Now It's Time for Short-Sellers to Panic

Now It's Time for Short-Sellers to Panic
By Dan Caplinger

May 5, 2009 Comments (0)


For more than a year, investors who own stocks have heard over and over again that they shouldn't panic. Now, their patience has finally earned a reward, and it's time for another group of market participants to have their turn at dealing with a challenging market.

Short-sellers have turned bets against the market into huge profits ever since the market peaked in late 2007. With so many stocks losing huge portions of their value, finding a profitable short-selling candidate has been like shooting fish in a barrel.

But over the past two months, the market's extraordinary rebound has put short-sellers in the squeeze of a lifetime. As you can see, some of short-sellers' most popular targets have performed extremely well since the market's lows in early March:

Stock
% of Shares Sold Short
Return Since March 9
1-Year Return

Barnes & Noble (NYSE: BKS)
34%
67.7%
(11.4%)
MGM Mirage (NYSE: MGM)
30.9%
305.2%
(80.6%)
Goodrich Petroleum (NYSE: GDP)
24.5%
75.8%
(22%)
Citigroup (NYSE: C)
23.8%
204.8%
(87.2%)
Hovnanian (NYSE: HOV)
23.5%
400%
(74.7%)
Green Mountain Coffee Roasters (Nasdaq: GMCR)
44.4%
97.1%
96.7%
Bankrate (Nasdaq: RATE)
36.1%
47.2%
(46.5%)
Sources: Yahoo! Finance and WSJ.com. Short interest as of April 15.

Those rebounds have been extremely painful for anyone who sold those stocks short. No matter how bad things get, investors who buy stocks can never lose more than what they paid for their shares. But as these examples show, short-sellers can do much worse. If you sold Hovnanian short in early March, for instance, you've now lost four times as much money as you initially received when you sold your borrowed shares.

Why do they do it? In some ways, short-sellers have much in common with any other investor. They do their research and try to find promising candidates for their investing strategy. It's just that the "promising" stocks that shorts look for are those that are least likely to do well -- companies whose businesses are failing or whose prospects have gotten so pumped up that there's no way the reality can ever meet shareholders' expectations.
Under ordinary market conditions, you'll usually find a few companies that fit the bill. In the past, stocks like Krispy Kreme and Crocs acted almost perfectly for short-sellers; hopeful investors bid up shares to the stratosphere, and then all it took was having the patience and financial resources to wait for the company's fundamentals to fall apart.

An embarrassment of riches

Now, though, short-sellers are in the same position that most investors enjoy at the top of a bull market. Shorts have had many chances to make huge amounts of money in the past year, but now, many of their best candidates have already fallen substantially. With many stocks having fallen 80% or more, the risk for short-sellers who continue to bet against the market has risen exponentially.

Perhaps the most dangerous part of short-selling is that if you keep upping your bet on a particular stock, you can end up being right about the stock dropping but still lose money. For instance, say you shorted 100 shares of General Motors last year at $22 per share. If you closed out the short now, you would realize a little over $2,000 in profit.

But now say you upped your short position to 1,000 shares. If GM stock rose to just $4 -- still an 80% loss from last year's levels -- you would have lost all your profits and then some.

Yet that's the dilemma short-sellers face now. Do you increase your exposure on existing positions, hoping shares will fall back but taking on a lot more risk -- or do you give up and cover your shorts in the face of the current rally?

Be panic-proof

There's no one-size-fits-all answer to that question. But by the time the situation comes up, you should already know what you're going to do. If you're going to sell stocks short successfully, you need several things:

An exit strategy.

Even more than with owning shares, you can't afford to panic when the market moves against you. Know your risk tolerance, and know in advance when you'll get out to limit your losses.

Discipline.

It's tough to watch a company's stock rise when you know its business stinks. Irrational markets can last a long time, though, so being patient is essential.

Hedges.

Sometimes, a safer way to short is to buy shares of another stock in the same industry. That way, you can make money overall even if your short does badly, as long as the stock you own does (relatively) better.

Short-selling is not for the meek, so don't do it if you're not comfortable with the consequences. And right now, with the market already having declined so much, short-sellers could find themselves even worse off than investors who've owned shares throughout the bear market.

