Haros Capital

My recent posts have been rather pessimistic so I thought I should post something that is looking good instead. And surprisingly (or not), it turns out to be an old brand name everyone should be familiar with, McDonald’s. Yup, old McDonald’s is currently outperforming the Dow Jones Industrial Average by a decent margin as shown below.

I can understand how McDonald’s is a defensive stock given that it is already a popular household name but I must admit I am surprised that it is behaving like a growth stock. However, I must point out that this fast food chain has been very successful in reinventing itself to keep up with the times. One example is how it started the McCafe concept to attract customers who just want a cuppa to chill outside of meal hours. This is in direct competition with outfits like Starbucks and honestly I think McCafe is giving Starbucks a good run for its money.

One personal observation over the years is that when I was a kid, McDonald’s used to be considered a luxury food place where parents will reward their kids when they behave themselves. However, these days, it seems like parents are trying hard to resist their kids’ request to go to McDonald’s (more due to its perceived junk food status) but end up going there anyway. One of the contributing factors is of course the rising affluence of parents. The other factor is the fact that the general cost of food has gone up more than the cost of a McDonald meal such that it is no longer considered a luxury food anymore. In fact, during times of economic recession, people actually turn to McDonald’s for relatively affordable food. Perhaps this explains why McDonald’s share price held up well in 2008 as shown below.

Another factor that may explain the ‘growth’ characteristic is the penetration of McDonald’s into emerging markets and I think there is still a lot of growth on this front. Recently, I just heard of someone who is interested in bringing McDonald’s to Bangladesh. Emerging countries are just experiencing what developed countries experienced during their own growth phase and if McDonald’s boomed along with that phase, it is not hard to imagine the same happening in the emerging markets with the Golden Arches being one of the recognised symbol of globalization.

When an old mature stock is behaving like a growth stock all over again, it should make one sit up and pay attention.

Disclosure: I own McDonald’s from around USD58 and I’m lovin’ it.

You be the judge.

Since the low of the recession

Since 1 year ago

Apparently, a Massachusetts pension fund is suing Hewlett-Packard directors for violating their fiduciary duties in connection with the abrupt departure of Chief Executive Mark Hurd, causing the company’s shares to fall. The lawsuit accused the directors of failing to properly disclose the existence of an internal probe into Hurd’s activities, failing to “police insider trading” by company executives, and trying to give Hurd tens of millions of dollars of severance he did not deserve. While I certainly do feel there is a case for the last one, it seems like the first two should be thrown out of the window immediately. I mean come on, there are many instances of internal probes going on in many companies at any one time, with many ending up as empty allegations or lack of sufficient evidence. In any case, would disclosing the existence of an internal probe be reason enough to cause the pension fund to sell HP shares? As for insider trading, I feel that this is something that is extremely difficult to police and I would suggest that insider trading, if any, in this case should actually have helped the pension fund to decide to cut their position in HP early. Let me explain by showing the following chart for HP’s share price.

Hurd’s resignation was announced after the August 6 stock market close resulting in the stock nosediving on the following Monday. However, if you look at the shaded boxed area, you can see that HP’s share price had actually fallen about 21% from the peak at one stage. This should have alerted any person holding on to HP shares that something is not right and that perhaps the prudent thing to do is to cut the position first, maybe even before the stock had a chance to fall 21% from the peak. Perhaps if there wasn’t any unusual behaviour in HP’s share price before the announcement on August 6, the price could have fallen by a much greater extent on that fateful Monday, to the same actual closing price. There is really nothing one can do after the announcement was made. Therefore, I would argue that the unusual behaviour before the announcement is actually a useful early warning sign and shareholders would do well to take heed.

It seems like the next “monetary easing” would be lower rates further out in the term structure since short rates can’t really go any lower. If the yield curve continues to flatten, especially if the long end also starts to come down, I would think the deflation camp would start to have their voices heard again.

June must have frustrated bulls and bears alike except for those that have decided to forget about markets and focus on the World Cup instead. Bears who shorted would have had to endure a significant rise to the middle of the month, maybe forced to cover only to see the pullback till the end of the month. Bulls on the other hand may be lured into taking long positions given the strength in the 1st half of the month, only to see losses mount as the pullback came fast and relentless. Well, let’s hope those who have chosen to focus on World Cup had a more interesting time. Meanwhile, let’s see what some macro indicators are suggesting.

The Baltic Dry Index had crashed about 46% within the space of about a month. This is reminiscent of 2008.

The Reuters/Jefferies Commodities Index seems to be rolling over in a slow fashion.

It turns out that the yield curve is in agreement with the equity market since the recession started. It predicted the recession by showing an inverted shape months before the official start of the recession. Then the short end started to drop, due to the aggressive interest rate cuts by the Fed. From March 2009, the yield curve started to steepen with the long end moving up. This coincided with the recovery of the equity market. However, April 2010 marked the turning point of the yield curve as it started to flatten as the long end came down. This also coincided with the turning point in the equity market as the downtrend started from the end of April till now.

