The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Earlier, I mentioned Jame’s Montier’s discussions of cyclical profit peaks and promised to post a few charts (below).  You can find the full white paper here, excerpts follow.

The key takeaway is that “GMO are firm believers in mean reversion; such record elevation in profit margins causes us much consternation.”

All charts and commentary below via Montier:

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Currently, U.S. profit margins are at record highs according to the NIPA data (see Exhibit 1). More freakish still is that these record high profit margins are coming during the weakest economic recovery in post-war history:

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Exhibit 2 shows that in simple trailing P/E terms the U.S. market isn’t actually expensive. However, the P/E is only one part of a valuation – it also depends upon the state of earnings. It is the margin component that is dragging our return forecast down. If we are incorrect on our assumption of mean reversion in profit margins, then our forecast radically alters. For instance, if instead of falling to 6% over the next 7 years margins stayed at today’s levels, our forecast would be closer to 4.5% p.a.:

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Apple is the 11th company to become the largest by market capitalization:
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click for larger graphic

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Source:
Confronting a Law Of Limits
JAMES B. STEWART
Published: February 24, 2012
http://www.nytimes.com/2012/02/25/business/apple-confronts-the-law-of-large-numbers-common-sense.html

David J. Merkel is a CFA, FSA. His forthcoming equity asset management shop is tentatively called Aleph Investments. From 2008-2010, he was the Chief Economist and Director of Research of Finacorp Securities.where he researched a wide variety of fixed income and equity securities, and trading strategies. Until 2007, he was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. From 2003-2007, he was a leading commentator at the investment website RealMoney.com.

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Recently I decided to spend some time analyzing the insurance industry.  It’s a different place today than when I became a buy-side analyst nine years ago.  Why?

First, for practical purposes, all of the insurers of credit are gone.  Yes, we have Assured Guaranty, and MBIA is limping along. Old Republic still exists. Radian and MGIC exist in reduced states.  The rest have disappeared.  In one sense, this should not have been a surprise, because the mortgage and credit guaranty businesses never had a scientific model for reserving.  I’m not even sure it is possible to have that.

Second, the title insurers are diminished.  Some, like LandAmerica are gone. Fidelity National seems to be diversifying itself out of insurance, recently buying up a restaurant chain.

Third, health insurers face an uncertain future.  Obamacare may disappear, or Obamacare could slowly eliminate insurers.  It’s a mess.

But beyond all of that, valuations are depressed across the insurance industry.  Part of that may stem from ETFs.  Insurers as a whole are smaller than the banks, but not as much smaller as they used to be.  Now, if you are a hedge fund, and you want to short banks, you probably have the best liquidity shorting a basket of financials, which shorts insurers as well.

That may be part of the issue.  There are other aspects, which I will try to address as I go through subindustries.

Offshore

By “Offshore” I mean P&C reinsurers and secondarily insurers that do business significantly in the US, and who list primarily on US exchanges, but are not based in the US.  Most of them are located in Bermuda.

In 2011, many of them were challenged by the high levels of catastrophes globally.  But the prices of the reinsurers did not fall because pricing power returned, and investors expect higher future earnings as a result.

Before I go on, I need to explain that what I will use to give a rough analysis of value is a Price-to-Book vs Return on Equity analysis [PB-ROE].  For more details, you can read my article here.  The short explanation is that companies in the insurance business (and other financials) are constrained by the amount of equity (net worth) that they have.  The ability to earn a return as a percentage of the equity [ROE] drives the market valuation as a fraction of the equity [P/B].

Here is a scatterplot for PB-ROE for the Offshore group:

Click to enlarge:

Companies above the line may be overvalued, and companies below the line may be undervalued.  ROE is what is expected by analysts for the next fiscal year, not what has been obtained in the past.

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No, not really.

I am as much of a Yelp fan as I am a Facebook fan — which is to say, not much at all. As a writer, I find the write-for-free-we’re-going-public approach of Yelp/Huff Po/Seeking Alpha utterly reprehensible.