Fool contributor Dan Caplinger hasn't sold anything short for a long while, though he does have a bunch of thumbs-down positions in CAPS. He doesn't own shares of the companies mentioned.

http://www.fool.com/investing/high-growth/2009/05/05/now-its-time-for-short-sellers-to-panic.aspx

****Investing Lessons From Benjamin Graham

Investing Lessons From Benjamin Graham
By Motley Fool Staff May 5, 2009 Comments (1)

A dictionary will tell you that investing involves putting money into assets with the intent of making a profit. But that's not the whole story. Speculating, for example, involves the very same process.

The legendary Dean of Wall Street, Benjamin Graham, differentiates the two approaches in his seminal work, Security Analysis, and in the process offers one of the best definitions of investing. Ever.

Graham says an investment is something that "upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative." [Emphasis added.]

Given that definition, a lot of us who think we are investing may come to discover that we're engaging in what I would call intelligent speculation.

So let's briefly review Graham's three criteria for an investment.

1. Thorough analysis : Do your homework
Warren Buffett used to write down why he was making an investment. If what he wrote wasn't crystal clear, he either did more research, or he'd decide that he simply could not understand the business well enough to make an investment.

Imagine you're buying a house. You'll make sure it's in a nice, safe neighborhood with a good school system before you put down your money. Buffett puts that kind of prudent diligence into his stock research, and so should you.

Really good investments are really hard to find. So when you find one that looks interesting, do your homework. Study the industry. Examine the competition. Find out everything that could possibly go wrong through boom and bust cycles.

2. Safety of principal : Never lose money
Buffett says he has two goals when making an investment.

Rule No. 1: Never lose money.
Rule No. 2: Never forget Rule No. 1.

There are three types of stocks:

• the overvalued type,
• the fairly valued type, and
• the undervalued type.

Your goal is to avoid the first, ignore the second, and buy the third.

One way to keep attuned to that goal is to focus on value over price.
Apple (Nasdaq: AAPL), for example, is a great business that has done all the right things to ensure its long-term success. Yet when it traded early last year at more than $200 a share, Apple had an extremely rich earnings multiple. As the ensuing year proved, even as Apple continued to exceed analyst expectations on earnings, you didn't have much safety of principal at $200.

But after the stock suddenly shot down to below $100, if you believed the economic characteristics of the business remained intact, then your investment thesis was entirely different.

The one variable is the price. As Buffett once said, "Price is what you pay. Value is what you get."

3. Satisfactory return : Risk versus reward
Any time you commit capital to one business, you are forgoing the opportunity to commit that capital to any other business. But that's OK, because if you are rational, the investment you choose will be better than all other alternatives.

So what should you be looking for? Well, you can always invest in the market through index funds and earn, on average, about 10% a year without exerting any effort.

Whatever you do, you should at least expect a higher rate of return than 30-year U.S. Treasuries, commonly referred to as the risk-free rate, which currently stands at around 4%.

A reasonable goal is to make investments that you think can exceed the market rate of return by 3 percentage points over the long run.

John Bogle once stated that more than 85% of active money managers fail to beat the stock market by 3 percentage points, so making investments that can yield you 13%-15% a year is a great return, given your alternatives.

Meeting the Graham threshold
So how do you find good prospects for stocks Graham might approve of? Using Motley Fool CAPS, the Fool's free online investing community, you can run a simple screen to find some reasonably valued stocks that have earned the attention of Foolish investors.

Stock
Current P/E
Estimated Future Earnings Growth

Accenture (NYSE: ACN)
10.9
13.3%
Cameron (NYSE: CAM)
10.3
12.0%
Enbridge (NYSE: ENB)
10.6
11.2%
GameStop (NYSE: GME)
12.2
17.0%
Nokia (NYSE: NOK)
12.7
13.8%
Raytheon (NYSE: RTN)
11.5
11.7%
Source: Yahoo! Finance, Motley Fool CAPS. P/E = price-to-earnings ratio.

Of course, screen results alone aren't enough to conclude that these are truly Graham-quality stocks. Rather, these give you a place to start your own research.


For more on value investing:
This Rally Is Ridiculous
The Best Opportunity This Decade
How Low Can Stocks Go?


This article, written by Sham Gad, was originally published on June 12, 2007. It has been updated by Dan Caplinger, who doesn't own shares of the companies mentioned. Apple and GameStop are Motley Fool Stock Advisor selections.

