I Admit It – I missed the Boat on that One

During the recent turmoil in the financial sector, there were a few companies that were particularly hit hard with massive losses (we’re talking tens of billions of dollars here). As many of you probably already know, several of those companies required huge cash infusions from the federal government to stay alive and prevent the entire financial system from collapsing. A crashing stock price was a natural consequence of these problems. Investors don’t like it when their companies need bailouts from the government.

This is exactly what happened to two of the worst culprits of the financial crisis – AIG and Citigroup. I’ve mentioned both companies several times in previous posts as some of the most severely affected names in the crisis. AIG, one of the world’s biggest insurance companies, was impacted through selling insurance policies against the very mortgage backed securities that caused the crisis. When those securities began to wither in value, it was left with billions in claims obligations from banks that it could ill afford. Citi, on the other hand, became deeply involved in the selling of mortgage backed securities. The company eventually became a hugely complex and slow-to-react institution that was unable to handle the downturn in the very products it sold.

Eventually the stock of both companies fell…and they fell hard. We’re talking declines of 95%+ from their highs. At one point, Citi was trading under $1 a share! But somehow, some way, after billions of dollars of bailout money from Uncle Sam, both companies were able to survive the crisis.

Time for the Runup

So at the height of the crisis earlier this year, both Citi and AIG were down in the dumps in terms of stock price. Eventually, after seeing some stabilization in the market, they were able to crawl back a few dollars per share. Citi went from its lows of $0.90 a share to almost $3. That’s a gain of over 300%, and the brave few that chose to invest during that time made out like bandits!

It was around that time that certain family members of mine encouraged me to buy Citi stock. Their logic was that since the company wasn’t going bankrupt, how much lower could the stock go? I thought otherwise. Forever the skeptic on huge runups that companies like this had, my thoughts were the following:

1. The government had HUGE stakes in these companies now (that’s right, fellow tax payers, you own 30%+ of Citigroup right now). This creates a huge conflict of interest for the company that many of Citi’s biggest competitors didn’t have.
2. Citi had to issue massive sums of new stock to stay alive during the crisis - meaning that the stock was so diluted, $3 could very well be a fair value for it, even if $30 was fair before.
3. This one is just common sense, the stock had already gone up 300%! How much more running room could it have?

Because of these (what I thought were logical) reasons, I refused to play with fire and buy Citi stock. Low and behold, the stock has continued to skyrocket since hitting $3 a share. In fact, it has gone up almost another 100% and is hovering around $6 a share.

Why Was I so Wrong?

OK, so I made a mistake. My family was on to something, and I missed an opportunity for an easy 100% gain. But, to me, the more important thing here is to understand where I was wrong. What did I miss about Citi that has caused the stock to go up six fold in a matter of months.

Well, what I was missing was what’s known as the ‘Short Squeeze’. This highly technical and not so much fundamental concept is when traders who are shorting the stock are forced to buy the stock in order to cover their short positions, thereby bidding up the price.

I’ve talked about shorting a few times before, but I’ll do a quick refresher. Shorting is basically betting that a stock will go down. You accomplish it by borrowing the stock from your broker and selling it. You then hope the stock will go down so you can buy it back later at a lower price. However, if the stock goes up, traders often have to buy the stock anyway to pay back their brokers and cover their losses (this is called ‘covering’ a short position). Sometimes when a stock is going up rapidly, there is a large amount of short covering that occurs, thereby driving up the stock price even higher due to the buying that must be done for the short covering. This is eventually known as a ‘short squeeze’, because the shorts are being ‘squeezed’ out of the stock and the stock price is vaulting even higher.

Well, during the worst times of the market, there was HUGE amounts of short positions on both Citi and AIG. At one point, Citi’s short ratio was 18% of float. That means that 18% of Citi’s total stock was being held as a short position – an absolutely massive amount.

Well, with that much short interest being squeezed out of the market after it became apparent that Citi and AIG would survive the downturn, the stock just rocketed up. And I totally underestimated just how short the market was on these stocks. The past few months have been a massive short squeeze for both Citi and AIG. Although there are also some more fundamental reasons for the runup, they’re few and far between.