Once again, the yield curve and equity market have proved to be leading indicators of the economy as recent economic news coming out of the US and China have started to show signs of weakening. Backward looking earning numbers have been rather stellar in the last reporting season and hence analysts’ expectations for the next season are still high. I would not be surprised to see earning numbers come in below expectations in the next reporting season. That might accelerate the next down leg that has already started in some markets and yet to start in some other markets.

Things have been turning ugly pretty quickly. I guess I do not have to repeat the headwinds that the markets are facing at the moment. But to see the impact on markets, a picture is worth a thousand words.

Euro-land crisis

Euro is in a free-fall…

PIIGS nations have entered a double dip recession as shown by Spain’s market index…

China trying to preempt property bubble… but with consequences…

Perhaps explaining why the Reuters/Jefferies CRB (commodities) Index is also falling…

Commodities dependant countries such as Australia are affected as a result…

Commodity currencies such as the AUD are also weakening…

It looks more and more like the much talked about double dip recession may be finally here.

Although the debt situation in Europe plus the Goldman Sachs fiasco is currently affecting market sentiment resulting in rising volatility, the fundamental picture is actually improving. Countries (ex PIIGS) have been announcing strong GDP growth figures as well as better than expected employment and consumption figures. Companies have also been announcing good earnings. Let’s look at the usual economic indicators to get a grasp of the general conditions.

The Baltic Dry index is still rising steadily in an uptrend. This indicates that the demand for shipping is rising and global trade is continuing to pick up.

The TED spread is still in a normal range although it has started to rise recently. The rise is probably due to the recent run-in of Goldman with the SEC leading to worries on potential impact on the US financial system. My sense is that this has more to do with public sentiment than any real systemic threat.

The yield curve is still in a normal upward sloping shape which indicates an expanding economic cycle.

As can be seen from the economic indicators above, general conditons should continue to support the uptrend in equity markets. However, the debt situation in Europe is the most probable party pooper candidate right now so let’s see how things develop further.

The following paragraphs in italics are words taken from an outstanding sportsman. He has competed in four Olympic Winter Games and was crowned Overall World Cup Champion in the sport of bobsledding. He totaled nine Crystal Globes for Overall World Cup final standings and accumulated twenty-two World Cup Medals in an outstanding bobsledding career. However, he feels his greatest sport achievement was not one particular event, but rather fourteen years of leading the Canadian Bobsleigh Team from low ranked relative obscurity to becoming a leading nation in the sport.

“Canada had one of the worst teams in the world when I first stepped onto a bobsled track. I quickly realized the difference between the best athletes in the world and myself and believed that I could develop to a level that would compete with them.

I spent years refining my skills, building teams and acquiring the proper resources that would position my team to compete with the best. In a few years, we worked our way up the ladder in World Cup competition. Eventually, we were placing in the top 10, then top 5 and soon found ourselves in a race where we could win Canada’s first World Cup medal.

We were in 3rd position following the first heat of a two-heat race. What do you think was going through my mind following the first heat of the race, knowing that we could win a medal after the completion of the second heat? What may go through your mind is how wonderful it would be to win a medal! One could think about all the newspapers and TV stations that will publicize the story! The prize money will certainly be nice! The medal sure will look great when it is hanging on the wall! Perhaps a lot of girls will be impressed with our medal winning performance! These are certainly thoughts of doom and failure! The only possibility of winning a medal in that race is absolute focus on perfect execution of the task of driving the bobsled down the track as fast as possible. The task is defined by the perfect use of the physical and psychological skills that have been developed specifically for the discipline at hand.”

What lessons can be drawn that might be applicable to the world of trading? The first lesson is that anything is possible with perseverance and hard work but the very first step is to have the right belief. This is a very subtle point that Ed Seykota was trying to make when he said that everybody gets what they want out of the market. Many novice traders started out thinking that trading is easy. This is the easiest belief to correct because they would find out very quickly that their belief is wrong. I know because I was one of them. The other beliefs are more difficult to correct because it is more fundamental. For example, some would believe that it is not possible to beat the professional traders because trading requires a lot of information that is not available unless you are one of the big boys. Therefore, such people will always be looking out for the hot tips from supposed market experts. Even when most of those tips doesn’t bear out, those that do will have a bigger psychological impact on them and they continue to look out for the next hot tip. Then there are those who believe that the market is one big casino. With this belief, they set out and trade just like they would do when they visit the casino. Invariably, the results would be due to random chance. Finally, there are those that share the same mindset as this sportsman and believe that they can develop to the level to compete with the best traders in the world. They then set out to develop themselves and acquire the necessary skills to do so, often spending years to cultivate those skills until their trading results become consistent.

The second lesson is that of focus, or rather the right thing to focus on. Notice how the sportsman was focusing on the perfect execution of the task of driving the bobsled down the track as fast as possible and not the fame that comes from winning the medal. In the financial markets, many people trade because they are thinking about the things they can do with the money that they might possibly get. However, good traders know that the money is only the by-product of good trading. So instead, they focus on the process of trading and following the rules that they set out for themselves that they know will give them an edge. More importantly, they understand that losing is part of the game and managing losses is more important than avoiding losses at all cost. This is often difficult for traders who are focusing on the money because it makes it more difficult for them to cut losses since taking losses is quite the opposite of what they have set out to do. Ironically, focusing on the money actually makes it harder to get it.