Stop Worrying About the Rally

Stop Worrying About the Rally
By Dan Caplinger May 5, 2009 Comments (0)


Everyone seems convinced that the recent rally in stocks has absolutely no chance of holding up. Yet a few years from now, what's happened since March -- and what's yet to come over the next few months -- will be just a bump in the road compared to the overall fortunes of the stock market.

Guts and glory
During times like these, it's tough not to think like a short-term trader. After the market was cut in half in just 15 months, stocks have now jumped by over a third from their March lows. In just two short months, the S&P 500 has erased all of its losses for 2009.

Moreover, those traders who picked the exact bottom have seen some of the worst-hit stocks during the bear market shoot back up with amazing gains. Take a look at some of the top-gaining stocks since

March 9:

Stock
Gain Since March 9
1-Year Return
5-Year Avg. Annual Return

Las Vegas Sands (NYSE: LVS)
569%
(87%)
(28.1%)*
Office Depot (NYSE: ODP)
374.6%
(79.1%)
(30.6%)
USG (NYSE: USG)
295%
(55.4%)
3.9%
International Paper (NYSE: IP)
221.6%
(40.8%)
(15.6%)
Bare Escentuals (Nasdaq: BARE)
218.5%
(50.9%)
N/A
Citigroup (NYSE: C)
204.8%
(87.2%)
(39.6%)
Dow Chemical (NYSE: DOW)
163.1%
(57.3%)
(12.9%)
Source: Yahoo! Finance.*4-year average return.

Profits like those we've seen from these stocks in the past two months often take years for long-term investors to earn. So it's no wonder that the rally has taken many unprepared investors by surprise -- and left them wondering whether they've made the wrong decision with their long-term investing strategy.

Irrational in two directions
Of course, as the table above shows, there's nothing particularly extraordinary about how these companies have performed when you look at them on a longer-term basis. They've all done worse than the S&P over the past year, and all but USG have underperformed the index since 2004.

The real question, though, is which is more irrational: the plunge in these companies' stock prices, or the ensuing recovery. Clearly, during times of panic like we saw in early March, investors believed that many of these companies were in danger of falling apart. Now, shareholders seem convinced that their failure isn't imminent -- yet they certainly haven't bid shares back up anywhere close to where they traded last May.

In that light, a small rally like this doesn't seem all that ridiculous -- especially in light of the bigger picture.

A little perspective
In late 2007, investors still believed the future would stay bright forever. When that scenario proved grossly incorrect, stock prices took a 57% haircut, most of which has happened just since last September. Now, after a seemingly huge rally, the S&P 500 is down "only" 42% from its record highs.

That 42% drop doesn't come as a shock to anyone. With unprecedented government intervention and uncertainty about whether the economic cycle is broken for good, lower share prices only make sense.

But the way we got there -- with an even bigger plunge and a subsequent bounce -- is what people are focusing on. And that's the wrong focus.

The right thing to do
Long-term investors know better. They realize that over the long haul, it makes absolutely no difference whether stocks take a straight-line path down or take investors on a roller-coaster ride. The important thing is figuring out which stocks have solid business foundations and taking advantage of attractive valuations when they come to buy.

You might be tempted to wait until this silly-looking rally ends and share prices on your favorite companies fall back toward their lows. That may even turn out to be the right call. But if you play that timing game, you're doing exactly the same thing as the speculators you've criticized -- and if your stocks don't cooperate, you may miss out entirely on a huge opportunity. Just as Warren Buffett missed out on Wal-Mart because of a fraction of a point, you could miss the next big growth stock.

As we know well by now, markets will plunge and soar from time to time. But you don't have to get caught up in the hype. Stick with the investing strategy you've developed for your long-term goals -- it'll serve you better in the end.
Fool contributor Dan Caplinger bought a little in March, bought a little in April, and plans to buy a little in May. He doesn't own shares of the companies mentioned.

http://www.fool.com/investing/general/2009/05/05/stop-worrying-about-the-rally.aspx

When you should not sell.

When you should not sell.

The Stock has Dropped

By themselves, share price movements convey no useful information, especially because prices can move in ALL sorts of directions in a SHORT TERM for completely unfathomable reasons.

The long-run performance of stocks is largely based on the expected future cash flows of the companies attached to them - it has very little to do with what the stock did over the past week or month.

Always keep in mind that it doesn't matter what a stock has done since you bought it. There's nothing you can do to change the past, and the market cares not one whit whether you've made or lost money on the stock.