My Lesson

So, my parents were right, and I was wrong (isn’t the first time). Citi was still a good buy at $3 a share because the short squeeze was very much still in progress. Unwinding 18% of short interest just takes some time. However, another interesting aspect here is that, because the runup in the stock is to a large extent a short squeeze, it’s not driven by fundamentals. This could very much indicate that the price is now artificially inflated and will eventually have to correct. Where that will be, I’m not sure. But maybe it’s time to actually short Citi and AIG….?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

Yet Another OPTION To Invest! (Pun Intended)

In the spirit of exposing the Investing Decoded world to new ideas and methods of investing, today I’d like to talk about options. If learning to buy stocks was like getting a bachelor’s degree, options trading is like getting a master’s. There’s a whole new layer of complexity associated with options that change the entire risk/reward profile of the instrument. In fact, I would advise most new investors to stay away from options. But at the same time, options can contain valuable information about a stock that you may already own or are thinking about buying.

What Is an Option?

Imagine that you’re looking into buying a stock (let’s just say GE for example). You’ve read all those awesome InvestingDecoded articles and have done your homework on GE. After all that, you’ve decide that GE should be up 10% by the end of the year. But there’s one slight problem, you don’t have the money to buy a significant amount of stock. Not to worry – all you have to do is take the money you have and buy a ‘call’ option for GE. The option will allow you to take advantage of upside (or downside if you buy what’s known as a ‘put’ option).

Conceptually an option is pretty simple – it’s a contract that give you the right – but not the obligation – to buy (call option) or sell (put option) a stock at a pre-determined price (the strike price). In our GE example, since you think the stock is going to go up by 10% by the end of the year, you can buy a call option that gives you the right to buy the stock.

Here’s the catch, though. Like most contracts, options eventually expire. So the option might give you the right to buy the stock at a certain price, but you will also have to ‘exercise’ that option by a certain date.

At this point you might be thoroughly confused, so let’s go through an example. Say you want to buy the GE stock because you think it’ll go up 10% to approx $17 by the end of the year, but you only have $100 to invest (not really enough to make a big impact). Instead of buying the stock itself, you start looking into buying call options for GE stock. Just like stocks, you can pull up a quote for GE options (they’re known as option chains). This option chain will show you what the various option contracts (various strike price/expiration data combinations) are trading at.

Looking at the GE option chain you can see that the December 17 Call options (meaning options that expire in December and have a $17 strike price) are trading at $0.50 per contract. This means that you can reserve the right to buy 100 shares of the stock for $17 at the 3^rd Friday of December (options contracts generally expire on the 3^rd Friday of the month and trade at 100 share increments).

So let’s say you buy a December 17 contract for GE while the stock is trading its current price of approx $14.50. As the third Friday of December approaches, if the stock is trading below $14.50 the option will likely also be worth closer and closer to $0 – until the actual expiry date, at which point it expires worthless. If you had bought the option, you would’ve lost exactly $0.50 – nothing more.

If the stock goes up as December approaches, the option will also trade higher. If the stock trades around $19, then you could expect the stock to trade more like $0.70 – that’s a 40% jump! You can then trade out of the option (sell the contract to someone else) and run. OR, you can wait until the option expires. Assuming the stock is still trading at $19, you’ll have the right to buy the stock at $17 and can then immediately turn around and sell it.

How Options Are Useful

As you can probably see by now, options can be somewhat complicated. That’s why I suggest that if you’re not wholly comfortable with them. To be honest, I tend to stay away from them myself. There are a few serious risks you should understand about them before you try your hand at them:

1. When you buy an option, all you do is own a contract – not a real asset. The contract is merely a piece of paper with an implied value. This is different from a stock where you actually own a piece of the company (a hard asset) and the dividend and voting rights that go along with them.
2. Options are used by a leveraging mechanism – they multiply the effect of a stock’s movement. This means that you can get into real dangerous situations if the stock goes the opposite way from where you expect. If the stock goes below the strike price of the call option, the option will be worthless and you'll lose 100% of your money.

But All’s Not Lost!

Even if you don’t invest in options, you can still benefit from them. This is because options can give you really good insights as to where the stock of the option is headed. For example, if on a given day there’s heavy buying for call options for a given strike/date combination, that indicates that investors are betting the stock will be going up by that date. It might be a risky bet because if it was really going up, many of the investors would probably actually buy the stock. But as an equity investor, you can look at the options of the company as a sort of barometer for where the stock is headed.

