Friday, July 25, 2014
Foreign Investors are Fancying Japanese Stocks Again
Whether front running more easing by the BOJ or taking bets on deep valued Japanese stocks, foreign investors are starting to accumulate Japanese equities once again. The first chart below shows the 12-week moving average of foreign stock investment in Japanese equities and the trend now appears to be solidly positive. The second chart below overlays foreign investment in Japanese stocks with the 1-quarter percent change in the Nikkei. It's clear that foreign participation in the Japanese stock market plays a key role in market performance and so continued foreign investment in Japan is likely to coincide with a rising Nikkei.
The Long End of the Treasury Market Continues to Flatten, Discounting Lower Growth
We've written in the past about the ongoing bull flattening of the long end of the yield curve here and here and how, despite the name, bull flattening is hardly bullish for stocks. We revisit this topic because with today's moves in the bond market (the 10-year yield dropped by 4bps and the 30-year yield dropped by 6bps), the spread between the 30-year bond and the 10-year bond has dropped to the lowest level since the fall of 2009 (chart 1).
So what? Typically bull flattenings are a precursor to rate cuts (hence the "bull" in the term). This time, however, the backdrop could not be more different. Fed is on the cusp of ending QE with the logical next steps of draining excess reserves and raising rates. It therefore likely to be the case that the bond market is discounting structurally slower growth.
How do we know? Since treasury bonds are risk free investments, the yield can be broken down into two components, a real component and an inflation component. A term premium is also assigned to longer dated treasury bonds, but this is typically a comparatively small portion of the yield so we'll ignore it for simplicity sake. As chart 2 below shows, the real (or growth) component as measured by TIPS yields has been falling all year while the inflation component (chart 3) has been anchored. From this we can infer that the majority of the 30-10 spread compression has been due to 30-year real rates falling faster than 10-year real rates. Chart 4 below, which shows the 30-10 spread on TIPS bonds, confirms this.
While stocks have been immune to this phenomenon since the middle of 2013 (chart 5), we have our doubts as to the ability of stocks to ignore the trends in the bond market indefinitely.
So what? Typically bull flattenings are a precursor to rate cuts (hence the "bull" in the term). This time, however, the backdrop could not be more different. Fed is on the cusp of ending QE with the logical next steps of draining excess reserves and raising rates. It therefore likely to be the case that the bond market is discounting structurally slower growth.
How do we know? Since treasury bonds are risk free investments, the yield can be broken down into two components, a real component and an inflation component. A term premium is also assigned to longer dated treasury bonds, but this is typically a comparatively small portion of the yield so we'll ignore it for simplicity sake. As chart 2 below shows, the real (or growth) component as measured by TIPS yields has been falling all year while the inflation component (chart 3) has been anchored. From this we can infer that the majority of the 30-10 spread compression has been due to 30-year real rates falling faster than 10-year real rates. Chart 4 below, which shows the 30-10 spread on TIPS bonds, confirms this.
While stocks have been immune to this phenomenon since the middle of 2013 (chart 5), we have our doubts as to the ability of stocks to ignore the trends in the bond market indefinitely.
Why Intangibles Matter - An Amazon Case Study
Much has been made of the fact that Amazon had a $126 million dollar loss in the second quarter even though revenues were an astounding $19.34 billion. How in the world is a company not profitable when revenues are approaching $20 billion on a quarterly basis? Because simply outdated accounting standards treat intangible investments as expenses which reduces current profit.
Amazon has been squarely focused on expanding over the past few years and we would argue they have been very successful as they have realized a least squares sales growth rate of 31% annually over the past five years. In order for this growth to take place, they have significantly increased both their tangible investments (i.e. more warehouses closer to more consumers to reduce shipping time) as well as intangible investments (i.e. developing new products such as the FireTV, Fire phone, unlimited kindle subscription service, and introducing Sunday delivery to 15 US cities). We can see this increased focus on long-term investing clearly in their financial statements:
Capex as a % of Sales - Current level is 3x what it was in 2007
R&D as a % of Sales - Current level is 2x what it was in 2009
Firm Specific Resources as a % of Sales - Other intangible investments have also been increasing
You can also see their long-term focus show up on their balance sheet. Intangible-adjusted long-term assets as a % of sales have increased from around 34% in 2007 to 49.9% currently.
Both traditional and intangible assets have increased as a percent of total assets as well.
Intangible-Adjusted Property, Plant & Equipment as a % of Assets
Intangible-Adjusted Intellectual Property as a % of Assets
They have paid for these investments by slightly increasing their long-term debt over the past few years as well as using up some of their cash on their balance sheet. Overall though, Amazon continues to have a very liquid balance sheet.
Intangible-Adjusted Long-Term Debt as a % of Capital
Intangible-Adjusted Cash as a % of Capital
Now we can see how much these long-term investments affect Amazon's bottom line from a traditional accounting standpoint that treats intangibles investments as current expenses rather than as an capitalized long-term asset that depreciates over time like a tangible investment. In this next section we are going to toggle back and forth from "as reported" data to "intangible-adjusted" data to clearly highlight the effects of the differences in accounting treatments.