Other market participants - the folks setting the price of the stock - are looking to the future, and that's exactly what you should do when you're deciding whether to sell a stock.

The Stock Has Skyrocketed

Again, it matters little how those stocks have done in the past - what's important is how you expect the company to do in the future.

There's not a PRIORY reason for stocks that are up substantially to drop, just as there's no reason for stocks that have tanked to "have to come back eventually."

Most of us would be better investors if we could just block out all those graphs of past stock performance because they convey no useful information about the FUTURE.


So When Should You Sell?

Run through these 5 questions whenever you think about selling a stock, and you'll be in good shape.

1. Did you make a mistake?
2. Have the fundamentals deteriorated?
3. Has the stock risen too far above its intrinsic value?
4. Is there something better you can do with the money?
5. Do you have too much money in one stock?

For every Wal-Mart, there's a Woolworth's

For every Wal-Mart, there's a Woolworth's

Sticking to a valuation discipline is tough for many people because they're worried that if they don't buy today, they might miss the boat forever on the stock.

That's certainly a possibility - but it's also a possibility that the company will hit a financial speed bump and send the shares tumbling.

The future is an uncertain place, after all, and if you wait long enough, most stocks will sell at a decent discount to their fair value at one time or another.

As for the few that just keep going straight up year after year - well, let's just say that NOT MAKING is a lot painful than LOSING money you already have.

For every Wal-Mart, there's a Woolworth's.

Finding companies that can be held long-term

The challenge: Finding companies that can be held long-term

Despite the volatility in the market, Tan says he is still a long-term investor.

“We bought into Parkson in 2002 when it was around 40 sen. It went to a peak of around RM10. If we had sold at 80 sen, we would have made 100% gains. The question is, if you sell, what are you going to reinvest in? The advantages of buying and holding is that if you have the right company, you don’t have to worry about reinvesting. Of course, at RM20, we would have sold because it would have been so overvalued. But a good company, managed well, has tremendous potential. If you buy and sell once in 10 years, you only have to be right twice. If I buy and sell every month, I have to be right 24 times a year. "

The dramatic drop in stock markets last year has led to the long-term approach of buy and hold being questioned. In an article in late April, The Wall Street Journal ran said that advisers are ditching the ‘buy and hold’ dogma in the face of massive losses.

For Capital Dynamic Asset Management Sdn Bhd’s managing director Tan Teng Boo, the question is not whether to invest long-term but in finding companies that can be held long-term. The value investor seeks companies selling at an attractive discount from the intrinsic value. And in this market, he is rubbing his hands in glee. Tan says he has been steadily accumulating stocks over the past year. The iCapital Global Fund, a fund for high net worth investors that was launched in July 2007, now only holds 6% in cash, says Tan.

“We see a lot of prices which have bombed out although the company has not,” he says. “I have never seen so much pessimism in so many places at so many levels of society in my life. The negative sentiment is a divergence from the economic numbers, which isn’t as bad as those seen in the Depression. This is a springboard for a major rally.”

The Retail Game

The Retail Game

Great companies in attractive industries generate returns on invested capital that far exceed the cost of capital.

1. However, retail is generally a very low-return business with low or no barriers to entry.

Retail bellwethers Wal-Mart and Walgreen earn little ore than 3 cents profit for every dollar of sales, so store management is critical. The problem is that many retailers don't execute as flawlessly as these two and flame out as soon as trouble hits.

2. The sector is rampant with competition.

Think of all the specialty apparel shops that try to imitate Abercrombie & Fitch and Gap. A few succeed; most fail, but the point is that nothing exists to prevent new concepts and stores from being launched. There are few, if any, barriers to entry. Customers may be swayed to buy a cool $50 sweater, but they'll quickly go to the store next door if the same sweater can be had for $40.


3. The primary way a firm can build an economic moat in the sector is to be a low-cost leader.

Wal-Mart sells items that can be purchased just about anywhere, but it sells it all for less than the competition, and consumers keep coming back for the bargains. Others may try to imitate Wal-Mart's strategy in the short run but lack the economies of scale to remain profitable employing the strategy in the long run.

How Healthy Is the Balance Sheet with All Those Leases?

Common Investing Pitfall: How Healthy Is the Balance Sheet with All Those Leases?

