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productive, resource, and financial assets: it may be important to differentiate between them

Recs

17

February 11, 2010 – Comments (18)

My name is Checklist34.  I made an absolute fortune by betting big on financial stocks over the last 11 months.  I still think, and I do apologize for the immodesty here, that is the best call on the markets I remember reading in 2009, and maybe the most profitable.  It has, for anybody who has read my blogs over the last year, been no big secret that my portfolio is poorly diversified and massively laden with financials.  >50% in financials. 

So i'm way long financials (with some hedges).  And I am now going to make an observation about how this is a potentially significant weakness in my portfolio...  besides the obvious risk of these stocks being highly leveraged to the markets overall (another market crash would kill them once again)...  they represent a form of being long the US dollar.  I'll explain below.

I would like to, for purposes of this discussion, break equities into 3 categories.  These are productive stocks, resource stocks, and financial stocks.  I'm not 100% sure what category retail stocks would fit in, so lets just forget about those for purposes of this discussion.  Service companies are also a bit of gray area, but quite often probably fall into the "productive stocks" category.  REITs additionally represent a bit of gray area, but DO NOT fall into the "financial stocks" category as defined below.

Resource stocks are companies like TCK, or maybe AA, or FCX, or whatever.  Miners, oil companies like Exxon, a company like CHK, and so forth.  They get stuff out of the ground and so on, they derive their revenue from natural resources.  Another category of companies that I would consider adding to the resource stock list would be some agriculture companies.  Other ag companies would be productive stocks...

Productive stocks are companies like DOW or DD, or F, or MON or INTC etc etc etc etc etc.  They make stuff, they offer services at times.  Manufacturing, relevant services like those offerd by IBM etc.  Pretty simple category here as well...

Our third category, for purspoes of this discussion, is financial stocks.  The assets of these companies are generally in fiat currency, in my case for the vast majority of the financials I own, they are in $US.  US Dollars.  Their income streams, in general, are interest derived.  Banks, BDCs, insurance companies come to mind. 

 

OK, simple enough.  Now for the next part of this discussion.  Lets look at 4 companies that I own.  DOW, Dow Chemical, a produtive stock.  TCK, Teck Resources, a resource stock, and XL, XL Capital, a financial stock (insurer) and ARCC, Ares Capital, a financial stock (BDC, a lender).

DOW has revenue of about $50-60B in normalized times, that is about 0.4% of GDP.  Its assets are primarily productive ones, plants, equipment, and intellectual property.  If we experience massive inflation...  DOWs revenue is likely to remain about 0.4% ofGDP.  So the value of the dollar halves, overall economic activity goes up 10%, GDP gravitates to ~$30B, DOW is likely to bcome a $100-120B company.  all rough crappy math.  Its equity price is likely to rise with inflation in the fullness of time, as equities have for most of recorded history, eventually (its not a smooth rise certainly).

TCK has revenue in $Canadian, and produces resources.  We need steel, TCK mines coking coal, our need for that isn't likely to decline.  So like DOW, TCK is likely to rise with inflation over time.  But in this case with $CAD as its currency it may stand to respond even better than a productive company - or at least quicker - to commodity inflation.

XL has revenue from primarily fixed income sources and writing insurance premiums.  Say its book value is $25/share and the dollar gets cut in half by inflation...  That book value is now worth $12.50 in todays dollars, while DOWs revenue stream grew the value of debt assets on insurance company balance sheets will not grow with inflation but rather will depreciate in dollar terms unless held to maturity with rising interest rates.  Their ability to generate revenue by writing premiums would have ability to rise with inflation.  If a company or person is willing to pay X% now for insurance protection, they are likely to remain willing to pay x% in the future for it.  But the vast value of XLs investment book today - practically all bonds and other forms of debt - would be damaged.  XL and the insurance market in general, could raise insurance premiums fairly quickly.

