Insert Catchy Knight Capital Pun Here

OK, now that you've thought of a cute pun that hasn't already been used by the plethora of oh-so-creative business news agencies over the last few weeks, we can talk about the important stuff. 

Knight Capital - it's a name that most individual investors know little or nothing about. But, in reality, most mom and pop investors (like yours truly at InvestindDecoded) have probably used its services at some point in our investing lives. That is why what happened to the company on the now infamous day on August 1st is very relevant. In my opinion, the events at Knight highlight a growing issue and a fundamental challenge faced by most industries in time of rapid technological change - technology evolving faster than regulations and, in some cases, common sense can ever hope to match. 

What Does Knight Do?

Knight Capital is essentially an online market exchange for stocks, options, bonds, etc. It's not too dissimilar to the NYSE or NASDAQ in that stocks are traded on its platform as the company processes orders and matches buyers and sellers. Further, and this is important, it also acts as a market maker. This means that, in the absence of sufficient buyers when there are many sellers and vice-a-versa, it is willing to step in and provide liquidity (i.e. take the other side of the trade for a short period of time - usually a few seconds) for the stocks that come through it's platform. In other words, not only does it act like a market place matching buyers and sellers, it may also become a buyer or seller as needed. 

Knight's process is done purely electronically through algorithms, which, in theory, are being monitored by humans. The point is, electronic trading can be faster and more efficient, thereby reducing transaction costs and reducing market disruptions. 

What Happened?

On the morning of August 1st, the NYSE reported unusual trading in several stocks. Stocks were trading very erratically and had volume 10's of times their normal daily amount, in just 45 minutes. Eventually Knight came out and said that the issue was related to a technical glitch in their system.

Now, there hasn't been any official cause determined for the glitch (I'm sure the Knight programmers are hard at work pinpointing the reason). But there have been very credible theories. 

Prior to 8/1, Knight released a software update to it's market making software. As many of you IT'ers now, all software goes through a rigorous testing process prior to being released, and this was no exception. To test the release, however, Knight had created a tester to simulate what a market would look like in the real world. In other words, the tester's job was to send through fake orders through the market making software, so the market making software could do its job. The tester didn't care what it was buying or selling, or for how much. Therefore, it was losing money on essentially every trade (by buying at the ask and selling at the bid). No worries though, it's just the testing world, not the real one. 

The worries start when you release the updated software into the real world, and you don't realize that the tester is still in there. That's exactly what happened at Knight. The new release was turned on on 8/1, and the tester started doing it's job, but this time in the real world. It kept on spitting out order after order, and the market maker kept filling it, but this time with real stocks. Knight then became a market maker for the stocks and begin buying and selling them, but at exactly the wrong price so as to lose money on every trade, and there were thousands of trades done.

In the end, Knight was in for a huge load of pain. For a company that made $115 million in profit last year, it had lost $450 million in the 45 minute span. The stock went from $12 to $2, and the company's very existence was in doubt until it was able to secure financing by essentially selling a majority of itself to a group of investors.

The Risks of Technology

Knight's issues are just the latest in a series of 'technical glitches' in the marketplace. I don't think these 'glitches' are necessarily becoming more frequent, but their impacts have grown. Other examples include the Flash Crash of 2010 where the Dow Jones  experienced an almost 1000 point swing in a matter of minutes. Facebook's IPO is another example along with the BATS IPO. The key, I think, is that technology in market structure is growing much faster than regulation can keep up. I don't think high frequency algorithmic trading is necessarily a bad thing for the market (although I do doubt some of the benefits touted by some of its proponents). But if it's implemented without the proper safeguards in place, you will continue to see the Knight Capital issues occur. In the case of Knight, there was no circuit breaker switch built into the system to put an emergency stop in place. The SEC, which in some instances could cancel trades that were erroneous, and did so for a small subset at Knight, did not intervene because Knight was the only one bearing the pain of the issue. Nonetheless, it's an issue that I feel will continue to get bigger without a truly robust controls process in place to minimize the general market from technology's gremlins.

Investor Impact

As individual investors, we may not directly see the impact of this in our daily lives, and nor should we. When you place a trade in Ameritrade, E-Trade, etc., it gets filled at a reasonable price commiserate to the risk you're taking with that trade. However, issues like Knight have a larger psychological impact on confidence in the marketplace. When these types of issues continue popping up, if the pain is felt by the greater public (I think anyone who bought FB at $45 on its IPO day and couldn't close the position later felt that pain), there's definitely a down the line impact for all investors. 