Many retailers use operating leases to "rent" space for their stores. Because these leases aren't capitalized and are kept off the balance sheet, they understate a firm's total financial obligations and can artificially inflate financial health. The leases aren't inherently bad or sneaky; in fact, their existence is core to most retailer's expansion plans. Lease obligations can be found in the footnotes of a firm's 10-K under the heading "commitment and contingencies."

Be sure to give a retailer a thorough checkup before declaring it to be in tip-top financial shape.

For example, Tommy Hilfiger appeared to have pretty good financial health going into 2002. The firm had $387 million in cash and $638 million in total debt. However, the specialty apparel firm also had $273 million of future financial obligations in the form of operting leases. If we add off-balance sheet leases to the debt on the balance sheet, the toal comes to $911 million, and the coverage ratios don't look as robust. Tommy Hilfiger entered 2002 with declining sales and stagnating profits and cash flow. When Hilfiger announced that it neede to close many of its retail stores in October 2002 and pay to break the leases, the stock price was hammered.

Are Those Same-Store Sales (SSS) Growth Numbers Accurate?

Common Investing Pitfall: Are Those Same-Store Sales (SSS) Growth Numbers Accurate?

Every quarter and, for most restaurants and retailers, every month, same-store sales (SSS) numbers are released. SSS growth measures sales at locations open for at least a year and excludes sales increases attributed to current openings (also known as new store sales growth). For purposes of reporting, SSS are also know as comparable-store sales or comps.

But, what if a new store doesn't fully mature in 12 months? The process of that new store reaching maturity in year two or year three helps boost the SSS figure, while sales at older stores may not be growing at all or are declining.

This is a very important consideration for companies that are transitioning from aggressive growth into slower or steadier growth. As long as they can open a greater number of stores year after year, the SSS or comps will look impressive. But every company's expansion plan reaches an inflection point - they're still growing, just not as fast. This has two effects.

• First, opening fewer stores obviously translates into smaller new store sales growth.
• Second, having fewer stores entering those productive years two and three also lowers SSS or comps.

The combination of slower new store growth and lower SSS or comps can send overall growh and the stock price plunging quickly.

From 1995 to 2000, Office Depot averaged 14 percent per year in new store growth. However, the office supply store business quickly became saturated when competitors Staples and Office Max also engaged in aggressive expansion plans. In 1999 and 2000, the last two years of its rapid expansion, Office Depot's total SSS increased 6 percent and 7.5 percent. In 2001, new store growth stopped and SSS declined 2 percent; the stock price sank below $10 from a high in the mid $20's in 1999.

Investing in Retail: Understanding the Cash Conversion Cycle

Investing in Retail: Understanding the Cash Conversion Cycle

One of the best ways to distinguish excellent retailers from average or below average ones is to look at their cash conversion cycles. The cash cycle tells us how quickly a firm sells its goods (inventory), how fast it collects payments from customers for the goods (receivables), and how long it can hold on to the goods itself before it has to pay suppliers (payables).

Figure: The cash conversion cycle

= Days in Inventory + Days in Receivables - Days Payable Outstanding

= 365/Inventory turnover + 365/Receivables turnover - 365/Payables turnover

Where,
Inventory turnover = Cost of goods sold/Inventory
Receivables turnover = Sales/Accounts receivable
Payables turnover = Cost of goods sold/Accounts payable

Naturally, a retailer wants to sell its products as fast as possible (high inventory turns), collect payments from customers as fast as possible (high receivables turns), but pay suppliers as slowly as possible (low payables turns).

The best-case scenario for a retailer is to sell its goods and collect from customers before it even has to pay the supplier. Wal-Mart is one of the best in the business at this: 70 percent of its sales are rung up and paid for before the firm even pays its suppliers.

Looking at the components of a retailer's cash cycle tells us a great deal. A retailer with increasing days in inventory (and decreasing inventory turns) is likely stocking its shelves with merchandise that is out of favor. This leads to excess inventory, clearance sales, and, eventually, declining sales and stock prices.

Days in receivables is the least important part of the cash conversion cycle for retailers because most stores either collect cah directly from customers at the time of the sale or sell off their credit card receivables to banks and other finance companies for a price. Retailers don't really control this part of the cycle too much.