Recently I bought Ford stock (F). Since then the following article came out about a bullish sentiment on the stock based on its option activity. This is a great example of how options trading impacts the actual stocks and you, as an individual investor who doesn’t directly invest in options, can benefit!

http://messageboards.aol.com/aol/en_us/articles.php?boardId=70219&articleId=63835&func=6&channel=Money+%26+Finance&filterRead=false&filterHidden=true&filterUnhidden=false

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

Millicom (MICC) Redux

Back in the Day…

A few months ago I wrote about Millicom International Cellular (MICC) – a wireless services company that provided pre-paid mobile phone service to third world countries. Generally I recommend stocks because I feel there’s an underlying fundamental strength within the industry or company. In other words, the industry or company offers something unique that is being under-appreciated in the marketplace. This was exactly the case when I recommended MICC when it was trading at approximately $52 a share. Back then, the markets seemed to be on their way to recovery and I felt that wireless communications would be one of the first industries to recover in non-industrialized markets. I also mentioned that I felt MICC had the potential to reach $70+ and beyond based on the recovery rate of the marketplace and how much the market discounted the stock.

Where Are We Now?

Low and behold, last week MICC hit $75+ a share. If you had invested in the stock when I had wrote about it (let me know if you did, it would make my day!), you would’ve made a cool 44% in approximately 2 months – well outpacing the market and about 100 times better than any savings account in the world! Now, you may say ‘Sahil, shouldn’t I sell everything now since it has hit your price target?’ Well, like most things in investing (life?) that answer isn’t so simple. We first need to understand why MICC was able achieve this upside explosion in such a short period of time. Was the market really this wrong about the stock? Well, the main reason we saw this run-up was because the company reported profits for the last quarter that were well ahead of expectations. They basically stated the following key points about their business:

1. Number of Subscribers up 25% to 30.8 million
2. EBITDA (earnings before interest, taxes, depreciation, and amortization) up 14%
3. Free Cash flow of $59 million

I think all 3 of these points are key positive indicators for MICC and are necessary components for a company on the upswing.

Now, this surprisingly good news for MICC was even better than what I expected – yes I suspected that MICC was being given enough credit in the market for their strong business model and the many indications of economic recovery, but even I didn’t expect 44% in 2 months. I didn’t expect it to experience such a drastic recovery in its business. At the end of the day, I feel that MICC is still doing better than most people expect. I’ve now reassessed my impression of the company with the latest results and have developed a new recommendation. At the peak of the market, MICC was trading at $120+. Although I don’t think it’ll reach that point anytime soon, I am comfortable with saying that with the latest quarter’s results, I think the stock can at least get to $90. In Wall St. talk, I’m raising my price target for MICC.

This isn’t a straight endorsement to buy the stock (or not sell if you already own it), and it shouldn’t be taken as such. That really depends on your investment horizon. Short and medium term I think the stock will have a little bit of a breather. I wouldn’t be surprised to see it go down back to the $60s. But by early next year, if and when the economic recovery really begins to show signs of life, I expect to see a runup to $90. Moral of the story? Don’t jump headlong into the stock yet, but keep a very close eye on it.

Possible Downsides

There are, as always, strings attached to my recommendations. The basic assumptions I’m making here are a continuation of the recovery of the economy – especially in the international market. And don’t mistake a stock market recovery as an economic one. I really want to see fundamental economic indicators (consumer spending, GDP, manufacturing ouput, and to a lesser extent unemployment) to recover. I also am assuming that MICC will surprise the street with positive news next quarter too. The market gave it a nice shot in the arm for its last quarter, but investors are fickle, and if the good times don’t continue, the stock can hit a snag. So, with that said, I think each investor needs to make a decision on how they want to tackle MICC. If it does hit the $60s again, though, I would seriously consider buying in.

Millicom's performance vs. the S&P 500 in the last 3 months:

In case you missed my initial post on MICC, read it here:

http://investingdecoded.blogspot.com/2009/05/stock-discussion-millicom-international.html

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

An Example of The Crazy Types of ETF's Out There

Earlier this week I was browsing around the various finance sites (as nerdy as it sounds, I do this for fun) and stumbled upon an article about a new type of ETF coming to the market. Since I did a primer on ETF's a few posts ago, and one of the advantages I mentioned that they had was the ability to invest in unique assets, I felt this ETF was a perfect example of exactly that.