I usually do not comment on another specific fund as a rule because I think everyone is entitled to their own investment philosophy and approach. However, there is this particular fund that has recently been brought to my attention thanks to the media (hyping about their spectacular 155% return in 2009) and I felt I had to break this rule because I think they may have misrepresented themselves in their investment philosophy. I shall not reveal the fund name since this is not meant to be an attack on the fund.

First of all, I must applaud them for having the courage to post their performance on their website in such a transparent manner for all to see. Many other funds are not as transparent for reasons only best known to themselves. Their investment philosophy is also found on the website and this is what I take issue with. Actually, their philosophy is well crafted and well written. However, they may have over-promised on certain things. A central tenet of their investment approach is the margin of safety principle. This is exactly what Warren Buffett preaches. As an example, if a stock is worth $1, they will only buy it at $0.50. This is because they value capital preservation as highly as capital appreciation. This all sounds good in principle but to see whether they are really able to achieve what they say, let’s look at their performance since inception.

It is clear that they have not preserved capital in 2008. Maybe they think that unrealised losses are not the same as realised losses or maybe they think that as long as actual market prices are still below fair market value, they have not really lost capital after all. The truth however is that the market doesn’t care what individuals think about the value of an asset. The market price is the real price and that is what really matters. This is the same mentality that people take with real estate and other assets where pricing is not as transparent. They affixed a certain value in their mind and they do not care what the real market prices are for these assets. However, the reality strikes when they need cash or when they are faced with a margin call and they are forced to realise their assets at the true market value at a huge discount from their ”fair” value. This natural behavioral tendency often gives rise to a false sense of margin of safety when the only real margin of safety is to recognise that the market is bigger than any individual and that you may be right in your analysis but the market doesn’t necessarily have to agree with you and that can cause a huge amount of pain if you do not respect the market. Even Warren Buffett learnt that valuable lesson in 2008 with his near disastrous play with derivatives. The only real margin of safety you can have is to try and control how much you can lose (i.e. real capital preservation through proper risk management) and let the market give you what it wants to give.

The fund managers of this fund may have their skills in doing what they are doing but capital preservation is definitely not one of those skills. If the fund can lose 70% of the capital before, it can certainly happen again. The fund will continue to shine as long as the bull market continues but I would not count on it to deliver once the next bear market arrives. But I guess the fund will continue to attract assets because there will always be investors who think they can make hay while the sun is out and be able to get out in time when the sun sets. All I can say is good luck!

Another scam artist has been caught, article from Reuters reproduced below in italics.

West Point grad charged in $30 mln US Ponzi scheme

Tue, Mar 30, 2010
WASHINGTON, USA – A West Point graduate who claimed his knowledge of physics allowed him to predict ‘with an uncanny degree of certainty’ trends in the futures market was accused on Monday in Ohio of perpetrating a US$30 million ($42 million) Ponzi scheme.

Federal prosecutors charged Cuyahoga Falls, Ohio, resident Enrique Villalba, 47, with one count of wire fraud for allegedly scamming 26 investors out of US$29.7 million through the sale and purchase of futures contracts.

Villalba, who also has a law degree, is accused of promising investors returns of 8 to 12 percent by using a ‘Money Market Plus’ methodology and by combining his knowledge of physics with a unique ‘momentum filter,’ prosecutors said.

The complaint also charged that Villalba did not put promised ‘stop’ orders in place to prevent excessive losses and that he diverted millions of dollars in investor money to fund Rico Latte coffee shops in Ohio, to purchase real estate and to make payments to some investors.

A Ponzi scheme is one in which early investors are paid with the money of new clients.

Villalba’s attorney, J. Timothy Bender, said that his client had voluntarily contacted the U.S. Attorney’s office last August and was cooperating with authorities.

Bender said Villalba had sought to recoup investor losses through increased leverage, ‘but those attempts not only failed but generated significant additional losses,’ which he didn’t disclose.

‘Mr. Villalba takes full responsibility for his actions and wishes to express how deeply sorry he is for the harm he has caused his clients,’ Bender said. ‘Any resolution of the case will undoubtedly include an order for restitution and Mr. Villalba is resolved to do everything possible to make his clients whole.’

In addition to the criminal complaint, separate civil complaints were filed against Villalba on Monday by the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission.

The criminal case is U.S. v. Enrique F. Villalba, U.S. District Court for the Northern District of Ohio, No. 1:10-cr-00133.

It is actually very easy to put scam artists out of business by just remembering the following simple rules:

1. There is no certainty in financial markets, only probabilities
2. When someone promises you a certain rate of return, refer to rule number 1

As Clint Eastwood said, “If you want a guarantee, buy a toaster.”  But it would be naive to expect scam artists to run out of business since as Bill James said, “When I started writing I thought if I proved X was a stupid thing to do that people would stop doing X. I was wrong.” For every scam artist that is caught, I wonder how many out there get away with it. I can only do my best to remind people around me the simple rules above. You can also do the same.