However, some stores, such as Sears and Target, have brought attention to the receivables line because they've opted to offer customers credit and manage the receivables themselves. The credit card business is a profitable way to make a buck, but it's also very complicated, and it's a completely different business from retail. We're wary of retailers that try to boost profits by taking on risk in their credit card business because it's generally not something they're very good at.

If days in inventory and days in receivables illusrate how well a retailer interacts with customers, days payable outstanding shows how well a retailer negotiates with suppliers. It's also a great gauge for the strength of a retailer.

Wide-moat retailers such as Wal-Mart, Home Depot, and Walgreen optimize credit terms with suppliers because they're one of the few (if not the only) games in town. For example, 17 percent of P&G's 2002 sales came from Wal-Mart. The fortunes of many consumer product firms depend on sales to Wal-Mart, so the king of retai has a huge advantage when ordering inventory: It can push for low prices and extended payment terms.

Home Depot finally started taking advantage of its competitive position by squeezing suppliers in 2001 and 2002. Days payable outsanding for the home improvement titan has historicaly been around 25. In 2001, the figure hit 33 days, and by 2002, it exceeded 40 days. By holding on to its cash longer and reducing short-term borrowing needs, Home Depot increased its operating cash flow from an average of $2.4 billion from 1998 to 2000 to $5.6 billion from 2002 to 2003.

Warren Buffett interview on how to read stocks (Petrochina)

http://www.youtube.com/watch?v=Lc791is6X0o

Warren Buffett: Why Buying Constellation Energy Group Is A Sweet Deal

Warren Buffett: Why Buying Constellation Energy Group Is A Sweet Deal

by Floyd G. Brown, Advisory Panelist, Investment U
October 01, 2008: Issue # 863

Last week, I suggested you ignore Washington and “the bailout plan,” and do what great investors such as Warren Buffett do in times of crisis - buy stocks.

Based on reader response, you would have thought I recommended investing in the Titanic, and doubling down on the Hindenburg. My email inbox was full of remarks from people who thought I had lost my mind, such as, “There are idiots out there saying [the credit crisis is] ‘no problem’…you know who they are!!!”

I think he means me…

But this kind of reaction isn’t out of the ordinary. In times of intense fear - such as this week - contrarian investors often have opposing views from the crowd. And while many investors are running scared, legendary investor Warren Buffett is betting big. Let’s see what Buffett just bought on the cheap and how we can profitably do the same…

Warren Buffett’s $10 Billion Spending Spree
Berkshire Hathaway, Warren Buffett’s holding company, spent nearly $10 billion in the last week. Not only did he spend $5 billion to acquire preferred stock in Goldman Sachs (NYSE: GS), but he also is backing MidAmerican Energy’s $4.7 billion buyout of Constellation Energy Group (NYSE: CEG) based in Baltimore.

Frankly, I find Warren Buffett’s investment strategy with this bid much more interesting than the Goldman Sachs deal, even though it is slightly smaller. In early January, shares of Constellation were trading at over $100, and yet its management accepted Buffett’s $26.50 a share offer earlier this month.

Constellation is a diversified energy company that owns an energy-trading unit. Its portfolio of energy generation plants covers the spectrum and includes the old-fashioned utility Baltimore Gas and Electric Company. Like many of the financial traders on Wall Street, the firm is a big user of borrowed capital. And because of this Constellation was slammed by the credit crisis.

Constellation’s CEO, Mayo Shattuck III, told The Wall Street Journal last week that he was forced to sell to Buffett after a “classic run on the bank.” Investors dumped shares, fearing CEG wouldn’t be able to get a $2 billion bank loan necessary to fund its energy-trading operation.

The additional cash was needed so the investment ratings agency wouldn’t downgrade the firm from investment grade. If that had happened, it would have increased Constellation’s collateral requirements by $3 billion - thereby putting it into bankruptcy.

“We engaged in discussions,” Mr. Shattuck said, “as we perceived we might not be in commercial operations for long.” According to Shattuck, Warren Buffett moved quickly and injected $1 billion in capital the day after the deal was inked.

Let me explain why this deal is so amazing…
Warren Buffett & The Constellation Energy Deal
The Constellation Energy deal will give MidAmerican control of five nuclear reactors, two in Maryland and three in New York. Plus they get:

• A large portfolio of coal and gas plants stretching from coast to coast.
• Baltimore Gas & Electric.
• And a profitable energy trading operation

all for less than it would cost to build one nuclear plant.