What are your thoughts? 

Questions/Comments/Feedback? Please don't hesitate to let me know. Suggestions on posts you'd like to see? Let me know!

The Standard Disclaimer:
Everything I've written above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary due diligence prior to acting on any recommendations, including consulting a financial adviser.

SCOTUS: Healthcare Reform is illegal...but not really

In case you haven't heard, the Supreme Court of The United States (SCOTUS) made a ruling on 2010's Affordable Care Act (ACA) and, essentially, upheld the entire law. The crux of the case was the individual mandate, which requires all taxpayers to buy health insurance or pay a (rather nominal) annual penalty. 26 states sued to have an injunction placed on the law as, they argued, it infringed on individual an state liberties. 

But the really interesting aspect here is the rationale that SCOTUS used, and the resulting impact for you and me. I went through some of Chief Justice John Roberts comments (note that these are only his opinions and not necessarily representative of all the judges) to gain a further understanding of the ruling:

"The Anti-Injunction Act provides that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person,” 26 U. S. C. §7421(a), so that those subject to a tax must first pay it and then sue for a refund. The present challenge seeks to restrain the collection of the shared responsibility payment from those who do not comply with the individual mandate. But Congress did not intend the payment to be treated as a “tax” for purposes of the Anti-Injunction Act. The Affordable Care Act describes the payment as a “penalty,” not a “tax.” That label cannot control whether the payment is a tax for purposes of the Constitution, but it does determine the application of the Anti-Injunction Act. The Anti-Injunction Act therefore does not bar this suit." 

"The Framers knew the difference between doing something and doing nothing. They gave Congress the power to regulate commerce, not to compel it. Ignoring that distinction would undermine the principle that the Federal Government is a government of limited and enumerated powers. The individual mandate thus cannot be sustained under Congress’s power to “regulate Commerce.”

In English, Congress does NOT have the power to create commerce, and if you view the ACA in this light, the individual mandate is certainly illegal. In a democratic and capitalistic society, government should not be the one deciding what businesses should be taken and which shouldn't. The market expected the individual mandate in the law to be struck down because of this very argument. BUT, Roberts argues that, although Congress does not explicitly state it as such, the ACA is really a TAX and not forcing commerce. A grey area for sure, but that's how he looks at it. 

This is good to know, though. Next time I file my taxes, I'm going to sue the IRS using the opposite argument - forcing me to pay taxes IS forcing commerce as it's supporting the H&R Blocks of the world. I'll let you know how it goes.

"(c) Even if the mandate may reasonably be characterized as a tax, it must still comply with the Direct Tax Clause, which provides:“No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.” Art. I, §9, cl. 4. A tax on going without health insurance is not like a capitation or other direct tax under this Court’s precedents. It therefore need not be apportioned so that each State pays in proportion to its population."

Even when viewing it as a tax, the law must be reasonably applied, which the ACA is. So we're good there. 

"(b) Section 1396c gives the Secretary of Health and Human Services the authority to penalize States that choose not to participate in the Medicaid expansion by taking away their existing Medicaid funding. 42 U. S. C. §1396c...A State could hardly anticipate that Congress’s reservation of the right to “alter” or “amend” the Medicaid program included the power to transform it so dramatically. The Medicaid expansion thus violates the Constitution by threatening States with the loss of their existing Medicaid funding if they decline to comply with the expansion."

Another part of the law required states to expand Medicaid eligibility to a broader population. The government would help reimburse the cost of this expansion, but if the states chose not to comply, all Medicaid funding would be taken away. Roberts did find this part of the law illegal, but the implications are limited as this will likely get tweaked anyway. They can just take the threat of withdrawing all funding away, and it should be able to stand otherwise.

Implications for You and Me

So, what does the ruling mean for us? The first thing to realize is this is by no means the end of the fight. Gov. Romney has already said that, if elected, his first task will be to repeal the law entirely. Further, now that SCOTUS has referred to ACA as a tax, yesterday WSJ had an interesting article on how the GOP may use certain law-making provisions that allows the senate to make changes to tax law with only 50% majority, and not the 60% usually required. In other words, be ready to hear more about this. 

