Friday, September 30, 2005

The Russian Front: Oil, Putin and Prosperity

September 29, 2005 -
Putin's time ends in 2008. Will Russia's begin? I don't follow Russian markets and recently I discovered that I don’t understand the psyche of Russian people (that discovery was made after talking to my high school buddies that still reside in Russia and my capitalistic dialect is not understood well there). I don’t even have a decent inventory of hard liquor at home, a disgrace by any Russian standard (or so I've been told). And please don’t be misguided by my Russian first name and “sophisticated” Russian accent when I talk about the country.
However, I want to point out a very important but lost headline: Putin will not be running for re-election in 2008. The Russian Constitution allows the president to serve only two terms and Mr. Putin’s second term ends in 2008. Mr. Putin’s consolidation of power over the last several years--which has left the country less of a democracy and more akin to a pre-Gorbachev Russia--had convinced many that he’d seek an amendment to the Constitution to allow a third term. His decision not to amend the Constitution increased my respect for Mr. Putin exponentially--considering he is close to possessing absolute power. And as we know absolute power corrupts absolutely.
The outcome of the 2008 election scares me a little. It’ll scare me even more if oil prices return to their long-term average. The devil we know now is better than devil we don’t (though I’m not calling Mr. Putin a devil, just an expression, Mr. Russian President). Though from a western perspective, Mr. Putin’s actions were very questionable to say the least. To a certain degree we know where he stands.
Russia’s recent prosperity, funded primarily by the western world, has been driven by high energy prices. According to the CIA World Factbook, oil, natural gas, metals, and timber account for more than 80% of Russia’s exports, thus leaving the country vulnerable to swings in world energy prices.
A turn away from this prosperity could prove to be dangerous and create an even more volatile economic situation. Hungry people are not famous for making rational decisions. Arguably that is how Hitler came to power in Germany. Though on the surface this statement appears eye catching, it is a reality of Russia. I remember the time when Zherinovskiy (not much different from Hitler on many levels) ran for president opposing Yeltsin in early 90s, and he received a very large vote count, considering how extreme his positions were on political and ethnic issues.
Russia has a chance that a country gets every 30 years or so to reinvent itself. If it captures this opportunity and reinvests huge inflows of funds from oil exports into developing other industries (and Russia has plenty of engineering talent to do so), it may come out stronger at the end.
Maybe this is my Russian skepticism talking, but Mr. Putin still has two years to change his mind, as he is only 52 years old - an infant in political years (ask Senator Byrd). A large terrorist event (god forbid) happening between now and the 2008 election would certainly provide justification for him to change his mind and amend the Russian Constitution.
Why do US investors care what happens in Russia? A fair question. Political stability in Russia will insure a stable flow of energy resources out of Russia. Russia is still the among the largest nuclear powers. Russia engulfed in political unrest will be a feeding ground for terrorists looking to get their hands on nuclear weapons.
Vitaliy N. Katsenelson, CFA Copyright 2005