As a gourmand — and a fat bastard — I prefer the Zagat model. There is a value to intelligent editing/curation, and that is worth paying the $25 per year to me. It also removes the gamesmanship and paid & fake reviews from the process.

I am (obviously) not a Luddite — a tech geek who loves his favorite websites, apps and gadgets. But I also recognize that the “Good Enough Revolution” as Wired called it, works great for certain audiences: College students, cash crunched, budget conscience.

However, I think that too often, we seem to be overlooking quality as well.

My issue isn’t Yelp per se — I love the massive set of choices online and mobile (I have both the Yelp and the Open Table iPhone App but hardly use either).  You can vote with your feet (or mouse, to use a quaint antiquity) if you want to go elsewhere.

My VC friends are not going to be happy with my saying this, but I wonder if $100 Million IPO makes much sense for a user generated, advertising supported model.

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Apple is disproportionately impacting indices and earnings data, skewing the picture of what is actually occurring.

WSJ:

“While most U.S. companies have struggled to meet earnings expectations, the Cupertino, Calif.-based maker of iPads and iPhones has surpassed even the most bullish of expectations, reporting $13.1 billion in profits during the fiscal 2012 first quarter that ended Dec. 31, more than double that of a year earlier. Revenue soared 73% to $46.3 billion. Those earnings account for about 6% of the S&P 500′s fourth-quarter earnings, according to S&P Indices, making Apple the biggest earnings contributor to the S&P 500.”

I have jokingly told people recently that there are 4 asset classes: Stocks, Bonds, Commodities & Apple. This article is more evidence supporting that . . .

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Source:
Apple’s Size Clouds Market
JONATHAN CHENG And BRENDAN INTINDOLA
WSJ, FEBRUARY 15, 2012
http://online.wsj.com/article/SB10001424052970204062704577223513581427728.html

Japanese 4th Q GDP declined by -0.6% Q/Q or -2.3% on an annualised basis (-3.1% on a Q/Q basis in nominal terms), much more than the decline of just -1.3% expected – net exports reduced GDP by a massive -2.6%. Growth was impacted by floods in Thailand (supply chain issues) and by weaker Global demand. The GDP deflator came in at a negative -1.6%. The only good news was that capital spending was up by +7.9%
and consumer spending rose by +1.2%.However, the overall data is yet more bad news from Japan. GDP should pick up in coming Q’s as a result of spending related to the earthquake/tsunami reconstruction spending, though I remain of the view that the Japanese economy, with the Yen at current levels, is going to suffer significantly;

Premier Wen states that China should “fine tune” economic policies as early as the 1st Q. He added that economic conditions in the 1st Q deserved attention and that quick action was necessary. Clearly, the Chinese economy is suffering (sounds like materially), the authorities are pretty concerned and are considering a mixture of policy actions (including stimulus measures/monetary easing?), with the announcement of the appropriate policy action imminently. (Source Bloomberg);

The Chinese authorities have told the country’s banks to roll over loans to local Governments, thought to amount to US$1.7tr – essentially China’s version of “kicking the can down the road” policy, which numerous countries have utilised. The obvious problem is that the vast majority of these loans can never be repaid, as the underlying projects are uneconomic. The local Governments are implicitly guaranteed by the Central authorities. Oops. (Source FT);

The Pakistani PM has been charged with contempt of Court for not
pursuing a corruption charge against the President Mr Zardari. There
have been widespread allegations of corruption by Mr Zardari – indeed,
his nickname is “Mr 10%”. However, the current problems reflect
growing tensions between the civilian Government and the military.
Pakistan has, since independence, rarely had a civilian Government
and, if the current issues escalate, may not have one again for some
time;

The Greeks passed the austerity measures in their Parliament necessary
to secure the 2nd bail out – by 199 to 74 votes – not a ringing
endorsement. However, all leaders of the main political parties have
to sign up to the measures – something that is going to be difficult.
All very, very boring stuff and Greece will both default and have to
exit the Euro Zone. The likely next PM, following impending elections,
Mr Antonis Samaras talks about renegotiating the deal following the
elections – yeah really. I think Mr Samaras is in cloud cuckoo land -
does he not understand that the Euro Zone, in particular, is totally
fed up of the Greeks and would love to get shot of them. The German’s
keep talking about the “Greeks needing to do their homework”. Well,
they wont and does that mean that they get to wear the dunce cap.