However, as the bill stands right now, you'll see a few changes:

• Medicare Tax Increases - For those making more than $200k/year ($250k for families), they'll have to start paying more into Medicare on their paychecks. They may also have to pay a slightly higher rate on dividend income depending on the situation. 
• Cadillac Plans - Higher taxes will be charges on so-called "Cadillac" plans - plans that have generous benefits and are given to higher level executives. The thought here is if you're getting better coverage than the rest of us, you should pay more for it, and that money should help pay for others' coverage. Many companies have already said that this provision may force them to stop offering those plans. 
• Indiividual Mandate - The big daddy - if you don't buy insurance either through your employer, exchanges set up by the states, medicaid/medicare, or privately, then, starting in 2014, you will start paying a penalty on your tax refund of $285 or 1% of your income, whichever is greater. By 2016, the penalty is $2085/family or 2.5% of income. This is the "tax" that SCOTUS is referring to. 
• Caps of HSA's - There will be official caps on HSA's. Most companies already some sort of cap, but now there will be a $2500 federal limit. There will also be a 20% penalty in misuse of HSA funds. Oh, finally, indoor tanning has already had a tax increase in place. 

My Take (Warning: This May Get Political)

My opinion on this is simple. The US Healthcare system is broken. If you don't believe me, then just look at the two charts to the right (Source: OECD/NYT). If you still don't believe me, then please call me, I'd love to hear your reasons. Therefore, something needs to be done. Now, the key is that whatever is done needs to be over-arching. It has to fundamentally change how healthcare is administered. Some things are already happening - many providers and payer are focusing on reimbursing for 'outcomes' and not 'procedures', and, although I feel that this is important, it will take time. Regulations can help speed the process along. A perfect example of this is the MLR requirements in the ACA. MLR (medical loss ratios) is the percentage of every premium dollars that is spent on paying claims. In the ACA, there is a minimum limit for the (roughly 80-85%). Although on the surface it may seem as odd, I think it will have an interesting impact on managed care companies - it will force them to focus more on their operational efficiency and manage overhead costs much more closely. This is something that I feel managed care companies have done poorly and has resulted in inflated costs for everyone.

So now that I've established the problem, the next question is what is a potential solution. The ACA is by no means perfect (I have my doubts on how these health exchanges will work depending on how they're executed). But the fundamental risk management strategy for health insurance needs to change so companies can better serve their members at reasonable cost without leaving some out in the cold and still being profitable. It's a tough balancing act, but the individual mandate tries to directly solve this in a sensible way (again, it needs to be over-arching, and that's what this is). Are there better solutions out there? I'm sure there are. Have I seen any proposed? No. So those running around yelling and screaming that this law is bad and will repeal it are basically saying either "there's a problem, I don't have a solution, so I'd rather just ignore it than use one that may work" or (even worse) "I refuse to admit there's a problem at all." That, to me, is just ludicrous.  

I'll also add that the current political climate just reinforces this argument. Politicians right now just don't get it. They seem to think that sticking to their bases and moving more to the left or the right is what the country needs. The national debt ceiling debacle last year was a perfect example of this. What they don't understand is that people elect them for a more important reason - to actually get things done. Instead of coming together and making compromises, they choose to move apart, and if ACA does get repealed, the chances of something else getting passed is next to zero. Again, the problem will still be there, and nothing will be done about it.

So, do I like ACA? It's a solid attempt at fixing an issue, yet it has some flaws. But those flaws are not nearly severe enough to go back to square one. That is the most dangerous scenario out there.  

PS - I didn't use this in my argument anywhere, but I found this chart interesting (from the Washington Post). Even if you consider the entire ACA a tax, the size of it is actually not as large as some GOP'ers are describing them to be. 

What are your thoughts? 


Questions/Comments/Feedback? Please don't hesitate to let me know. Suggestions on posts you'd like to see? Let me know!


The Standard Disclaimer:
Everything I've written above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary due diligence prior to acting on any recommendations, including consulting a financial adviser.

Behind the Ratios

The last couple posts on investingdecoded have been decidedly macro in nature. That's not necessarily a bad thing. I am a firm believer that the macro environment is an important part of investing, even if you're doing fundamental bottoms-up analysis. Nonetheless, every investor has to make sure that they are also focusing on specific fundamentals, and today I'd like to discuss one of the most common ways of doing this - multiples analysis. 