Wednesday, September 28, 2005

Discussion on Katrina

I have a had a very interesting discussion with David Miller, a fellow contributor to, on Federal government’s role in hurricane Katrina. David publishes Biotech Monthly and knows biotech industry inside and out. I wrote the following:
I think the Federal government is to blame in part for the level of destruction caused by the hurricane. This is not a political statement but rather an economical one; remember I am a capitalist pig (not a political one)!
There is a very good reason why insurance companies did not want to underwrite flood insurance in New Orleans. The probability of a city residing below sea level being flooded is very high, and thus private insurance companies would have had to charge premiums that would make living in New Orleans unaffordable. The Federal government was selling flood insurance below its true market cost, thus tax payers have subsidized the true cost of living in New Orleans.
In the absence of Federal government intervention, people would have thought twice about building houses in a high risk flood area, as the "market" cost of insurance would have entered into economic equation of that decision.
This unfortunately is catch up time financially, as taxpayers across the United States will be rebuilding New Orleans, and yes, this $2000 is coming from their pockets. Is it the right thing to do? Yes, we have to help our own in such an unbelievably terrible time of disaster. However, we should be mindful of what impact government actions (even those which are driven by good intentions) will have on the human behavior and the resulting externalities.
According to the WSJ, Allstate (ALL) is gradually pulling out from Florida, as local insurance bureaucrats don't allow the company to raise rates to charge local residents enough for the risk of non-recurring events - hurricanes - which “non-recur” every August and September. Allstate is a not a government entity thus it makes decisions that are arguably economically sound. David Miller responded:
If the federal government doesn't underwrite insurance in the hurricane areas, then it would also have to ignore the consequences of not being insured. Our society is simply not capable of that. If we "merely" assume the lack of subsidy would cause people to move, then the additional concentration of population in "non-at risk areas" (wherever the heck that is) has a significant (and almost always unintended or ignored) cost that also must be factored in.
I saw such unintended consequences occur in coastal Washington state when reliance on flawed science eliminated immense tracts of productive farm land from active production. Populations streamed to the cities to flee the resulting economic destruction, causing significant financial burdens. Education which, by State constitutional mandate, was funded by the proceeds from this farming has been chronically underfunded ever since (creating a downward economic spiral).
Those who make the pure capitalist/economic/whatever argument it makes no sense to rebuild New Orleans or other areas demolished by recurring natural disasters (Northridge, CA; tornado alley, nearly all river basins; etc.) naively assume it isn't a zero-sum game. Those displaced folks have to go somewhere and there is a hard dollar and economic cost to that. I replied:
David - great counter argument! Of course the lack of Federal government intervention would have changed human behavior, but then it would have been a rational decision made without outside interference. Let me run this exaggerated, but realistic example by you.
The Federal government started underwriting volcano destruction insurance and selling it at a small fraction of the cost. Towns built on the top of active volcanoes could enjoy a spectacular view of the ocean, and have become a huge tourist attraction. The land is cheap, so why not build a house? The bank will give a loan, but will require volcano destruction insurance. By this action the government has augmented human behavior transferring the cost of the insurance to tax payers, who have not reaped the full benefits of enjoying a spectacular ocean view, and at the most visited the volcano town once in awhile while staying in an overpriced bed and breakfast.
Next time you go to Florida and see a multi million-dollar villa built on the side of the ocean, remember you are paying for that with your hard earned taxes.
Oh, and one more thing...
I read in the Economist a couple days ago that recent reforms in Germany called Agenda 2010, which are pushing Germany from Socialism towards Capitalism, appear to be paying off.
All Germany had to do was remove the incentive instituted by the government for unemployed people not to look for a job. And yes, there was a side effect: it has lowered consumer confidence. But I'd rather live in the country with higher employment and less confident than other way around. David Miller responded:
OK, Vitaliy. I love the illogical extreme example so let's run with that... I'll grant you the government screwed up. With that in hand, we have a decision about those volcano dwellers. Do we let them suffer and figure it out themselves? How about prohibiting them from rebuilding there? If we prohibit them from rebuilding there, where exactly do they build that is immune from natural disaster and still allows them to economically prosper? Where could we move these hospitality industry workers that would have the appeal of volcano-top resorts?
The beach? Oops, hurricanes (or earthquakes). The river? Oops, flooding. The city? Oops, who want to get away from it all ten block up town? A "hill" in Kansas? Not exactly the same experience (and tornados).
My point is decisions repealing the "moral hazard" have a dollar cost and an opportunity cost. I am unconvinced those costs are less than what we are doing right now.
I replied: Dave this is what we do. We save them, help them and than let them decide what they want to do. However, if they want to move to the volcano land they'd have to buy insurance from the private companies that would insure a true risk. Why should you and I pay for their love of ocean views and volcanoes?
You are right! Nothing (except Colorado - that is what I keep telling my wife) is safe from natural disasters. But let people subjecting themselves to the risk of those disasters pay a true cost of those disasters. Private (as opposed to government) insurance companies will do their best to gage the risk and they'll price insurance polices accordingly.
Vitaliy N. Katsenelson, CFA Copyright

This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Approach to risk management

