Month: May 2014

A few links:

Klaus Kastner’s “observing greece blog” has interesting background info on Pireus bank, raising a few more questions. Also read the comments to my Pireus bank blog post, where I exchange views with Klaus. I will try to get my hand on one of those Cypriot banks, as soon as I have time, to see whether this “negative goodwill” is indeed warranted…

Wonderful book review by the rationaloptimist, I have already ordered a copy!

One of my favorite blogger’s reading list. Very interesting.

Although not an economist, Dalrymple skilfully dissects Krugman. I wish I could write like him….

Kyle Bass’s dire views on Asia. I fully agree with him that people underestimate China’s vulnerability. (Disclosure: short CNY and AUD)



Calvalley Petroleum (CVI/A:CN): uncorrelated high risk/high reward opportunity

Another interesting stock I’ve come across during my recent  screening exercise is Toronto-listed Calvalley Petroleum, an oil explorer whose main producing asset is in Yemen. Clearly, country risk is a big issue here. No wonder, the stock has given shareholders a bumpy ride in the past (see stock chart below).


The stock reached its high during the 07/08 oil craze and hit a bottom during the financial crisis at around 1 CAD per share. It traded up due to QE and was hit hard by the 2011 events in the arab world, when security risks increased dramatically as a result of the arab spring. It is currently trading at around 1.5 CAD per share. As discussed below, the security/political risk is real for Calvalley and can be considered the biggest risk for the company.

The stock has a tiny market capitalisation of USD 120 million and looks cheap with a trailing PE of 5 and PB of 0.6. Calvalley is not only debt free but has USD 84 million of cash and cash equivalents parked in a Canadian Bank, i.e. almost 2/3 of the market value are supported by net cash not subject to country risk! Although not a classic Ben-Graham-type of net-net play I still consider it to have some margin of safety since a typical net-net usually doesn’t have highly profitable operating assets: in 2013 the company had a Free Cash Flow to equity of USD 20 million (operating income – less capex). I would say the potential loss is limited by the Cash at the Canadian bank. It is also good to see management owning 25 percent of the company, with the bulk owned by the CEO and his family trust.

As already mentioned, security risks are real in Yemen. In its shareholder letters, Management mentions frequent supply disruptions and problems with bringing product to market due to a lack of infrastructure. The extreme natural and political climate hit the company in Q1 2014: Calvalley had a negative quarter as it could not sell any of its oil due interruptions of transportation to its pipline (by truck) that started at the end of 2013. The company even had to shut down production as it ran out of capacity to store oil. As a consequence, inventory (68,000 barrels) is up almost 100 percent from the 37,000 barrels recorded at the end of Q1 2013.

As the saying goes, you cannot have good news and a cheap stock. Over the years the market has derated Calvalley substantially as evidenced by the historic evolution of the various multiples in the table below.


The attitude of the market towards the company has changed dramatically: whereas in 2007 the market assigned an enterprise value (EV) of 77 USD per barrel of reserves for the assets of the company,  it is currently valuing the barrel of oil in the sand at 11 USD. (Note: For EV calculations I have not deducted the cash on the balance sheet, as a large cash pile is clearly necessary from an operating perspective due to the huge operational risk) – despite the fact that management has been able to increase reserves by 40 percent over this timeframe. Interestingly, the current valuation is only somewhat higher than the 9 USD per barrel recorded at the end of 2008, in the midst of the financial crisis, a time when Brent oil was trading below 50 USD per barrel – compared to 110 USD now – and credit spreads on investment-grade debt were higher than junk-bond spreads today. In some sense, therefore, it can be said that the market prices Yemen-risk higher than systemic risk at the end of 2008.


Calvalley is a high risk/high reward investment. As a consequence of the low valuation I consider the risk to be largely priced in. Even without figuring in its growth potential, the stock can double from here over the next five years. Due to the recent disruptions however, negative price performance in the short term is highly likely. In a world of central-bank-depressed risk premiums an asset where risk is fully priced in is rare and attractive. Therefore I have initiated a small position for my portfolio. As always, this is not a recomendation to buy or sell stock. Do your own research!

Cisco Follow Up: CEO Chambers warns of NSA spying consequences

After having mentioned the risk in my last post, the confirmation this morning that CISCO feels the pinch from NSA-spying. Now, at least, I know why the stock looks so cheap. The link is here:

How big is the risk? I do not have the faintest idea. The bet seems to be uncorellated, though.