ARCC has revenue, lets just say for the heck of it, only from debt.  It can generate new value from writing new loans.  In a situation where we experience rapid inflation the value of its current book would be diminished much like XLs.  And like XL it could only raise revenues over time by lending higher dollar amounts to companies.  If you are a company that has $10mil of revenue today and you need $1mil in a loan to fund growth, in our future inflationary environment you would be a $20mil company needing $2mil (10% of revenue in each case, which would buy the same things in each case).  But ARCC cannot raise the amount of loans it has out quickly at all.  Each loan is paid back in a fixed amount of $$, and that fixed amount of $$, upon the loan being repaid, is all that ARCC would have to reinvest at some future time.  So 2 of its loans made today for $1mil would be required to make one equivalent loan in our hypothetical future situation where everything has doubled in price.  

So we see here some interesting things...

First, as the dollar weakens, TCK benefits immediately.  Its product is sold in $CAD and it is first in line to see prices for its products rise.  Witness the huge spike in commodity stocks during the weak-dollar periods fo the last coupld years.  

Second, in time (however unsmooth it goes at the beginning), DOW can and would raise prices to pass inflated commodity prices on to its customers.  Probably be ugly at the beginning...  but eventually DOW would not suffer in inflation.  

Third, a company like XL could raise insurance premiums to match the now-inflated environment, but its existing book would be permanently damaged.

And last, a pure finance company like ARCC would wind up most pinched by a rapid fall in the dollar.  Because with the price and cost of everything going up its customers would require loans more more $$, and ultimately Ares would only have a fixed and fairly slow to grow amount of $$ available to itself to invest.  

So...  maybe we see a bit of a playbook for the onset of significant inflation.  When it hits you'd want to be in resource companies, then shift to productive companies as prices of resources stabilize to benefit from them getting caught up to the change  and...  holders of financial stocks may suffer during periods of rapid inflation.  

The flip side for financial stocks, of course, is that inflation would inflate the value of hard assets collateralizing their loans.  We have seen the hellish havoc that sudden deflation - and the associated drop in the value of these hard assets used as collateral - can have on financial stocks... so maybe financial stocks are difficult to own in any environment where we see rapid changes in the value of the currency in which they deal.  

But, assets used as colalteral aside, financials seem to be better suited for stable-currency or strong-currency environments than weak currency ones.  And this may be a weakness in my portfolio...  if we get strong inflation at some future time.  Which I consider basically inevitable as its the simplest way out of the national debt problem. 

And, so...  maybe we have some lessons here.  REITs > BDCs for dividend/income plays in a case where significant inflation is occuring and maybe productive dividend payers like VZ, T, or MO should also be considered in lieu of BDCs for a portion of a portfolio hoping to generate income if one expects an inflationary environment or dollar depreciation.

Something I need to consider and ponder at great length...  

18 Comments – Post Your Own

#1) On February 11, 2010 at 2:37 AM, Tastylunch (29.29) wrote:

REITs > BDCs for dividend/income plays in a case where significant inflation is occuring

Yes but not all REITS are necessarily great inflation hedges. I'd avoid Hotel and most Mall REITS in a high inflationary environment due to their abnormally high vacancy rates right now already. RevPar numbers for Hotels in particular are abysmal.

anyway there's a site I like for some REIT info, if it helps called reitwrecks.com

he makes a convincing case imo, that REITS lose much of their inflation hedge benefits if vacancy rates goes over 10%

http://www.reitwrecks.com/2009/07/reits-real-estate-inflation-hedging.html

I'm sure there is decent REIT plays out there. I dont which ones they'd be. Bill Ackman still likes General Growth and Corrections Corp of America. 

JakilatheHun alsodid quite well with them last year. I don't know if he still likes them.

Since you've previously mentioned you have farmland  directly you do have a inflation hedge asset there. If I recall correctly farmland is one of the very most heavily correlated assets to the dollar.

Props again on the killer call. Goodvibe4ever was about the only other prominent player I remember being vocal about it around then.