If you've never done multiples analysis, I'll try to describe it in a drastic oversimplification. Multiples analysis is essentially valuation a security (we'll focus on stocks/equities) using certain ratios designed to reveal particular aspects of the company (e.g. profitability or asset efficiency). It's very popular in the industry and you'll see many a talking heads on CNBC use multiples like P/E, EV/EBITDA, etc. in giving their assessments on particular stocks. For instance, they'll say "Stock ABC is trading at a 12x P/E while the industry is at 15x. This indicates that it is undervalued because of x, y, and z reasons and is a good buy".

But what do these multiples mean? And how should one use them? It's not as easy at it seems, and many of these multiples provide insights beyond just the number and its relation to another number. 

Popular Multiples

There's a few multiples that are particularly popular in the industry:

P/E (Price to Earnings Ratio) - Perhaps the most commonly used, this is a company's stock price divided by its net income per share (i.e. EPS). It's normally done through taking the last 4 quarters of EPS. The typical number can range anywhere from 0x to 100x (since earnings can be very volatile) but most companies will generally fall anywhere between 10-17x. 

Forward P/E (Forward Price to Earnings) - Similar to P/E except instead of taking the last 4 quarters of earnings, you take the estimated next 4 quarters of earnings. The earnings are usually estimates from sell-side analysts or your own. 

EV/EBITDA (Enterprise Value to EBITDA) - This is another commonly used multiple that takes the company's enterprise value (EV=the total market cap of the stock + debt + preferred stock + minority interest - cash). As you can see, it includes the debt and other aspects of the company's capital structure. To that end, you need to scale that to a earnings metric that includes those components. Enter EBITDA - earnings before interest, taxes, interest, depreciation & amortization. You use this ratio to compare companies that may be similar otherwise, but have a very different mix of equity and debt (i.e. differing capital structures). 

P/B (Price to Book Value) - Similar to P/E, except you replace the denominator with the book value of the company. This is generally used for companies that require a lot of productive assets on their balance sheet to generate profits (e.g. banks). It's less used for companies like technology, where the productive assets are not necessarily stated directly on the BS. 

P/CF (Price to Cash Flow) - I've mentioned in the past how important cash flow is, and this metric emphasizes this again. You can use various types of CF, assuming they're compared correctly. 

P/S (Price to Sales) - Technically this multiple isn't correct (you shouldn't compare Price, which is the stock price only to equity holders to Sales, which is distributed between equity and debt holders). But in cases where EBITDA and Net Income are negative, it can be used. 

D/P (Dividend Yield) - Less used, but it's just the last 12 months dividends divided by price. 

Seems Easy Right? Not So Much

So you take the appropriate multiple for your company and compare it to the industry. Depending on what side it falls to the industry, you have an idea of over or under-valued, right? Wrong! You need to look at multiples as just one piece of the puzzle. Is there a reason why the company is trading at a discount to P/E vs. its peers? In most cases, yes, there's a good reason. Your job is to take find those reasons and make a judgement call. 

Just as importantly, there's important drivers behind these multiples that you need to understand. Different multiples are telling you different things about the markets implied expectations for the company. Let's run through them using equations:

P/E=(1-b)*(1+g)/(r-g) where b=%age of earnings not paid out in dividends, g=earnings growth rate, and r=cost of equity capital. 

Note that the P/E makes a direct implication of what the market expects the companies earnings growth rate should be. 

P/E Forward= (1-b)/(r-g)

Same here. Forward P/E also makes a similar implication.

EV/EBITDA - There's no further breakdown required here. It is what it is.

P/B=(ROE - g)/(r-g) where ROE=return on equity=net income/total shareholder's equity (r and g are the same as above)

Here, you're making an implication of how efficiently the company utilizes shareholder's equity as well as the growth of earnings. 

P/CF=(FCFE*(1+g))/(r-g) where FCFE=free cash flow to equity and g=growth of FCFE

Here, you're making an implication on how fast the cash flows are growing. 

P/S= P/E*(Net Income/Revenue)=P/E*Profit Margin

Making an implication on how profitable the company is as well as it's earnings growth prospects (through the P/E multiple discussed earlier.

So understanding those multiples you're using is extremely important. Most people don't talk enough about what they're implying, but as a investingdecoded reader, now you know! Doing this analysis is vital in any stock analysis, so be sure to use it! Next time, we'll discuss what I feel is one of the most important ratios, but one that isn't as commonly known to layman investors. 

What are your thoughts? 