What's This New ETF?

The article is from thestreet.com (founded by CNBC's very own Jim Cramer). Titled 'Long-Short ETF Finally Makes It's Debut', the article describes an ETF the uses an interesting investing strategy in order to amplify returns.

There are two components to this ETF - the long and short. Although they are related in the overall strategy of the ETF, they are essentially the opposite concepts. 'Long' (aka going long or longing) is basically the investing strategy most people use - in effect it's the 'buy low and sell high'. When someone is 'going long', they are buying stock in the hope that it goes up and they can sell it at a higher price later.

Short (aka going short or shorting) is pretty much the exact opposite of going long. In this case you actually sell the stock first (usually after borrowing it from you broker) and buy it back later - hopefully at a lower price. Here, you basically 'sell high and buy low'.

So what the 'Long Short' ETF does is invest all of its assets going long. It then attempts to amplify returns by going short an additional 30% of the assets. Since you sell the stock first when going short, and thereby receive the money for the sale in cash, the fund will then invest those funds to go long an additional 30%. Overall, for every dollar the fund has, there's actually $1.60 invested ($1 long, $.3 short, $.3 long with proceeds from short). It's an interesting and risky way to amplify returns.

My $.02

LIke I mentioned earlier, I think this is an interesting investing approach. If the models being used to determine how to allocate the long and short positions is sound, you can really make some solid returns while still having a natural hedge against adverse market movements.

But before you go ahead and sink a bunch of money in this ETF, you need to understand the risks. Shorting in its basic form is a risky proposition. When you're going long, the most you can lose is 100% (the stock goes to $0). However, when you're going short, the downside is unlimited - the stock can go forever up. Furthermore, by shorting you're going against the grain. Most people still want the market to go up (esp. the companies who's stocks are on the market). As a short position holder, you're fighting that and opening up to downside risk.

To add to those risks, you're taking the proceeds from the short position to go long. So you can have a double adverse scenario if you're short position goes up and your long position goes down. In this case, not only are you losing money in the short position, you don't even have as much power to buy the short position back (called 'short covering') since the proceeds are worth less as well. This can lead to some very tricky 'rock and a hard place' type scenarios.

The bottom line here is, 1) I would never recommend anyone try this long/short strategy on their own (i.e. without investing in this ETF or other professionally managed fund). However, if you have the appropriate risk appetite and the fund proves itself to be sound, I would look into possibly investing in the fund. Assuming the models are sound, this can be an excellent way to make some serious profits. Just make sure you understand the risks! :-)



Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

Does Inflation Really Pose a Risk?

I was recently reading the Wall Street Journal (courtesy of the Agoura Hills Renaissance Hotel) and came across an interesting article by Scott Patterson titled 'Inflation Fears? Not In This Job Market'. In it he explains an interesting theory around inflation in a poor job market like the one we have today. I feel that this article is more relevant than usual for InvestingDecoded readers because inflation is a bigger issue than normal these days and can potentially impact investing strategies for you and me.

The Big Deal About Inflation Today

The reason why inflation is more important today is simple - the amount of government debt out there today. Inflation is a fairly simple concept with a lot of science behind it. All it is is the rising of prices over time. It's the reason why a Hershey's bar used to cost 5 cents and now costs $1.49. With the growth of industry, the scarcity of resources, and the increase of consumer buying power, prices tend to rise.

However, another driver for inflation is the supply of money. The theory is that the more money is available in a given economic system, the less value it has and, therefore, the more you'll need to buy things. Over the last few years, the government wars in Iraq and Afghanistan, TARP bailouts, and economic stimulation packages have literally cost the government trillions. To pay for these, the government has essentially had to increase the money supply substantially - they had to print more money on a scale not seen since WWII.

With this increased supply, there is a growing concern in the market that inflation will run rampant in the near future - thereby devaluing the buying power and earning power of consumers and corporations respectively.

What Patterson Has To Say

Scott Paterson's article, however, takes a more contrarian view on the inflation issue. His argument is that history has shown that inflation is not really a threat as long as the unemployment rate is high. The rare exceptions to this rule include the oil crisis of the 1970s. With 9.5% unemployment today, the chances of investors' worries about inflation running rampant is just not going to come through. Generally, economists feel you need a rate around 4.8% or lower before inflation can significantly accelerate. This rate is therefore known as Nonaccelerating Inflation Rate of Unemployment (NAIRU). What this says is that until the unemployment rate recovers significantly, we shouldn't really have to worry about inflation.