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#2) On February 11, 2010 at 10:25 AM, mrindependent (85.78) wrote:

Plus one rec for your insightful attempt to evaluate the impact of inevitable inflation.  I have one thing to add to this analysis:

 I believe that companies that earn high returns on invested capital will fare better than companies that earn low returns on invested capital.  My reasoning is as follows.  When inflation occurs, both revenue and expenses theoretically go up accordingly.  If both revenues and expenses go up by 5% due to inflation, then earnings will go up 5%.  Unfortunately, the amount of capital required to finance the business also goes up 5%.  If the company earns a 50% return on invested capital, this cash flow drain is no big deal because 5% is only 10% of the companies 50% profit.  If, on the other hand, the company only earns 10% returns on invested capital, then the 5% requirement to finance "inflation growth" is a HUGE ISSUE.  Suddenly 1/2 of the company's cash flow is required simply to keep up with inflation.  Free cash flow for dividends and reinvestment is constrained. 

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#3) On February 11, 2010 at 12:43 PM, devoish (98.44) wrote:

First of all, +1 rec for the thoughtful post. 

Our third category, for purspoes of this discussion, is financial stocks.  The assets of these companies are generally in fiat currency, in my case for the vast majority of the financials I own, they are in $US.  US Dollars.  Their income streams, in general, are interest derived.  Banks, BDCs, insurance companies come to mind. 

It is impressive to see how hard it is to kill this old wives tail.

 Their income streams, in general, are interest derived.  Banks, BDCs, insurance companies come to mind. 

We have just seen a financial industry implosion because the income streams of these companys were not derived from collecting interest, but from being the middle man, buying and selling interest streams.

Your version still exists, but it is important not to confuse the two. GS just did well because they out-traded somebody and also collected fees, not because they were collecting interest. Once they clean out the traders, it will be interesting to see how they change their skin.

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#4) On February 11, 2010 at 1:22 PM, checklist34 (99.71) wrote:

mrindependent, good thought and thanks for sharing it. 

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#5) On February 11, 2010 at 1:39 PM, checklist34 (99.71) wrote:

devoish, you raise a good point about some financial institutions, a very good point.  A fair bit (i honestly don't know what the ratio is) of their revenue streams come from fees, like mortgage origination fees, which are a % of the loan and as such would rise with inflation. 
Much the same as the way that an insurers premiums would rise with inflation (because if insurance is worth 1% of revenue to a business, or 2% of income to a person, it still would be in the inflated environment).  

However, and I concede that I don't konw that this is correct, that doesn't help a BDC generating all of its money from loans to private companies...  

And in any case, I think we would see a clear cycle of stock reactions to the onset of significant inflation.  Resouce stocks may well rally early, followed by A, followed by B, etc. 

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#6) On February 11, 2010 at 1:52 PM, checklist34 (99.71) wrote:

Tasty, ...  hotel reits aren't good recession hedges as increased vacancy rapidly wipes out profits, but in the fullness of time the value of a hotel room will appreciate with inflation as room rates drift higher.  Certainly hotel rooms today cost far more than 20 years ago, and that ratio is likely just as dramatic as the change in car prices or plastic prices and what not... no?  I'll look the reitwreck link over thoroughly, and thanks very much for posting it.  Looks, on a quick glance, like an interesting site.

Thanks for the compliment on the call at the bottom.  That call and subsequent action put my parents in a position to retire, and made the lives of myself and my former business parter a whole lot rosier.  Happy days.

The farmland, which I'll add to over the next couple of years until its at least 20% of my total assets, is a resource stock/productive stock hybrid and should fare well in an inflationary environment...

 

I am long a smattering of REITs, with a speculative position in GGP being by far the biggest position (I honest to god got the shares for 37 cents)... but en summe they do not comprise a significant portion of my portfolio, just 2-3%.  I hope to add to them as I sell some other things off...

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#7) On February 11, 2010 at 2:34 PM, Tastylunch (29.29) wrote:

Certainly hotel rooms today cost far more than 20 years ago, and that ratio is likely just as dramatic as the change in car prices or plastic prices and what not... no?