Our approach to risk management shows through our research process. To finish first, first you must finish. Thus looking down (for risk) often is more important than looking up (for return). In a long only portfolio there are three interrelated pillars to risk management: diversification, stock selection, and valuation. Diversification Diversification – is the only free lunch an investor will ever get, as risk reduction doesn’t need to lead to subsequent reduction in return. Taking diversification a step further, stress testing a portfolio for probable risks coming to fruition is critical, as it exposes the weakness of the portfolio in the event probability turns into reality.
Stock Selection and Valuation:
We look for three things in every stock Quality, Value, and Growth: Quality - companies don’t operate in a competitive vacuum, even the most successful will stumble at some point. Where the strong (quality) get up and regroup to move forward, weaker ones may not. These are the characteristics that define high quality companies: Sustainable Competitive Advantages – a deep moat around its business often created by strong brands, high barriers to entry, patent protection etc - allowing a company to have a leg up against competitive threats.
Predictable Earnings – companies that have high recurring revenue components usually exhibit lower sales volatility and higher predictability of their earnings and cash flows, thus have less operational risk.
Significant Free Cash Flows (operating cash flows less capital expenditures) – is very important for several reasons: first of all, these companies are usually not as capital intensive which often leads to a higher return on capital. Second, it lowers the risk of the business as the company doesn’t rely much on outside financing. Third, a great source for raising dividends and buying back stock – possibly providing an additional source of shareholder return.
High Return on Capital (and economic value added returns) far exceeding the cost of capital, another scorecard for value creation.
Strong Balance Sheets – our stock selection process usually leads to companies that underutilize debt, as companies that have high return on capital and great cash flows (usually far past their infancy stage) tend to finance their growth from their cash flows.
Value – we utilize a multi-prong approach to determine a company’s appropriate valuation. To determine direction of the value we utilize discounted cash flows. It is a great tool to measure the market expectations that are built into a stock’s valuation; also the process of going through the model is invaluable as it shows the drivers of value in the company (i.e. margins, sales growth, working capital, capital expenditures etc…) However, discounted cash flows is not exact and is very sensitive to assumptions To estimate a more appropriate valuation level, we use relative (to peers and historical valuations) and absolute valuation metrics i.e. price to earnings, price to operating cash flows and price to free cash flows.
Margin of safety – we cannot stress enough its importance for many reasons. Margin of safety provides room for disappointment. It is only a matter of time before even the best company will disappoint Wall Street. However, a company that trades at a discount to its ‘appropriate’ valuation (margin of safety) is likely to respond less violently to the disappointment. If we made a mistake in our projections for earnings growth the punishment rendered for our miscalculation is not as severe when we have a large margin of safety.
Growth – since we approach investments from a very long term perspective, often we don’t know when the market will fall in love with our companies again, in fact we love to buy stocks that have fallen out of favor. However, if companies have grown their earnings our patience will be compensated when the love affair resumes, as PE will be expanding on top of higher “E” – earnings. Key Themes: In today’s environment the following secular risk/trends are a concern to us: · Substantial slowdown in the Chinese economy and its impact on demand for US products. · Rise or fall of oil prices – our portfolios are positioned mostly to benefit from the likelihood of long-term decline in oil prices. We have some exposure to oil stocks as a hedge in case oil prices climb further or stay high. · The US housing bubble imploding and its impact on consumer discretionary spending and/or rising interest rates and their impact on the overleveraged US consumer, we are limiting our exposure to consumer discretionary stocks. · The US trade deficit causing a further decline in the US dollar - we added some high quality, very high yielding European ADRs to mitigate that risk. Outlook for the financial markets: Investors will be paying for the excesses of the last bull market for a long time. We expect the stock market to go nowhere with plenty of volatility and micro bear and bull markets in the interim. This market will require some fine-tuning to the investment strategy for even a long-term investor. “The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us”. -- Peter Bernstein There is another risk that may be even more damaging than risks described above – our emotions. Understanding “the linkage between effect and cause” helps to regain control over ones emotions. To achieve that control an investor should do the following: · Understand the companies in your portfolio. Understand the drivers of growth and the risks inherent in the business. If you don’t understand them don’t buy it. Show me an investor who understood Enron). Warren Buffett doesn’t buy companies he doesn’t understand and we advise you to do the same. · Do your own research – to be a rational investor, one needs to come to a decision on his own, not on somebody else’s advice. · Write, write, write – write down in depth your rationale for making an investment decision. This will achieve two things: it will give the clear reasons why you bought the stock in the first place. At the time when emotions are trying to get the best of you, you’ll have clear, rational thoughts on paper, making an unemotional decision a lot easier. Finally, it is easier to lie to yourself, than to the paper, writing things down forces one to be honest with oneself and rational. Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Wednesday, September 07, 2005

Merck - Back of the Envelope Analysis

I played around with Merck's financials this morning. It appears that MRK will be able to keep paying the dividend despite major blockbuster expirations (Zocor and Fosomax) without dipping substantially into its $13 billion war chest. Here is my back of the envelope analysis (excel spreadsheet). Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.