My Take On All This and What it Means For You

Scott Patterson actually has some very valid points. A lot has happened over the last 60 years that could easily cause inflation to skyrocket, and if his theory has held through that whole time, there a good chance that it'll hold through this time as well.

However, there are some very important caveats here. This downturn is distinctly different in both magnitude and source from all previous ones. The fact that the bedrock of the financial system was shaken like never before (e.g. Lehman Brothers survived a Civil war and 2 World Wars but couldn't survive this downturn) I feel speaks volumes. The percentage of our debt load when compared to GDP is close to the highest it has ever been. These things could easily turn Mr. Patterson's theory on its head. Therefore, although I don't think the inflation issue is huge at 9.5% unemployment, I think it'll be a big deal at something higher than what history suggests.

For us investors, this means that we need to plan for inflation in our portfolios. In other words, buy more commodities (Oil Included) and international based companies during inflationary periods. Stay away from companies that require a lot of foreign resources to make products that they sell locally (as much as I shouldn't say this, Accenture would be a good example).

Inflation is a dry and, for most people, not very interesting concept. However, in this environment of huge government spending, it has become a much bigger part of the equation for even individual investors and how they should allocate their portfolios.



Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

ETFs- The Best of Both Worlds

Since my first days of investing, I’ve had dozens of people (friends, family, colleagues, acquaintances, etc.) as me a simple question, ‘How do I invest my money?’ It’s a simple question, but an extremely loaded one. Investing is not something I think anyone should take lightly. Some people open up a trading account and invest in whatever comes to mind. Others participate in structured investment programs like 401K’s and employee stock purchase plans with little to no understanding in what they’re investing in. Both strategies, although sometimes successful, can cause major problems down the road. As I try to tell everyone, investing is something that should be taken seriously and requires time and understanding. This is your hard earned money (or at least somebody’s hard earned money), throwing it investments that are not fully understood is a dangerous proposition. Now this post isn’t meant to be an instruction manual on how to invest. Actually, that series of posts is on its way. Instead I wanted to talk about a specific tool that I recommend all relatively new investors utilize.

The ETF Concept

ETF’s (short for ‘Exchange Traded Funds’) is an investment tool that any average investor can buy into as an alternative to stocks or mutual funds. They are basically a collection of some asset like stocks, commodities, or

Bonds, broken up into little pieces and sold to investors. You might realize that this sounds somewhat like a mutual fund, and you’d be right. But there are some very important differences between ETF’s and mutual funds which make ETF’s an attractive option. Let’s go ahead and list some advantages and disadvantages:

Advantages of ETF’s Over Other Types of Investments

1. Instant Diversification – Instead of buying into a single stock, an ETF is a collection of assets (a common example is stocks). Therefore, by buying an ETF, you avoid buying a single asset and leveraging yourself out to it, thereby increasing risk. An ETF, like a mutual fund, will allow you to minimize the risks associated with buying a single stock (aka diversifiable risk) and gets you instantly diversified.
2. They Trade Like Stocks – When you buy a stock, you put in an order and the order goes through once the market is open (assuming you don’t have specific conditional orders). This generally isn’t true for mutual funds, where you have to wait a few business days for transactions to occur. ETF’s trade like stocks. You can buy and sell them instantly during market hours – thereby giving you the flexibility for more fluid trading.
3. Ability to Buy More Unique Assets – There is a large variety of ETF’s out there. There are simple ones that buy stocks of a specific industry or company size. But there’s also some more exotic ETF’s that give investors the ability to buy things like Commodities, Bonds, Real Estate, etc. There are some serious risks with these more exotic ETF’s and I’d advise you to tread carefully here.
4. Lower Costs – Because ETF’s are passively managed (i.e. the process of selecting stocks as highly automated and is based on the type of ETF you’re buying), they generally have lower fees to own them when compared to actively managed mutual funds. These costs generally run between .5% to 2%.