Typically that is correct. But the same issue that plagues Hotels is what is plaguing Retailers namely the consumer credit crunch. So there is still deflation among their tenant base if you will.It's not the recession that's the issue, it's the extreme lack of consumer credit.

Until that eases both will be plagued by over capacity and probably won't act as hedges they normally do. Because in this environment it's next to impossible for them to be able pass on rent increases.And that of course is what matters in terms of inflation hedge. (and why coal/oil etc can be pretty good ones imo, everyone still has to have it to some degree regardless of price)

Retail may have longterm specific issues, the US has something on the order  of 4 times retail sq ft per person as other developed nations. So we could very easily see a long term slog there. I don't it will necessarily crash but it will be hard for them to grow in a consumer debt crunch.

GGP is kind of a special case. I bought in at 47 cents but I chickened out and sold at about 90 cents or so. That was really stupid. :(

Hotels are interesting, I thought they'd do better than they are (weak dollar and all that) . If the US repairs their image abroad they might be able to reattract foreign tourists...But right now our Chinese friends don't seem to want to visit. :)

My best guess is Apartment REITS of the various REIT classes could be the best hedge as a group as I think Americans are moving generationally away from home ownership ( I think we hit the high water mark on that with people owning two-three homes etc in 2004-2006). Although they overcapacity issues too, it's less bad than Office, Hotel and Retail imho.I think demand will recover there first.

anyway reitwrecks is a fun blog, I think you'll like it. He thinks we've hit the the commercial rE bottom. I guess we'll see. :)

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#8) On February 11, 2010 at 6:18 PM, Option1307 (29.69) wrote:

Another stellar post, thanks for sharing your thoguhts. They are always insightful and have a nice logical flow to them.

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#9) On February 11, 2010 at 11:38 PM, checklist34 (99.71) wrote:

Tasty, the page on reitwrecks shows that in the gulf-war fueled inflation in the early 90's, reit's were actually down...

this is true, but... there was a commercial real estate crisis of epic proportions right around that basic time, the S&L crisis and all of that.   Also the war is unusual circumstances that may have an affect on travel habits and so forth. 

And I'd observe that in the long, protracted period of inflation in the first 2/3 of the oughts, REITs did quite well, probably eventually reaching bubble status around 2007ish...

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#10) On February 11, 2010 at 11:57 PM, checklist34 (99.71) wrote:

option1307, thanks very much I really appreciate it.  :)

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#11) On February 12, 2010 at 12:11 AM, Tastylunch (29.29) wrote:

checklist34

That early 90's RE market was just terrible and actually pretty comparable to now in my opinion. Much moreso than the aughts....oughts whatever they were called.

If memory serves the popularization of the REIT around that time actually was the catalyst to revive the RE market in the 90's. I think it was Schiller who said the RE market would have remain depressed for about ~7 more years if it weren't for so many new REITS flooding the market with capital.

long, protracted period of inflation in the first 2/3 of the oughts, REITs did quite well, probably eventually reaching bubble status around 2007ish..

Right but note that in time period you had three crucial things we do not have now

1) strong consumer demand/low vacancy

2) A moderate predictable level of inflation

3) strong credit markets

In my opinion this REIT market is much more like 1991-1992 than 2002. Wihtout an external capital injection, I have a hard time seeing REITS being able to pass on higher costs effectively via rent with occupancy so low.

But it is hard to know defintively since REITS do not have a very long history to observe. They've only been around since 1960 or so and they've really only been prominent since the late eighties to my knowledge.

That's my two cents anyway.

I hope Jakila comes by, he's probbaly best CAPS analyst on REITS. I'd like to hear his take, he was very bullish on them last year, but I think he's changed his stance to neutral now. Not sure.

 

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#12) On February 12, 2010 at 12:31 AM, checklist34 (99.71) wrote:

i hear you on differences between the first 2/3 of the oughts and today...

but i'd say REIT prices fairly well discount those differences, no?  I am thinking the best buys in REITs will be ...  the best yield in 3 or 5 years from todays PPS.  This means sifting through damaged units for survivors and future thrivers.  Difficult game, but ...  

