Tag Archives: freezing assets shout out

(Supply) Chains Keep Us Together

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The Ukrainian crisis is still underway, which got us to thinking about event-driven investing. That and yucca, which I was told was traditional Ukrainian drink. It is mixed in a large communal vessel and then passed to each participant. I tried it with friends a while back and it’s worth the effort—if you aren’t going anywhere for a while. As I mentioned in my last post, I am not a big fan of short-term trades. Having said that, my opinion is that there are investable ideas that come from an unexpected change in world events such as the one in the Ukraine; if one is willing to look deeply into the potential effect on input costs and supply chains.

Using the Ukraine as an example it, and former Soviet Union countries in general, is one of the few places outside of North America that has large scale, and long established, mechanized farming; a left-over from the collectivized farms under Communism. This is one reason the Ukraine is one of the most important grain export countries in the world. Unfortunately for the Ukraine it not only might have lost access to Crimean ports via the recent referendum, many ports on the Black Sea that were not affected by the referendum often have a notable Russian ethnic presence. How this might impact future Ukrainian grain supplies and/or exports via the Black Sea is yet to be seen, but it appears that this has had somewhat of an impact on grain prices as of this writing (California’s drought also likely played a role).

Can an investor find short term opportunities in these situations? I think it is very hard not only due to high frequency trading and artificial intelligence, but also due to corporate hedging. Most companies that have high exposures to commodities hedge their exposures, often for several months out. However after a period of time those hedges expire and need to be rolled over and reflect the new, usually higher, commodity prices. It can difficult for an investor to pinpoint when that might have an impact on earnings estimates, but eventually it should occur in the out years if prices are still elevated.

Additionally uncertainty in supply due to unexpected events can cause companies to reassess supply chains and adjust their sources accordingly. The financial impact depends on a number of factors such as existing worldwide commodity stocks, existing inventories at a particular company, logistical concerns, if a substitute can be used in place of that particular commodity, and the like. It can take time to determine if and when any of these factors, combined or in tandem, have an impact on a company’s costs.

Therefore disruptions in supplies and increased commodity costs might not have a visible effect on margins for several quarters, if at all. Using our example of the Ukrainian Crisis, we might not see grain prices impacts (assuming sustained higher prices) on reported earnings numbers of companies that use those grains this year due to hedging and supply chain factors. However there might be an impact in the out-years that may not be reflected in estimates. Taking advantage of that potential discrepancy may take more time, patience, and research than many investors are willing to undertake. Herein lays the opportunity.

In the meantime do your analysis, be patient, mix up a big batch of yucca, and pass it my way.

Bring Back the Vinyl

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Back in the day when we liked a song we would buy things called albums or CDs. This, for an 80’s era teen, was a risk when disks were $9-$14, so we had to determine if we could live with the album to justify the cost. Fast forward to today it costs $0.99 for one song you know you already like, at least at the moment. However, with songs becoming more commoditized due to so many downloadable options, musical trends can change so quickly that your “cheap” purchase could be a waste of money.

This reminds us of the equity market today. With artificial intelligence and high frequency trading becoming such an important part of market volume (approximately 50-70%) and quote activity (perhaps as high as 90%+), it has had a notable downward impact on average holding periods and likely impacting market volatility, an extreme example being the “flash crash”.  This makes me tell myself every day when I enter the office “chances are I am not trading with humans, but with algorithms and I have no idea how those algorithms are structured.”

Therefore, I tend to do far less short-term trades of individual securities than I once did because of investment horizon risk. Because of these algorithms, my belief is that my risk/reward tradeoff may be neutralized by a computer that can establish correlations and execute risk arbitrage strategies more often, more accurately, and much more quickly than I could ever imagine. This in my opinion adds an element of risk that was not there before. Namely the impact of algorithms impacting market moves more than I anticipate during my investment horizon.

But what about valuation, doesn’t it matter even in shorter-term trades? Yes I believe it does, but likely beyond the investment horizon of my trade. By definition a trade is a very short term holding. It is not an investment. By the time the market does adjust itself, the time horizon for my trade may have passed and I could be stuck with negative alpha longer than planned.

Therefore, like me buying a song that I enjoy for the moment but quickly becoming a thing that takes up bytes on my IPod, short term trading in my view is riskier than it once was due to computerized trading algorithms. That’s why I tend to gravitate to names that I can live with longer than a moment—like my Elvis Costello records.

SWEEEEEEPPPPPP HAAAARRRDDD!!!!!!!

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Originally we were going to write about a disappointing Chinese PMI in conjunction with an improving US manufacturing situation and their macro ramifications, but watching Olympic curling changed our mind. Why? Because curling made me think about how investors may respond to changing macro conditions.

Unlike other ice sports, Curling does not have a Zamboni cleaning the ice between periods (i.e. ends). Therefore ice conditions change during a match affecting the stone’s speed and curl (direction). While changes in the ice are noticeable (often dramatically so) as the match progresses, this is just part of the game. As a result you try to predict how a shot will react in a particular condition. However, strategy—looking for opportunities for good stone placements—never changes.

