than it is 80% more expensive than it was half a year ago, I am seeing better opportunities to play a European market melt up. Also, the stock is close to the €16.50/share fair value estimate presented by 2014 Ira Sohn Contest winner Michael Guichon.

I will remove the stock from my open positions.

Buying AIG (NYSE:AIG)

Yesterday I purchased shares of AIG (NYSE:) after its earnings release and tweeted about it. Last year, Barron’s wrote a bullish article on the company and did a good job of explaining why it was too cheap. At my purchase price of $52.50, AIG trades at only 75% of book value (excluding accumulated other comprehensive income). That is a valuation given to companies losing money and with troubled balance sheets. However, AIG is has been profitable the last 4 years and is trading at 10 times this year’s earnings.

The bears would argue that AIG should trade at a depressed valuation because its ROE has been mediocre at only 6% the last 3 years and is so severely regulated that it is essentially a utility. I would agree that utilities are a good comparison since they barely earn 10% ROE, but the market awards them on average a PE multiple of 17 and they trade for an 80% premium to book.

In fact, one of the reasons that made me wait until after the earnings release was to see how aggressively AIG was buying back stock. It turns out when annualized the company bought back 8% of its shares outstanding during Q4. Coupled with the dividend, the company is currently returning all of its profits back to shareholders. So, in effect, the stock has a 10% yield which is much better than utility stocks. Also, when AIG purchases its stock at 75% of book it is increasing ROE.

In addition, I believe there is a possibility ROE can increase without share buybacks. Since AIG is sensitive to economic growth, if the US economy performs as well as I expect, that will help demand for the insurance products that it sells. Moreover, rising interest rates will allow AIG to rollover its maturing fixed income assets into higher yielding bonds than currently available.

Also, AIG is overcapitalized as its assets to equity ratio is 5 to 1 where historically it was 10 to 1. An increase in leverage to 7 or 8 to 1 should push ROE over 10. A higher ROE is likely to be rewarded with higher multiples.

AIG Financial Ratios

It is also comforting to know that one the largest shareholders of AIG is the highly successful mutual fund manager Bruce Berkowitz. The following is an interview from WealthTrack where he explains his rationale for making AIG comprise almost 50% of his largest fund’s assets.

In my view, AIG is in the sweet spot of having a low valuation coupled with improving fundamentals. I have made it one of my largest positions and will track its performance here.

 

Buying Nikkei Futures Priced in $USD

I tweeted on Thursday that I thought that there was a greater than expected chance for the Bank of Japan to positively surprise markets and increase its QE program. The BOJ did increase its QE amounts and I tweeted that I bought Nikkei futures as the market exploded higher.

I believe Japan’s 22 year secular bear market ended in November 2012 when the Nikkei rose by 85% in just 6 months. After 17 months of consolidation, Japanese stocks look ready to make another big move up.

Nikkei Long Term Chart-2

My bullishness on Japan rests mainly on Prime Minister Shinzo Abe’s determination to create inflation. As shown on the following chart, Japan has had virtually no inflation over the last two decades meaning that the BOJ has been unable to provide negative real interest rates for the Japanese economy.

Long Term Japan CPI & Interest Rates-2

When Abe was elected, he pushed for the BOJ to increase its inflation target to 2% and named Haruhiko Kuroda as new BOJ Governor. Kuroda, who is cut from the same cloth as Bernanke and Draghi, believes deflation must be fought off with aggressive monetary easing to raise long term inflation expectations. That, he argues, would lower real interest rates and encourage spending.

In fact, Kuroda had been arguing for the BOJ to adopt an inflation target a decade before it set one in January of last year and has spoken in favor of QE for years. And he lived up to his dovish reputation at his first meeting as BOJ governor by announcing that the BOJ was going to double the monetary base within 20 months.

Despite this, economists estimate that Japan’s inflation rate is likely to fall well below its 2% target by next year. The recent drop in oil prices is a further deflationary shock, but gave Kuroda an opportunity to add to stimulus. Last Friday’s BOJ’s announcement of expanding its already enormous QE program makes it clear that he is adamant about hitting the BOJ’s inflation target.

To grasp the enormity of the program, consider that the BOJ is committing to expand its balance sheet by 17% of GDP annually – equivalent to the Federal Reserve implementing QE1, QE2  and QE3 at the same time. As proven by the Fed’s and BOJ’s QE programs, it can force people into bidding more for riskier assets causing stock prices to surge.

Central Bank Assets  (% of GDP)-3

But what makes Japanese stocks particularly attractive is that they are still reasonably priced. They trade for less than 14x forward earnings and 1.3x book value. The recent depreciation of the yen and the fall in energy prices make it increasingly likely that forward earnings estimates will be reached. And if Abe is successfully able to implement the third arrow of Abenomics, structural reform, then Japanese equities could do even better than I expect.

I decided to buy the $US denominated Nikkei futures trading on the CME because I am concerned about continuing yen weakness and the risk of a Japanese government debt crisis down the road. Japan’s debt load is so enormous that I believe it is already insolvent though it will ironically require the BOJ to successfully create meaningful inflation for the markets to get spooked. In the meantime, I expect Japanese stocks to experience a crack up boom. I will track my trade here.