CISCO Systems (CSCO:US): Value in the most unlikely of all places!

This post was written before this week’s positive earnings surprise sending the stock up 7% in after hour trading, confirming in some way the low expectations built into the stock price. Read the link for details:

I wrote a few posts ago, that I was surprised to find interestingly valued companies in what I consider to be overvalued markets. This is especially true of Cisco Systems which I consider at least fairly valued. Needless to mention: in an environment where tech-stocks, some of which produce little long run benefit to society (what is Twitter good for?), are valued at absurd multiples, it is an achievement to find a fairly priced blue-chip stock. Although I am far from being a tech-geek, even I knew Cisco Systems: it is one of the leading tech companies of the world and market leader in computer network equipment (servers, routers a.s.o.) and has been around since the beginning of the internet age. The company refers to its business model as providing the “backbone” of the internet, and that metaphor is probably not too far-fetched.

Cisco: strong fundamentals at low multiples

The company has a market cap of USD 122 bn. with a liquid asset position (cash + investments) of around USD 47 bn. Total debt of the company sums up to USD 42 bn. of which USD 17 bn. are interest bearing, i.e. the company is debt free and conservatively financed. Full year revenues (2013) came in at USD 48.6 bn. and a net income of around USD 10 bn. which results in a trailing PE of around 12.5. The company started paying a dividend in 2011 and has raised it twice in the following years and currently yields a respectable 3.2 percent. The dividend is comfortably covered three times. Furthermore, the company has a policy to return 50% of its Free Cash Flow, which it estimates at USD 11.7 bn., to its shareholders via dividends and buybacks. Usually I am no fan of buybacks, but since I think the company attractively valued I am comfortable with this decision. If you include the likely buybacks, cash returned to shareholders stands at roughly 5.7% – not bad at all!

Considering that revenue growth has averaged 9.5% p.a. for the past ten years, the stock looks cheap at these multiples unless one is either willing to predict either a significant reduction in growth or a substantial reduction in profit margins – or both. Since the stock trades 30% below its Dec. 2007 high it looks as if this is what market is pricing in. It is true, growth has slowed somewhat and it stood at 8% for the past four years.  The company certainly is maturing but the pessimism looks somewhat overdone to me. The net profit margin has fluctuated between healthy 20% – 25% over the past ten years hinting at the presence of a “moat”, which seems plausible. After all, ask yourself: how likely are you to switch your server provider just because a somewhat cheaper competitor comes along? Think of all the security risks you are taking! I am no tech expert, but it feels quite well entrenched to me. Furthermore,  I also like the fact that it is also not as sexy as “social media” and hence less likely to be undercut by an irrationally acting, venture capital financed would-be entrant.

Risks: goodwill and NSA spying

Of course no investment comes without risks. In Cisco’s case I feel most uncomfortable with the numerous acquisitions it undertakes every year. Goodwill  stands at USD 32 bn. and is up from USD 12.5 bn. in 2010. Heck, it looks like a serial acquirer! It is little consolation that no major goodwill impairments had to be booked so far. I will conservatively assume that a large part of these acquisitions are really substitutes for R&D spending, which has implications for the Free Cash Flow estimate. I will (arbitrarily) assume that the goodwill has to be amortized over 10 years and that 2/3 of it constitute “maintenance capex”. If you agree with me the company specified Free Cash Flow (FCF) of USD 11.7 bn. would have to be adjusted for USD 2 bn. leading to a “adjusted” FCF of USD 9.7 bn. and a – still attractive – FCF Yield of around 8%. Obviously, this is just a rough, unscientific and arbitrary adjustment which certainly could be done better. However, it nonetheless confirms the attractive valuation.

The second biggest risk factor is purely qualitative, however certainly no less important. The fact that American internet companies have been complicit in NSA spying has angered many outside the US, especially in emerging markets such as China and Brazil. Some companies such as IBM have already felt the pinch. Whereas I do not know whether Cisco has been involved, this probably doesn’t matter as clients might grow weary of American internet companies generally. This could prove a hindrance to growth in these markets.


At these levels I consider Cisco attractively priced and have established a small position, small because I am not a tech expert and do not feel confident enough evaluating the business model. The market seems to price in a reduction in either growth or profit margins that seem excessive to me and I am willing to bet against that. This is not a recomendation to buy or sell any stock. Do your own research!