Greece exiting the Euro Zone – getting more and more convinced that it
is not a major problem (ex an initial knee jerk sell off) for the Euro
Zone;

Portuguese 10 year bond yields are down to around 12.4% – some 20bps
lower. Spanish and Italian bong yields are also lower – Italian by
more. Looks as if Spanish and Italian yields will converge. Will
Spanish yields be higher than Italian – I certainly think that they
should. Spain’s largest unions are calling for a mass protest on the
19th of this month;

Want to buy a cheap Ferrari. Well go to Italy. Early this year, an
Italian friend of mine advised me that Italian tax authorities had
raided a fashionable skiing resort in Italy and had checked out owners
of expensive car, restaurants, luxury shops etc. A week thereafter one
shop reported an increase in sales of 400% – yep that’s 400%. Italian
authorities continue to target owners of expensive cars according to
Bloomberg, who are dumping them asap. May well, go back to London via
Milan or Turin. Joking aside, an increase in tax collection will make
a significant dent – possibly even result in a balanced budget in
Italy. The IMF believe that the “black economy” is about 30% of
Italy’s GDP – who knows – however, its a big number;

Rupert Murdoch is facing additional problems in the UK. A number of
journalists, including the deputy editor, have been arrested as have
people at the Ministry of Defence and the police. Allegations of
widespread phone hacking, combined with paying off the police and
other Government departments continue to surface. The Sun newspaper is
Murdoch’s most profitable and indeed, influential newspaper. The
problem, however, could worsen much further, in particular if its
extends to the US, as the authorities could charge News Court under
the US Foreign Corrupt Practices Act. Bad news for Murdoch, as if this
does indeed happen and News Cort is found in violation of this Act,
his licences for various parts of his US media empire could be
threatened and/or cancelled. This is going to be extremely difficult
for Murdoch and, I for one, would be particularly cautious;

The UK’s Confederation of British Industry (“CBI”) sees signs that the
UK economy is improving and, indeed, they expect GDP to be positive in
the current Q, thereby avoiding a technical recession. Interestingly,
they suggest that the BoE need not increase the size of the QE
programme current Sterling 325bn, following last Thursday’s increase.
It does appear that the UK economy is improving faster than
anticipated, though GDP for the current year is forecast at a lack
luster +0.9%. The BoE has, in the past stated that they would wish any
recovery to become embedded and QE, off the table following this
round, well lets see. Having said that the BoE owns so many gilts -
over 30% when the current programme ends that it might actually be
difficult to buy any more. I suppose they could buy corporate bonds
and or mortgages etc. In any event, its too early and the BoE is one
of the most transparent of Central Banks – they will signal their
intentions nearer the time;

Asian markets are higher, though China closed flat to slightly lower.
European markets are around 1.0% higher. The miners and the A$ are
higher on the likelihood of stimulus in China – hope they climb a bit
more, as I want to add to my shorts. If the Chinese markets dont rally
on the prospect of stimulus measures……..

The Euro is strengthening on the better? Greek news – currently
US$1.3270 – still remain of the view its a great short against the
US$, especially above US$1.33. Gold is at US$1734 and spot Brent at
US$118.50 – really hate oil at these levels.

The beach is beckoning, as are the mojitos.

-Kiron

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My Washington Post Sunday Business column is out. This morning, we look at how overvalued the $100 billion dollar Facebook IPO is.

The print version had the full headline What’s Facebook worth? Much less than advertised — in the online edition, it was Less than meets the eye at Facebook.

Its based on my discovery from the Facebook S1 filing that merely clicking on a “Like” button anywhere on the internet counts you as an active user according to FB’s unique metrics.

Here’s an excerpt from the column:

“Last week, I made a surprising discovery about Facebook: It has far fewer “active” users than it claims. I learned this from a note buried deep in the company’s S1 — the IPO document it filed with the SEC in order to go public. Based on its S1, the social-networking giant’s value is probably much less than most investors seem to think.