This is a lot like investing.  There are a lot of changes to the macro playing field occurring constantly; but we usually have no idea to what extent those changes will impact the market in aggregate. Therefore how do we investors adapt to all these changing crosscurrents on our playing field? By ignoring them in the macro and paying close attention to them in the micro. It’s exceptionally hard to predict what a decelerating Chinese manufacturing situation may do to the US economy, but it is far easier to adjust one’s earnings estimates for companies that do or wish to do business in China, such as Emerson Electric, Yum Brands or Apple. If those estimates end up being outside your risk tolerance you can adjust your positions in those names accordingly, likely leading to aggregate changes in your portfolio that reflect these changed circumstances. This often leads to a better decision making process than a top down approach–trying to divine how a perceived macro change will impact a portfolio. Therefore I’ll leave the dramatic macro calls to the talking heads on financial networks.

So like curling, its better that we pay attention to our portfolios one shot at a time than trying to predict how playing conditions will alter the game in total. Conditions in curling ice, and markets, do change but you can make adjustments to your “game” so your tactics change but not your goal—making good shots.

Whether or Not Weather Matters

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Last week January retail sales numbers were released and were below consensus. Some market prognosticators pointed toward bad weather as a factor in the retail sales drop. There is no doubt we have had a tough winter, but are severe weather events enough to change investor strategy?  I don’t think it does.

Why? Part of it perhaps is the media strongly reacting whenever there is a notable weather event in the Northeast, where most reporters reside. This may have an impact on how data is analyzed by investors in the short-term as a good portion of which also live in that region. Plus with weather becoming more of scientific debate with points/counterpoints surrounding global warming, adverse weather often gets more ink than it once did.

Being a Midwesterner, I have always been astounded at the attention that weather events in the Northeast get, especially when it pertains to snowfall. The fact of the matter is that while we in the Midwest get on average more inches snow in total per year, certain major cities in the Northeast usually get on average more large snow accumulation days per year than certain major cities in the Midwest.

Considering the Northeast does get on average many sizable snowstorms, conceptually the market should discount a range of potential severe weather events as many typically happen each year. However this winter arguably has seen worse weather than most, especially here in Minnesota, and some companies have guided numbers down due to weather. But there is also some danger into looking too closely at weather related data points, especially since there were also a large number of consumer discretionary companies that did not guide down due to snowstorms. Additionally, many would say retail sales were somewhat lackluster before January and internet sales, which are arguably weather independent, were also not as robust as earlier months.

But what about truly significant weather events like Hurricane Sandy? Don’t they have an impact on retail sales? Perhaps in the short run, but looking at the chart below one can argue that statistically significant changes in retail sales correspond more toward economic cycles and events (e.g. dot com bust in 2001 and 2008-9 financial crisis) than any weather event in particular.

Data source: US Census Bureau

Therefore I usually figure I am better off from an investment strategy standpoint determining valuations of retail companies, where we are in the cycle, and trying to discern retail trends than trying to predict short-term weather impacts.

Or perhaps as one famous Minnesotan, Bob Dylan, put it “You don’t need a weatherman to know which way the wind blows.”

Catching a Buzz—Bees and Investor Sentiment

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OLYMPUS DIGITAL CAMERAOne of my joys is beekeeping. In fact, I have learned a great deal about human investing behavior from observing bee behavior. For example many people believe that bees hop from one flower to the next, be it a dandelion, snap dragon, petunia, or whatever flower happens to be around. Actually bees are very particular about what flowers they visit. They usually focus solely on what is blooming in force at the moment such as a grove of apple trees or a large field of clover. Investors, for better or worse, are very similar—“the swarm” congregates to whatever is currently blooming in the market.

Investment styles come in and out of season, much like flowers. Most investors focus on the business cycle—certain sectors work at certain times in the cycle. We believe this is true, but we also think that we can break it down even further. Since most of us have a financial background, often times how investors focus attention on certain financial statements (i.e. income, cash flow and balance sheet statements) can work better as a guide to collective investor sentiment than analyzing individual sectors.

For instance when we are in the middle of a market upturn, investors often focus on income statements as they struggle to ascertain what to pay for future growth. Cash flow and balance sheets in this phase may not tell the whole story in the short-term as increased leverage and lower cash flows as companies increase sales forces, capacity, head count and other expenses associated with potential growth. Therefore accurately forecasting revenues on the income statement in this phase may be the most crucial task especially if investors believe that operating leverage on the income statement follows.

As the market matures and goes into a downturn, usually this is when we see cash flow statements take center stage. Investors may become preoccupied with the sustainability of results. More predictable free cash flows mean more potential earnings streams, more cash flows to shareholders and likely a less volatile stock. Additionally the ability to deleverage with free cash flows not only strengthens the financial outlook of the company; it also should give it a better ability to refinance debt as often interest rates decline at this phase of the cycle.

Finally as the market bottoms, this is often when balance sheets get their love. This is when investors focus on inventory levels, working capital management, debt ratios, potential goodwill write-downs and the like to determine how well the company is positioned to come out of a downturn financially. If the company has a strong balance sheet, it should have the ability to be more nimble than its peers to make timely growth investments in the future.

Therefore we likely can learn a lesson from our furry black and yellow friends. Don’t look at what individual bees are doing (although they are fun to watch). If one wants to determine which direction the market is going, watch the swarm. It may tell you where the cycle is if “the buzz” is focusing on one particular financial statement.

If you are interested in bees and beekeeping, I recommend “The Beekeepers Lament” by Hannah Nordhaus.