High Yield Credit Follow-Up

If you are too busy to read my recent post on Marty Fridson’s speech at the Grant’s conference…

…the following chart by JP Morgan sums it up nicely:


The chart shows how the volume of high-yield issuance leads default rates, the more bonds are issued over a cycle the higher the proportion of failing companies in the future. This chart suggests that high issuance activity leads to lower credit standards and hence higher default risk. Now, we all know that correlation is not causation but I do not think that the pattern observed is spurious. If you subscribe to this logic you should als demand higher credit risk premia as issuance volume rises. Now, in reality markets behave in the opposite way: high issuance tends to correlate with low spreads and vice versa? How can this be?

My professor at university was a “Journal of Finance”- type of guy and a firm believer in efficient markets – a respected figure in academia. I remember a discussion with him on credit cycles, such as depicted on the chart, where he was surprised by the fact that credit cycles exist, after all, the rational agent in the standard theoretical models is supposed to “look-through” all this correctly on average and take all facts (such as this chart for example) into account. Standard theory cannot explain credit cycles and conveniently assumes it is a spurious phenomenon, i.e. it doesn’t really exist. Just like bubbles do not exist. My Professor has taught me a lot and I am still grateful for the excellent education I got, but I certainly do not agree with him on this. As a consequence of our conversation and being a practical investor with a theoretical bent I thought a lot about this problem over the years.

From an Austrian perspective the mainstream view is flawed as it treats the price (i.e. the risk premia) as the result of people’s actions: the rational agent optimizes his portfolio given his preferences and the correct economic model (think distributions, risk factors a.s.o). This optimization exercise yields the market efficient price, i.e. currently record low total yields on junk debt accurately reflect likely defaults in the future. In other words: the correlation observed in the chart is entirely spurious, it is a coincidence.

According to the Austrian worldview the world is too complex for anyone to understand it (i.e. the agents either cannot know “The model” or there is none), consequently it doesn’t make sense to model them as if they optimized some model. Rather, they base their decision on prices: observed and expected prices are the BASIS of their actions – NOT the result. It was the Austrian economists who first stressed the information aspect of price.  Without true market prices, a society based on the division of labour cannot exist and, taken to the extreme, is bound to collapse. This insight allowed Mises already in 1922 in his book “Die Gemeinwirtschaft” (“Socialism” in english) to predict the failure of communism/socialism at a time when western intellectuals were exited about the “communist experiment” unfolding in Russia. Hayek took the analysis even further and ultimately received the economics Nobel Price for his work. (Not that I think much about economics Nobel winners)

As an Austrian, therefore I am not surprised to see anomalous behaviour whenever I know that non-market (i.e. central bank determined interest rates) prices influence the decisions of market participants. In product markets manipulated prices are accompanied by such phenomena as under/overproduction of goods/services. The famous queues in front of bakeries under communism come to mind. The ill effects are not limited to “real”‘ products, however: Far from it. Austrian business Cycle Theory shows that manipulated interest rates are the main driver behind boom and bust, recessions and depressions.

Consequently I DO expect the chart above to be a meaningful predictor of what is likely ahead.  Nobody, of course can predict with any scientific precision when and how the events are going to unfold. Managing these choppy waters successfully as an investor is probably better classified as art rather than science.





Warren Buffet – symptomatic for the failure of modern elites

Let me be clear: just as every value investor I admire Warren Buffett’s skills as an investor and have learned a lot reading his letters. I also appreciate his ability to express his thoughts in a witty and folksy way – it is required reading for every serious practitioner of investing. However, I prefer the Buffett of the 60-ies and 70-ies with his sharp style and willingness to tell the unpleasant truth, rather than the kind grandfather-type trying to be everybody’s darling. Rather than pointing out current developments to our political class (and I think there are a lot of things going wrong on both sides of the Atlantic), thereby using his understanding of business and reputation for the greater good, he tries to be everybody’s darling and plays into the hands of politicians urging for greater taxation of wealth and more regulation – although he must be aware of what that implies for the future.

Now, I understand that confronting general public opinion is unpleasant and requires a willingness for conflict, a willingness that certainly diminishes with age. But this is exactly what makes a person great: if not him, who can afford it, who else?

The “streetwise professor” has an excellent post on Buffett’s his recent moves from the perspective of an energy-market expert. Far for being concerned for the greater good, he shows, Buffett proposes regulation to benefit from it by squeezing the competition.