One advantage of working in finance is that you get to meet lots of very nice, really smart people such as David Wilson, who writes the Chart of the Day column for Bloomberg. His column is my Sudoku, as I challenge myself to poke holes in the correlations it identifies between various assets. It’s good wonky fun.

On Feb. 3, the column used Facebook’s SEC data to show how fast the firm was growing. FB was becoming a “daily habit for more users,” and the numbers from the IPO filing were extraordinary: 845 million Monthly Active Users and 483 million Daily Active Users.

MAU? DAU? I had never heard of either metric, and novel accounting for public companies is always a red flag. Don’t just take my word for it, ask a Groupon investor.

I thought these metrics were suspect. If you do not have to go to Facebook.com to be counted as an active user, are the metrics misleading? I asked Wilson, who pointed to details in the S1:

“Daily Active Users (DAUs). We define a daily active user as a registered Facebook user who logged in and visited Facebook through our Web site or a mobile device, or took an action to share content or activity with his or her Facebook friends or connections via a third-party Web site that is integrated with Facebook, on a given day. We view DAUs, and DAUs as a percentage of MAUs, as measures of user engagement.”

Let me translate: If you clicked a “Like” button anywhere on the Internet, then you are a Daily Active User. Even if you never go to Facebook.com.”

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I really like that the Post used the Limericks Économiques I referenced right at the start of the column:
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click for ginormous version of print edition

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Source:
Less than meets the eye at Facebook
Barry Ritholtz
Washington Post, February 12 2012
http://www.washingtonpost.com/business/less-than-meets-the-eye-at-facebook/2012/02/09/gIQA7RtF7Q_story.html

Washington Post Sunday, February 12 2012 page G6 (PDF)

I have been arguing that $100B is rather rich for Facebook. Perusing the S1, and discussing this with Bloomberg’s Dave Wilson has further confirmed this.

Why? It has to do with what they consider a daily or monthly “user.” Indeed, this is extremely significant, because the excitement about Facebook’s reach and user base is driving valuations to levels that may be setting the company up for investor disappointment.

Consider the 843 million monthly users and the 450 million daily users. Those sound like enormous numbers — but what do they really mean?

As it turns out, there is far less to being counted as a FB user than meets the eye. If you click on a Like button any given day, you are counted by Facebook as an active user that day.

From the S-1:

Daily Active Users (DAUs). We define a daily active user as a registered Facebook user who logged in and visited Facebook through our website or a mobile device, or took an action to share content or activity with his or her Facebook friends or connections via a third-party website that is integrated with Facebook, on a given day. We view DAUs, and DAUs as a percentage of MAUs, as measures of user engagement. (emphasis added)

All of those people clicking all of those “Like” buttons are counted as active that day, EVEN IF THEY NEVER GO TO FACEBOOK.COM.

Think of what this means in terms of monetizing their “daily users.” If they click a like button but do not go to Facebook that day, they cannot be marketed to, they do not see any advertising, they cannot be sold any goods or services. All they did was take advantage of FB’s extensive infrastructure to tell their FB friends (who may or may not see what they did) that they liked something online. Period.

This helps to explain why Facebook’s annual revenue per user is so low:

Facebook – $5.02
Google $30
Netflix – $148.20

It also helps to explain why Facebook’s valuation may be so greatly exaggerated. Retired Neuberger Berman value investor and present CNBC commentator Gary Kaminsky observed that at similar multiples as Facebook, Google would be trading at $850 and Apple trading at $1250.

The question for investors: Can Facebook monetize their users at a rate 5-10X greater than what they are currently doing? If they can, their valuations are far more reasonable. If they cannot, then this is a very very expensive company.

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Valuation Issues

Source: Barron’s

Via Venturebeat, we see this massive Google revenue review:
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click for ginormous version

I love these giant long term charts. This one covers more than two centuries. It looks at long term US interest rates — the 30 year bond where available:

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Click to enlarge:

Source: What Drives The Bond Market?
Chicago CFA Handout by Bianco Research LLC
January 18, 2011