Disadvantages of ETF’s

1. Passive Management – Yes, they may be cheaper than mutual funds of the same category, but this advantage also has a downside. Because ETF’s are just a basket of stocks, you don’t have active managers that try to lean the fund towards the better stocks in the category. For example, if you buy an ETF that invests in stocks of financial companies (XLF), it will simply be a basket of financial stocks weighted based on the size of the company (the bigger the company, the more weighted the ETF will be towards that company). An actively managed mutual fund that invests in financial company stocks could be smarter and try to adjust its weighting based on the stronger financial companies. However, better performance from actively managed funds is obviously never guaranteed and their higher costs can often offset the benefit.

A simple ETF example is the S&P 500 ETF called the ‘Spyder’ and ticker symbol SPY. This ETF is a basket of stocks that are included in the S&P 500 index (in other words, the 500 biggest publicly traded companies). The ETF tracks very closely to the S&P 500 – so buying the ETF is like buying a piece of the S&P 500 index. Below I’ve included some details of the SPY and relevant information along with a link to the comparison graph between it and the S&P 500 itself.

Summary Details on the SPY

Comparison Chart Between the SPY and the S&P 500 since Jan 2009. Notice the almost exact correlation:

Why Should I Invest with ETF’s?

The reason is pretty simple. Most investors, especially newer ones, generally don’t know enough about individual companies in order to invest completely in them. However, the investor may understand the motivations for investing in that category (whether it be industry, region of the world, asset class, etc.) that it’s still a good idea to invest in them. Usually there’s an ETF for that category that the investor can get into at a relatively low cost.

How Do I Invest in ETF’s?

Like a mentioned before, one of the beauties of ETF’s is that they trade like stocks. This means that they have ticker symbols, and can be bought through normal investing channels like an online broker. Using the SPY example above, you can simply put an order in to buy a given number of shares of the SPY and you’ll instantly have exposure to those stocks.

What Other Kinds of ETF’s Are There?

Also like I mentioned before, there’s tons of options out there for ETF’s. There’s even one that inversely tracks the market (SH). This means that these ETF’s go up when the market goes down. If you think the economy is going to get worse, then this might be a good option for you. If that’s not enough, there’s even an ETF that has a double inverse correlation to the market. This means that if the market goes down 1%, the ETF will go up 2%. If you’re really sure the market will go down, this is an interesting option.

Comparison Chart Between Proshares Short S&P 500 (SH) and S&P 500. Notice 1-1 inverse correlation

Comparison Chart Between Proshares UltraShort S&P 500 (SDS) and S&P 500. Notice approx 2-1 inverse correlation

My point here is that there’s an option for everyone, regardless of what you want to invest in. There are some major ETF companies that create and manage the ETF’s. These include Barclays, and Morgan Stanley. To see your options in the ETF world, I suggest either going to their websites, or simply googling it. A search I did for “Africa Stock ETF’ returned 189,000 results and one of the top ones was the Africa ETF from Market Vectors (AFK)

The Bottom Line

As you can see, ETF’s provide a great alternative for investors that want to either want cheap and easy diversification in their portfolios or want to invest in more exotic assets. I highly recommend you new investors out there look into these because they you’ll be able to gain exposure to areas you’re interested even if you may not fully understand the individual companies. As you learn more, you can then look into getting into more specific companies.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

A Primer on the Airline Industry, and Why I Would Never Invest in It

As some of you already know, I have a degree in Aerospace Engineering. The choice for pursuing involved a multitude of factors, one of them being since I was a child, I was always fascinated by flying. I would sit at airports wide-eyed seeing the various aircraft scurrying around both in the air and on the ground (I’m not going to lie, I still do this today).

With this fascination, however, sprung a natural interest in the companies that owned and operated those huge aluminum beasts. Since then, I’ve followed the airline industry closely and have tried to understand in depth their operations, challenges, and ultimately, why they’re so bad at making money! Eventually I came to a basic understanding, don’t ever invest in an airline (or at least a US based one).