Questions/Comments/Feedback? Please don't hesitate to let me know. Suggestions on posts you'd like to see? Let me know!

The Standard Disclaimer:
Everything I've written above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary due diligence prior to acting on any recommendations, including consulting a financial adviser.

Analyzing the Jobs Picture

A few weeks ago, the US labor department released their monthly employment report for January. I wanted to talk about this today, because the number was surprisingly good and led to a strong up day in the stock market. But it's important to read deeper into the numbers and see what they mean. Yes, on the surface they were much better than expected, but, as cliched as InvestingDecoded can be, the devil is in the details. 

Understanding the Numbers

First, let's talk about what the report is and how it's calculated. First, and most important, the unemployment rate is calculated as the percentage of working age people that don't have a job but are actively looking for a job. This is key - if you're not actively looking for a job, you're not considered unemployed. Also, the government does analyze the 'underemployment', which is people that are working, but are actively searching for something better (e.g. working part time but want full-time). The labor force participation rate is the percentage of the total working population that is actively working or searching for work. It's important to look at all these numbers combined to provide a more coherent view of the country's employment picture rather than a headline number.

Finally, and this is something that's been controversial especially in January's report, is the seasonal adjustments. These adjustments are made to essentially smooth out the numbers and provide a more realistic estimate. January's report had a somewhat larger than usual adjustment, and some are saying that the gains in employment are just a function of the statistical assumptions made by the BLS in coming up with the figures (read more about that here).

So To The Numbers

Alright, so the unemployment rate fell to 8.3% as the economy created 243k jobs - well ahead of economist expectations if 140k. But in the details, you see the following information:

• The number of people working part time for economic reasons (i.e. underemployed) did not change at 8.2 million. This indicates that people aren't getting promoted from part time to full-time even though they want to and is concerning for the overall health of the job market.
• The number of long-term unemployed people (those that have been searching for 27 weeks or more) hasn't changed at 5.5 million or 42.9% of the unemployed. This shows that we still have a ways to go in adjusting our workforce to be more aligned with the skills required for the current economy. 42.9% of the unemployed in the country still don't seem to be on that path.
• The labor participation rate held steady at 63.7% - so even though there were more jobs created, it doesn't seem that the percentage of people actually working has increased. 
• The average workweek was unchanged, indicating that companies have not had to 'stretch' their employee's hours to keep up with demand. Average hourly pay increased slightly (0.2%), also indicating that employers haven't had to pay more to retain good workers. 
• In terms of where the jobs came from - a majority of the jobs came from the services sector (70k), which is typical. The manufacturing sector added 50k jobs, and the most promising part of this is that it was almost all in durable goods - which is a good indicator for the health of the overall economy. Government jobs was flat, bucking a recent trend of government layoffs. I would expect that trend to resume soon, and, frankly, I don't mind it at all. 

Conclusions

So looking deeper into the numbers, it seems that the recent report wasn't quite as promising as it seems on the surface. What I would consider the leading indicators (things like average workweek or hourly wages) didn't improve. Long-term unemployment is still an issue and points to a large part of the unemployed that are structurally present. 

Nonetheless, I think the report was still overall positive as it shows the economy continues in the right direction. I would be on the lookout for revisions for the number in the coming months. But, again, make sure you look into the details!

What are your thoughts?

Questions/Comments/Feedback?Please don't hesitate to let me know of 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

Everything I've written 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 a financial advisor.

A Sweet Opportunity?

A while back, I bought a cereal box with an interesting advertisement on it. I took a picture of it, and it's shown above. This label piqued my curiosity because I've been hearing about the debate between High Fructose Corn Syrup (HFCS) and sugar for a while now through reports on various news channels and even TV propaganda commercials. However, after seeing this label, and being the ever-curious investor, I decided to check if there's an investment opportunity to be had.

The Background and Some Stats

So I went exploring for the driving force between the use of HFCS and the dynamics of the industry. The use of HFCS began really growing in the early 80's as scientists were able to create a substitute that was very similar to cane sugar at a molecular level (see the movie 'The Informant! if you want an entertaining way to learn more). As the chart to the right shows, many people attribute the rise of obesity in America to HFCS, but the link is tenuous, and nothing has really been proven. 