Amazon's gross margin has actually been on the rise over the past few years.
However, their as reported net margin is pitiful at 0.4%. However, when intangibles are properly capitalized it rises to a much more respectable 8.4%.
Amazon's operating cash flow as a % of sales is 7.4% using reported data. However, their intangible-adjusted OCF as a % of sales increases to over 21%.
All of their profitability ratios change dramatically for the better when intangibles are properly capitalized as well.
ROA increased from 0.7% to 10.5%
ROE increases from 2.8% to 21.9%
And ROIC increases from 1.8% to 18.6%
Finally, let's take a look at how different valuations look for Amazon from an intangible perspective.
From a Price to Sales perspective, and of course sales don't change whether or not you are using an intangible accounting treatment, Amazon is trading slightly below it's 10-year average of 2.3. It currently sits at 2x sales.
However, from a Price to Cash Flow and obviously a Price to Earnings perspective, Amazon looks much less expensive from intangible point of view. Amazon's reported P/E ratio is above 100x (we cap our data tables at 100x to limit outlier effects in our aggregate data series. 100x is preposterous enough and anything greater than that is simply noise in the data), however, Amazon is trading at a more respectable, if not still rich 24x P/E ratio from an intangible-adjusted perspective.
And the same story holds when looking at P/CF. As reported it stands at very high 27.9x cash flow but the intangible-adjusted ratio is only at 9.6x.
All in all, you can see that for a company that is focused more on delivery superior long-term growth than short-term accounting profits, proper accounting treatment of intangible assets is incredibly important in understanding the true nature of a firm.
Amazon has been squarely focused on expanding over the past few years and we would argue they have been very successful as they have realized a least squares sales growth rate of 31% annually over the past five years. In order for this growth to take place, they have significantly increased both their tangible investments (i.e. more warehouses closer to more consumers to reduce shipping time) as well as intangible investments (i.e. developing new products such as the FireTV, Fire phone, unlimited kindle subscription service, and introducing Sunday delivery to 15 US cities). We can see this increased focus on long-term investing clearly in their financial statements:
Capex as a % of Sales - Current level is 3x what it was in 2007
R&D as a % of Sales - Current level is 2x what it was in 2009
Firm Specific Resources as a % of Sales - Other intangible investments have also been increasing
You can also see their long-term focus show up on their balance sheet. Intangible-adjusted long-term assets as a % of sales have increased from around 34% in 2007 to 49.9% currently.
Both traditional and intangible assets have increased as a percent of total assets as well.
Intangible-Adjusted Property, Plant & Equipment as a % of Assets
Intangible-Adjusted Intellectual Property as a % of Assets
They have paid for these investments by slightly increasing their long-term debt over the past few years as well as using up some of their cash on their balance sheet. Overall though, Amazon continues to have a very liquid balance sheet.
Intangible-Adjusted Long-Term Debt as a % of Capital
Intangible-Adjusted Cash as a % of Capital
Now we can see how much these long-term investments affect Amazon's bottom line from a traditional accounting standpoint that treats intangibles investments as current expenses rather than as an capitalized long-term asset that depreciates over time like a tangible investment. In this next section we are going to toggle back and forth from "as reported" data to "intangible-adjusted" data to clearly highlight the effects of the differences in accounting treatments.
Amazon's gross margin has actually been on the rise over the past few years.
However, their as reported net margin is pitiful at 0.4%. However, when intangibles are properly capitalized it rises to a much more respectable 8.4%.
Amazon's operating cash flow as a % of sales is 7.4% using reported data. However, their intangible-adjusted OCF as a % of sales increases to over 21%.
All of their profitability ratios change dramatically for the better when intangibles are properly capitalized as well.
ROA increased from 0.7% to 10.5%
ROE increases from 2.8% to 21.9%
And ROIC increases from 1.8% to 18.6%
Finally, let's take a look at how different valuations look for Amazon from an intangible perspective.
From a Price to Sales perspective, and of course sales don't change whether or not you are using an intangible accounting treatment, Amazon is trading slightly below it's 10-year average of 2.3. It currently sits at 2x sales.
However, from a Price to Cash Flow and obviously a Price to Earnings perspective, Amazon looks much less expensive from intangible point of view. Amazon's reported P/E ratio is above 100x (we cap our data tables at 100x to limit outlier effects in our aggregate data series. 100x is preposterous enough and anything greater than that is simply noise in the data), however, Amazon is trading at a more respectable, if not still rich 24x P/E ratio from an intangible-adjusted perspective.
And the same story holds when looking at P/CF. As reported it stands at very high 27.9x cash flow but the intangible-adjusted ratio is only at 9.6x.
All in all, you can see that for a company that is focused more on delivery superior long-term growth than short-term accounting profits, proper accounting treatment of intangible assets is incredibly important in understanding the true nature of a firm.