I said in March to my advisor and former business partner this:  the best buys in insurers and BDCs will be book value in 2 or 3 years relative to price today.  see what i mean?  not current p/b, but price to future B. 

In the REITs case I'd say its price to future yield...  just a thought.  I don't know shit about REITs, but i've been approached by a couple private future-REITs recently who hope to buy hotels and/or apartment buildings on the cheap today for future gains.  They cal themsleves vulture funds, weird.

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#13) On February 12, 2010 at 12:46 AM, Tastylunch (29.29) wrote:

i'd say REIT prices fairly well discount those differences, no? 

Depends. You can still can get the guys who barely survived like DDR pretty cheap. But the strong players like Simon Property group aren't cheap at all imo. BPO could be an interesting play if you wnat a strong one, they are loading up on cash, I think they plan to go shopping. But they are part of the giant Brookfield family of stocks (BIP, BAM etc)that are kind of a mess to tear apart and value since they are so interconnected.

REITS have really really rallied hard  but that doesn't mean you can't find a good one from the horde, which is what it sounds like you are planning to do. It just means as a class they aren't that cheap imo.

In the REITs case I'd say its price to future yield

If you can determine that I'd say that would be the way to go. I think future Cap rates are harder to predict than people suspect given the current credit issues. But perhaps that's my own weakness.

now that i think about Floridabuilder mentioned a couple REITS a while back. 

i've been approached by a couple private future-REITs recently who hope to buy hotels and/or apartment buildings on the cheap today for future gains.  They cal themsleves vulture funds, weird.

Hah I've heard of guys like that. I'd be personally be more interested in the apt guys than hote. Welll that's ahrd for me to say. I hate dealing with residential tenants, they are a real PIA.

but you know all RE is hyper local, so it just depends on what they are buying  of course.

investopedia.com has some good primers on REITs if you want to learn more about them

alos JakilatheHun has some great breakdowns here and at seekingalpha on how he values them (he's a bit more of an optimist than I am so that might suit your tastes) . 

I gotta run, but I'll try to toss the links in here tomorrow night.

Off topic: Was rereading this checklist and thought it might be of interest to you

how to start your own hedge fund

http://www.fwallstreet.com/blog/170.htm

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#14) On February 12, 2010 at 12:50 AM, Tastylunch (29.29) wrote:

One last thought if the gov't report today wasn't smoke, 2011 or after might actually be the time to go looking for REITS

http://www.nakedcapitalism.com/2010/02/congressional-oversight-panel-serious-pain-in-commercial-real-estate-just-starting.html

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#15) On February 12, 2010 at 1:17 AM, checklist34 (99.71) wrote:

tasty, i will read that link tomorrow, ....

Jamie Dimon of JPM called a bottom in CME, fwiw.  and in general, frankly, I don't think that any crisis that is widely predicted and anticipated will actually have that big of a negative effect.  Its the dramatic surprises that kill..

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#16) On February 12, 2010 at 8:36 AM, hrc777 (< 20) wrote:

TCK- While a Canadian company, all its sales are in $US.  Coal, copper and zinc are sold in $US.  Its COSTS are in $Cdn, so as the $US declines, its costs go up.  You only benefit in this with the weak$/strong commodity senario.

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#17) On February 13, 2010 at 2:00 AM, checklist34 (99.71) wrote:

hrc, they report results in $cad...  thanks for the info, i'll look into it.  :) 

its my only foreign currency stock.

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#18) On February 13, 2010 at 2:32 AM, Tastylunch (29.29) wrote:

Checklist here  are some of the links I promised

Jakila 's REIT analyses in 2009 ( he did a lot more than I remembered)

if nothing else they are very good primers/reminders on how to value REITS.

Why Hovde is wrong about General Growth

Lexington Realty Trust : A Solid Value

that last one includes links to 6 other REIT essays he has as well.

Don't know if it includes any info you don't already know, but I like the wya the kid approaches REIT valuation.

sorry couldn't find the floridabuilder post.

Hope you have a good weekend. I'm off to bed finally.

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