 However, I think what's more meaningful is how sweeteners are used in the US as I think this will be where the investment opportunities will arise. So here are the stats I've found (source links are below):

• The average American consumes 35.7 lbs of HFCS and 44 lbs. of sugar annually
• As of 2010, sugar costs about $0.30/lb and HFCS costs $0.20/lb to buy for food makers
• Artificially added sugars to food account for nearly 16% of the average American's caloric intake. Nearly half of this is from sweetened beverages (i.e. soft drinks).
• The average soft drink has the equivalent of 10 teaspoons (that's not a typo!) of sugar in it. 

Those are the basic sugar stats. But there are also interesting stats about both sugar and corn that I think play a large role in the dynamics of the industry:

• The US is, by far, the largest producer of corn in the world with 41% being produced there (second place is China with 19%).
• Along with production, the US is also by far the largest exporter with 53.8% of the world's exported corn coming from the US. 
• The usage of corn is broken down on the chart to the left.
• The US is the 10th largest sugar producer in the world (26.8ktons/yr) with Brazil being first (455.3 ktons/yr)

The Debate Behind Usage?

The big debate behind HFCS syrup is a suspicion that many in academia as well as the general public that HFCS is not as healthy as natural cane sugar. The thought is that the body is not able to process HFCS the same way as sugar and more of it is stored as fat. Consequently, eating/drinking foods with sugar is more healthy than equivalent foods with HFCS. However, everything I've read thus far indicates that there's no concrete evidence that this is the case. Instead, the obesity epidemic may not be as much related to how much HFCS vs. sugar you consume, but how much of either you consume. The first chart above showing the consumption patterns really does make this the more plausible explanation. There's some research that suggests that the volume of sweetener (HFCS or sugar) in a given food essentially shocks your body, and, thus it isn't able to process the sweetener fast enough leading to long-term health issues. Given that the average soda can has 10 teaspoons of sweetener in it, I would think that this seems more plausible. 

Nonetheless, the debate is still alive and well, and I think it will continue to be for a while. But why are some companies switching to sugar now? And why are some not?

Directions from Here?

I think the answer to that is marketing and cost. As you look at the statistics for corn and sugar production, you see why HFCS is cheaper than sugar to produce. This is driven by the abundance of corn produced in the US and is further the exacerbated by the farm subsidies. But as both corn exports have risen due to emerging market growth as well as the growth of ethanol usage, HFCS prices have been driven upwards. Thus, the spread between sugar and corn has narrowed to the point where companies are willing to take in the extra cost (which now only comes out to be 1-2cents per 2 liter soda bottle) to be able to market themselves as HFCS free. I think another driver is the fact that the FDA has stated that HFCS is no longer considered a 'natural' product and any product considering itself 'natural' should no longer use HFCS. 

Going forward, I think the re-emergence of sugar will continue, but not on a mass scale. Indira Nooyi of PepsiCo has already stated that they have no plans to switch mainstream products to sugar as their researchers have not been able to find any health advantages. Plus, the volatility of the sugar markets and the government's obvious support for the corn industry play a big role in keeping it the king crop in the US. Finally, as food makes up less than 10% of corn's usage, it'll be tough for food consumption alone to make a significant dent in corn usage. All these will ensure that HFCS will be a major player in the sweetener business for years to come. 

Can You Make Money Off Of This?

I think the biggest investment opportunity that lies in this space is if a major beverage maker makes a significant push into sugar. Non-beverage makers just don't use enough sweeteners to have an impact. But for beverage makers, I see 2 ways this could happen 1) there's some definitive proof that HFCS is detrimental to the body (I think this is unlikely) and/or 2) there is a major rise in corn prices which makes the pricing spread much smaller. If this occurs, I would invest in the companies supporting the sugar industry in the US. Since most of US sugar is grown in FL and Louisiana, farm equipment companies and retailers with large presence in those regions stand to benefit. You can also look into fertilizer players or chemical companies that make products that are particularly heavily used in sugar growing. These players also would stand to benefit from a rise in corn prices should scenario 2) play out. But they could be hit hard if 1) plays out.    

The sugar/HFCS debate is an interesting one - for both health and investment reasons. Right now, I don't think there are significant investment opportunities until larger shifts occur. But, the health opportunities are there, and the change is simple - consumer less sugar/HFCS.


Source links: 1, 2, 3, 4, 5, 6, 7, 8 

What are your thoughts?

Questions/Comments/Feedback?Please don't hesitate to let me know of 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

Everything I've written 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 a financial advisor.