European Pharmaceuticals Continue Outperformance, Remain Tres Cher
As discussed in yesterday's quarterly investor call (see here for a recap), the counter-cyclicals (and the growth counter-cyclicals, in particular) are currently the most attractive group in MSCI Europe. Regular readers know that one of our favorite, knowledge-rich, heavy r&d investing groups is the Pharmaceutical sub-industry. So how are the constituents performing relative to the MSCI World?
For the most part, uptrends are intact in our point-and-figure charts:
A few names have suffered setbacks, however:
Overall, valuations remain some of the highest in all of MSCI Europe:
For the most part, uptrends are intact in our point-and-figure charts:
A few names have suffered setbacks, however:
Overall, valuations remain some of the highest in all of MSCI Europe:
The team has posted a new video: “Investing in a Late Cycle Environment”
Yesterday our Portfolio Manager Steve Vannelli hosted a conference call. Here’s a video recap of what he said about the economy, global equities, and more ...
Thursday, July 24, 2014
A Tick Up In German Credit Default Swaps
Given recent drama among Portuguese financial institutions, we are not especially surprised to see an uptick in the yield on credit default swaps (CDSs):
What is a little more surprising is the move up--small though it may be (so far, anyway)--in CDS for Germany, aka the region's strongest economy:
Whether or not this can be linked to recent weakness in the common currency is up for debate. However, it is interesting to note the relationship over the last few years where the two tend to move in opposite directions-- i.e. the euro falls as CDS rise and vice versa:
Will German CDS continue to rise as the euro tests support at 1.35 (having fallen below its 50- and 200-day moving averages earlier this summer-- see here)?
What is a little more surprising is the move up--small though it may be (so far, anyway)--in CDS for Germany, aka the region's strongest economy:
Whether or not this can be linked to recent weakness in the common currency is up for debate. However, it is interesting to note the relationship over the last few years where the two tend to move in opposite directions-- i.e. the euro falls as CDS rise and vice versa:
Will German CDS continue to rise as the euro tests support at 1.35 (having fallen below its 50- and 200-day moving averages earlier this summer-- see here)?
What's Wrong With The Housing Market In The South?
Prior to the Great Recession the general belief in the housing market was that there actually wasn't a national market per se but that the US housing market was an aggregation of many smaller regional and local markets. Even when this belief was tested during the national housing crisis as the US experienced a widespread decline in housing prices, the magnitude of the fall in prices varied greatly among different cities according to the Case-Shiller data (in general the greater that rise in prices pre-crisis, the greater the decline during the crisis). For example, prices in Dallas only fell by 11.2% from their highest price level while prices in Las Vegas declined by 61.7%. Dallas is now 8.1% above their pre-crisis highs while Las Vegas is still off by 43.8% from their pre-crisis high.
This brings us to June's new home sales report released today (and back to the housing starts report from last week) . The southern housing region is having a terrible year so far and it is dragging down the rest of the national housing statistics with it. This is because of the four identified regions (Northeast, South, Midwest, & West), the southern region is by far and away the largest housing market in the US. Since 1973, it has on average accounted for 46% of the total new homes sales in the US. And over the past 10 years, it has account for more than half of all new home sales.
Total new home sales declined by -8.1% in June and are now down 11.5% year-over-year. In the South, new home sales have fallen from 251K annualized at the end of last year to 209K annualized in June. Overall, new homes sales are down 17.4% year-over-year in the South. As we have noted before, the weakness in new home sales is tracking mortgage applications for purchase pretty closely.
As new home sales decline, inventory is increasing as the months' supply of houses for sale is rising. At 5.8 months, it is at it's highest level since October 2011. What is somewhat surprising is we aren't seeing an increase in the median months for sale even though it seems that there is more inventory on the market. However, it looks as though it takes time for an increase in supply to hit how long it takes to sell a home and if this past relationship holds, then the amount of time it takes to sell a house could be on the rise over the next year.
This brings us to June's new home sales report released today (and back to the housing starts report from last week) . The southern housing region is having a terrible year so far and it is dragging down the rest of the national housing statistics with it. This is because of the four identified regions (Northeast, South, Midwest, & West), the southern region is by far and away the largest housing market in the US. Since 1973, it has on average accounted for 46% of the total new homes sales in the US. And over the past 10 years, it has account for more than half of all new home sales.
Total new home sales declined by -8.1% in June and are now down 11.5% year-over-year. In the South, new home sales have fallen from 251K annualized at the end of last year to 209K annualized in June. Overall, new homes sales are down 17.4% year-over-year in the South. As we have noted before, the weakness in new home sales is tracking mortgage applications for purchase pretty closely.
As new home sales decline, inventory is increasing as the months' supply of houses for sale is rising. At 5.8 months, it is at it's highest level since October 2011. What is somewhat surprising is we aren't seeing an increase in the median months for sale even though it seems that there is more inventory on the market. However, it looks as though it takes time for an increase in supply to hit how long it takes to sell a home and if this past relationship holds, then the amount of time it takes to sell a house could be on the rise over the next year.