Now, that is his right and i do not hold that against him from a business perspective. As young value investors we should however recognize, that these measures limit growth and social mobility. They consequently inhibit our possibility to compound wealth accordingly. We should also not hesitate to criticize one of our idols if we think (as I do) he deserves criticism.

More worrying: there is also a certain short-sightedness to this call for more regulation in order to protect one’s spoils. To make my point short: if you think it through to its ultimate consequences, in an overregulated society social mobility is greatly inhibited and the prospect for violent revolution increases. Our global business elite, although certainly well meaning, do not seem to understand this point enough. Is this what Lenin meant when he reportedly said about the bourgeoisie: “in their greed they will sell us the ropes, with which we will hang them”? Let’s hope there are still some leaders with courage out there!

Matt Levine on the latest Bank of America accounting maze – or, why our bank accounting/regulatory rules don’t make sense (Part II)


In the last post I argued, how increasing the amount of regulation necessarily increases complexity. Furthermore, I argued that basing regulatory capital requirements on banks’ own assessments, increases complexity even further as it introduces a high dose of subjectivity (paired with conflicts of interest) resulting ultimately in arbitrary and hard to predict regulatory action.

In this post I will touch the issue of moral hazard in the current banking/regulatory framework.

No progress in the last five years addressing the moral hazard issue

The BofA story is symptomatic for the banking industry: as soon as there seems to be an opportunity to increase leverage (i.e. to reduce capital) bank management will take it. It seems nothing has changed, despite every politician on the globe preaching how we need a robust banking system. In the case of BofA passing a regulatory stress test, led management to conclude that it had USD 6.5 billion of “spare” capital. Later it turned out that the stress test capital calculations were wrong and it had to revise its decision – much to the amusement of commentators such as Matt Levine.

Now one might say it is the duty of management to maximize shareholder value and if management thinks that levering up the balance sheet is the right way to go, let it be. Generally speaking, there is nothing wrong with this view. It just ignores that banks are not entirely comparable to private companies even though bank managers love to stress they are businessmen as everyone else. The reason of course is that a substantial part of a bank’s earning power stems from government granted privileges:

  • Deposit insurance, i.e. lowering the cost of leverage thereby providing an incentive to increase it
  • Access to central bank facilities, further decreasing the cost of leverage by lowering the need for a liquidity reserve to meet outflows

Historically banks have been granted these privileges not to enhance stability, as you are thought in your mainstream-macro course, but to finance government expenditures, e.g. wars or social programmes. For example, it is widely acknowledged nowadays among historians that WWI could not have lasted that long, if the necessary funds would have had to be raised by taxation (thereby greatly reducing its popularity with the masses) instead of printing the amounts necessary (thereby deferring the cost of war) – an action which ultimately led to the abandonment of the gold standard.

Given that a large part of the economic value of a bank is due to government support, it can be argued (even if you are free market like me) that, under our current arrangements, tax-payers are legitimate stakeholders in every bank. The problem with this state of affairs, however, is that it is inherently conflicting as the interests of tax-payers and shareholders/management are diametrically opposed. So far, so good and usually this fact is widely recognized, the common view being that it is the governments (regulator’s) job to moderate this conflict with the government acting as an agent of the tax-payer. The problem is, and this is usually NOT recognized: the government is not a suitable agent as it has a symbiotic relationship with the banks! How? Simple: banks like larger leverage/balance sheets, government like more credit financing, i.e. larger balance sheets. Expanding credit and voter confidence usually go hand in hand. The interest of a government with budget deficits (are there any others?) and banks are aligned, which explains why bankers are probably the most successful lobby-group (farmers a close second), be it in Brussels or in Washington. People who are furious that bankers seem to get away with everything although they are, in the general public’s eyes, the “culprit” for the last crisis, do not understand this last point enough, in my view!

To sum it up: we live in a world where banks are expected to maximise shareholder value, just as if they were your average car producer. Since they do not pay the full cost of leverage, increasing leverage is shareholder maximizing (technically speaking: the value of the equity option increases due to higher volatility as the increased leverage doesn’t increase the cost (option strike) commensurately), which is why managers/bankers, as a rule, will usually take every chance at increasing leverage, thereby undermining the stability of the system. The regulator usually has a symbiotic relationship with the very banks it is supposed to control, which is why regulation fails more often than not. Viewed this, not much has changed in the past five years as the main rules/incentives in the system are still same.

In the next post I will touch the issue of bank accounting rules.