The Impact of ETFs

In previous posts, I've discussed the use of ETF's, and how they can be an effective way for individual investors to easily and cheaply make investment bets while simultaneously gaining instant diversification. The concept of an ETF has been hugely succesful. Just check out the graph on the left to get an idea of how popular they've really gotten. But one thing that has been bugging me for a while now is, with the prolific growth of ETF's, what is their impact on the market? Furthermore, could ETF's be at least somewhat responsible for the increase in market volatility we've seen over the last few years? Well, to help me answer these question, I went to trusty old Google and found a few papers discussing this very topic. The Kauffman Foundation has a really interesting analysis on this, and, for the most part, I agree with it. Blackrock also has a shorter (and certainly biased as it is one of the largest ETF companies in the world) paper on the subject which agrees with some of the points of the Kauffman paper. 

Some Key Highlights and My Take

The Kauffman paper is a pretty long read. But no worries, that's what InvestingDecoded is here for. In a nutshell, the paper makes the following points:

• The emergence of ETF's is detrimental to smaller capitalization companies as the trading of ETF's has an undue influence on the stock prices of these companies and takes focus away from their fundamental values. 
• Some ETF's are invested in instruments that are dangerously illiquid, which can have catastrophic consequences should severe adverse market events occur. 
• The amount of shorting occurring in ETF's is also extremely dangerous and can cause 'flash crash' like situations (see chart on right). 
• The concept that ETF's are immune from severe short-squeezes because you can 'always create new units' is a fallacy.
• ETF's likely have a greater impact on market volatility than High Frequency Trading, the more common suspect in this phenomenon 
• In terms of recommendations, the paper, among other things, recommends:
• Increased transparency on how ETF's are created and structured
• Limits on ETF shorting
• Circuit-breaker rules to prevent severe market moves
• The ability for smaller firms to opt out of inclusion in indices and, consequently, ETF's 

In general, I think the paper has some very valid points. I think the growing proliferation in ETF's has created a somewhat hidden hazard in the market. WIth an ETF, an investor can instantly pour in millions, if not billions, of dollars into a single sector or commodity. It's hard to imagine how this would not have a significant impact on the underlying assets in the ETF. As this occurs, you can potentially impact hundreds of unique assets (e.g. stocks) simultaneously, thereby driving correlations. I'm sure there are plenty of trading strategies out there based solely on making big bets on sectors/geographies/asset classes/commodities using solely ETFs. As ETF's become more liquid and prevalent, this strategies will become cheaper and more impactful to the overall markets. There's no real other way to do this type of trading as effectively. Mutual funds aren't liquid enough and can't be traded intraday. Buying such a big group of stocks/bonds/etc. on your own would be expensive and time-consuming. Other types of derivatives like options or futures can also have liquidity issues. ETF's are truly the quick hit for the markets, and that can have dangerous consequences.

Interesting Tidbits

To further illustrate this point, the Kauffman article had some very interesting tidbits of information that I think are worth pointing out. 

Here's a few of the highlights that I found particularly interesting

In common stocks, heavily shorted stocks are subject to a 'short squeeze' in which a stock's price can rapidly rise to bring out new supply that can be borrows. While 5 percent short interest is considered very high for common stocks, as of June 30, there were six ETFs with more than 100 percent short interest and at least thirteen ETFs with more than 5 percent.

Having more than 100% short interest is a scary stat no matter how you cut it. Yes you can create new units, but how many can you create? What will be the market impact? It probably won't be pretty. 

In other words, on a typical day, more than 37 percent of the entire trading value of the underlying securities trades is in a single small capitalization index ETF (IWM).


Also very interesting. It goes directly to the point that more and more of a given stock's trading is dictated by the acitivity of the ETF related to its index rather than anything related to its own dynamics (whether it be fundamentals or technicals). 

The popular SPDR gold shares, the world's largest gold ETF, holds more than 1,280 tons of bullion, more than most central banks [it's the 5th largest holder of gold in the world!]. Investors have been promised an ability to easily trade an asset whose  long history belies any notion that it is, or should be, easy to trade. Once retail investors decide it is time to sell gold, will sovereign funds stand there with outstretched hands? We think not. 

And I agree. There is a case to be had for creating liquidity where it isn't entirely appropriate to have it. 