The Basics

I’m not going to patronize you and go into details on what airlines do – I’m going to assume everyone already knows that. One thing I do think that some people don’t realize is the sheer number of sub-operations that are required to operate an airline. The include:

1. Aircraft – Buying/Leasing/Selling, Inspecting, Maintaining, Overhauling, Field Repairs, etc.
2. Ground Operations – Managing the various offices (on airport and off), terminals and associated facilities (yes, sometimes the airlines actually own those terminals)
3. Information Technology – One of the coolest aspects of airlines. Ever wonder how your luggage gets where it needs to go when it’s among luggage from people going all over the world? It’s all IT baby (and despite people griping about it, airline baggage handling is actually a very accurate process. It’s one of the few business processes the gets even remotely close to a 6 Sigma operation).
4. Logistics – There’s a whole lot of back-end logistics that goes on for airlines. Everything from tracking a plane from origin to destination, to rerouting 100’s of flights due to a storm and accommodating the affected passengers . It’s pretty complex stuff.

There’s a bunch that I’m skipping, but you get the idea

But Herein Lies the Problem

Take a look at the list above again. Notice that pretty much all of those aspects of airlines listed are fixed costs. In other words, even if the airline wasn’t able to sell a single ticket, they would still need to pay those costs. This is known as an industry with a high capital cost structure. It just takes so much money just to run the operation, regardless of how much people actually use the product. This also relates to another concept known as an ‘exploding asset’. And exploding asset is the seat on the airplane. The airline has to pay all the costs for the plane, labor, operations, etc., to get that seat available and give it value. However, as soon as that airplane door closes, if that seat is empty, it no longer has any value. It’s an asset that (figuratively of course) explodes. Airlines have every reason to minimize empty seats – and this is the primary reason why you see flights getting overbooked – to minimize the chances of having those valuable assets ‘explode’.

There’s also a Catch-22

Even with the high fixed costs airlines would probably be able to make some money. But here’s another challenge they face. The biggest single cost for the airlines is fuel, and the cost for that fuel is directly proportional to the price of oil. In the energy markets, the price of oil generally rises when the economy is good. So when the economy is good, the costs for the airlines rise dramatically (sometimes as much as 3 times). However, the airlines can’t charge nearly enough to recover those cost increases.

In the same vain, when the economy is bad, the price for oil generally drops (in the current downturn, oil fell from a high of about $150 a barrel, all the way to $30 and is currently hovering around $70). But now the problem becomes revenue. Fewer people are flying and prices are going down. The airlines can’t catch a break either way.

Competition

Another challenge the airlines face, and this primarily applies to US based airlines is competition. Prior to the 1980’s airlines were regulated. However, since deregulation, they have started to compete more directly with each other. Unfortunately there were (and still are) way too many airlines and the industry has gone through decades of consolidation and liquidation to eliminate this competition (the most recent being the Delta/NWA merger and the ATA and Aloha Airlines bankruptcies). The high level of competition plays into the pricing power issue mentioned earlier, because even when the economy is good, airlines have trouble raising prices because they’re so heavily competitive with each other.

The Bottom Line

With the issues mentioned above, along with many others, the US Airline industry will constantly have trouble being consistently profitable – there are just too many reasons for them not to. Because of this, the industry as a whole has not made a single penny in profit in total over the last 25 or so years. As an investor, I can’t bring myself to buy into a company that faces so many consistent challenges. When pretty much all the major players have filed for bankruptcy in the last 10 years (e.g. United, US Air, Delta, Northwest), it makes it hard to stomach buying their stocks (although I think trading the stocks is still a viable option. Just don’t hold them for too long).

But All Hopes Not Lost!

Although things are bad now, I don’t think it’s the end of the world for the airline industry. Here are a few major business structure changes that I think in time will help the industry become profitable. If you see some or most of these changes happen (they probably need at least 10 years to even begin happening), you should start looking at the stocks again:

1. Continue Consolidating – We need to get rid of more of the weaker players. Some airlines that I really think need to disappear are US Air (horrendous customer service and a perpetual bankruptcy filer), and Frontier (just not big enough to compete)

2. Cut Fuel Expenses – The industry needs to work with the aircraft manufacturers to make a concerted effort to cut fuel costs. The investment needs to be made in technology so this huge burden is lessened. Boeing’s new 787 plane is a step in that direction, but is only a first step.

3. Put Emphasis Back On Customer Service – With the drastic cuts to customer service levels put in place by pretty much all the major airlines, I think there’s opportunity for airlines to use better service as a real competitive advantage. Reduce or eliminate the nickel and diming and treat your passengers with more respect and I think you’ll have a recognizable advantage that people will be willing to pay more for – thereby giving you some previous pricing power.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.