Extending The Argument

Although I think both the articles make valid points. There are some things that I think are missing. First, I'd like to learn more about the impact of levered ETFs, the ETFs that mimic an index, but multiply its effect through use of derivatives. Wait, does that mean you're getting a derivative of a derivative? Has that been done before? Did it turn out well? Yes, Yes, and No. Think synthetic CDO's. 

Also, to prove the point in the Kauffman paper, I'd like to see a comparison of trading patterns of small cap stocks that are included in an ETF's vs. those that aren't. Although that comparison may be difficult to make, it may shed some interesting light on the impact of ETFs. 

What are your thoughts?

Questions/Comments/Feedback?Please don't hesitate to let me know of 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

Everything I've written 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 a financial advisor.

AMR's Bankruptcy - It's About Time

AMR, the parent company of American Airlines and American Eagle, filed for Ch 11 bankruptcy last week. The timing of the move is somewhat surprising considering that they company still has over $4 Billion in cash on its balance sheet. I personally thought they were going to hold out until a little later. However, looking deeper into the situation of the airline, it actually looks like a pretty shrewd, albeit still later than it should be, move.

The Motivation

The Dallas based airline is the only existing legacy carrier to never have filed for bankruptcy since the industry's 1978 deregulation. Some carriers have gone through it several times. Although initially it may seem that bankruptcy is a bad move, it can be an efficient way to clear out your obligations when business is bad (and business has been really bad for airlines for a while now). This is especially true when many of your competitors have gone through the process already, and you're left with a structural cost disadvantage. 

In the case of AMR, the company has a higher cost structure than its competitors, particularly in the labor cost arena. It also has one of the oldest fleets (I abhor flying those MD-80s) and, after a round of mergers that AMR chose not to (or couldn't) participate in, the company was in pretty bad shape. After the Delta/Northwest and UAL/Continental mergers the company was left in a danger zone of being a major carrier but still having a scale disadvantage to its major competitors (US Air is in the same boat in my opinion). So my thought is that a bankruptcy was inevitable, and management has been delusional trying to avoid it but still not making aggressive moves on neither the cost nor scale front to still be competitive. 

So, why bankruptcy now? Well, I think this question is particularly interesting considering, just a few weeks ago, AMR made the largest single aircraft order in history by buying 200 Boeing and 260 Airbus aircraft. Although it is unlikely that the bankruptcy will impact these orders, the move does give credence that the Ch 11 filing is more of a strategic move. The straw that broke the camel's back, I think, is labor negotiations. The pilot association had just rejected a new labor agreement. So, AMR, realizing that it has a wave of pilot retirements coming up, and those pilots increasingly taking the lump-sum payout (worth around $800k/pilot),  the $4B in cash was going to dwindle even more quickly. And this is an expense that AMR can much more easily reduce in bankruptcy court. 

The Fallout

So what are the impacts? You can expect to see some capacity reductions. You can also expect to see new labor contracts negotiated, and probably some planes taken out of service (they're actually still making payments on Fokker F100s that have been out of service for 5 years). Overall, you'll see an AMR that is leaner, but there shouldn't be drastic changes to the flying experience in the near future. 

The Model Going Forward

I think you'll see a few strategic changes going forward. First, AMR still has a scale disadvantage (albeit not a huge one). They're also relatively weak on Asia service. So I think a merger may be in play here. US Air might be an opportunity, although I don't think the route system commonality is there, particularly in the more profitable international travel. JetBlue is a name that's thrown around and is likely a stronger possibility as it will allow AMR to beef up its NYC presence. The recent Airbus order also addresses fleet commonality issues. The one that I think is also possible is Alaska Air. They already have a codeshare agreement. AMR doesn't have a major presence in the west, and the Alaska is solidly profitable.  

Finally, I think what you'll have to see is an AMR that's much more aggressive in managing its product. I've been a loyal AA flyer for years (and last year had their highest frequent flyer status), but it wasn't for their superior service. The planes will need to get better, the service will need to improve, and the capacity will need to grow in the long run. All of these have generally been heading the wrong direction in the 4 years I've regularly flown the airline. 

PS - I'm only saying this because a friend told me he bought Northwest Airlines stock after they declared bankruptcy, not realizing that the stockholders usually get wiped out completely, but DON'T buy AMR's stock. It's in the realm of arbitrage hedge funds now until it's value turns into a big fat zero. 

What are your thoughts?

Questions/Comments/Feedback?Please don't hesitate to let me know of 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!