Currently Constellation controls 9,000 MW of power generating capacity. To build or replace these assets would cost billions more than Buffett is paying.

Warren Buffett Starts A Bidding War
In fact, Warren Buffett is getting such a great deal on Constellation Energy that a bidding war is erupting.

Électricité de France International, the French power giant and Constellation Energy Group’s largest shareholder, is making its own offer to buy the firm for much more than the $4.7 billion accepted by management from MidAmerican. EDFI said it is offering $35 per share to buy Constellation. The only problem is Constellation’s board has already agreed to go ahead with MidAmerican, and they’ve already cashed Buffett’s billion-dollar check.

In addition, there are tough regulations prohibiting foreign companies from owning nuclear assets in the United States… Good luck to the French and Constellation’s other shareholders intent on breaking up this deal. (This morning, Constellation traded at $23.75, a 11.58% discount to Buffett’s buyout price. Which could open the door to some short-term arbitrage gains - as the market still hasn’t made up its mind about the buyout.)

Bottom line, there are lots of extraordinary deals right now, but it can take an iron constitution to be a buyer in this environment. If investment greats like Warren Buffett are investing without fear, then we should be doing the same. So I encourage you to look for companies trading for far less than they are worth.

They are out there for the bargain minded investor.

Good investing,
Floyd

PS. Why is CEG trading at a discount? Stay tuned. Next week, I’ll look at arbitrage situations… And how to profit from them.

Today’s Investment U Crib Sheet
Warren Buffett once said, “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” And that is exactly how he has approached his recent railroad purchases.

In Investment U Issue #846 Floyd showed us that there are still vast fortunes to be made in the transportation sector, and why Buffett has been loading up on them.

Buffett is infamous for buying companies trading at a discount to their value. And for the average investor, it can be hard to tell whether a company is under- or over-valued by looking at the stock price. But, by understanding a few sections on a company’s annual report, you can understand the financial picture of any company, just like he does.

The current market downturn has created an environment where thousands of stocks are trading at multiyear lows. But finding the good ones can be difficult. To find these diamonds in the rough, learn how to screen stocks like a professional.

Earlier this month, Alex Green showed us why Buffett has been the single greatest investor of our lifetimes. Alex also walked us through Warren Buffett’s investment strategy, what kind of questions he asks, and the three reasons he’s buying right now.

More on this topic (What's this?)
How Buffett Has Failed the True Test of Leadership (The Enlightened American, 1/27/09)
Constellation Energy (CEG) Merger Arbitrage Opportunity (Dividend Growth Investor, 10/28/08)
Buffett Bargain Hunting Despite 2008 Losses (Money Morning, 2/12/09)
Read more on Warren Buffett, Constellation Energy Group at Wikinvest



http://www.investmentu.com/IUEL/2008/October/warren-buffett-why-buying-constellation-energy-group-is-a-sweet-deal.html

World Stock Markets, Now vs Then

World Stock Markets, Now vs Then

Source: Global Financial Database.

(The above graph tracks behaviour after the peaks in world industrial production, which occurred in June 1929 and April 2008.)

While the fall in US stock market has tracked 1929, global stock markets are falling even faster now than in the Great Depression (Figure). Again this is contrary to the impression left by those who, basing their comparison on the US market alone, suggest that the current crash is no more serious than that of 1929-30.

Also read:

Market Performance Around Recessions

World industrial production, trade and stock markets are diving faster now than during 1929-30.

World industrial production, trade and stock markets are diving faster now than during 1929-30.

Tuesday, April 7, 2009

World Economy Falling Faster Than in 1929-1930


Barry Eichengreen, an expert on the Great Depression, and Kevin O'Rourke, take issue with the notion that the current downturn is less severe than the Great Depression. While the slump in the US is not as bad, that mis-states the global picture.

Note that many economists expect the US to suffer less than the big exporters, namely China, Germany, Japan. The reason is that the economic adjustment required of surplus nations is greater than that of debtors. Similarly, in the Great Depression, the US, then a major exporter, was harder hit than the overconsuming importers such as Britain, who defaulted on their debts.

The one bit of cheer is that this time around, government action is more aggressive, but it remains to be seen whether it is sufficient.

From VoxEU:

Often cited comparisons – which look only at the US – find that today’s crisis is milder than the Great Depression. In this column, two leading economic historians show that the world economy is now plummeting as it did in the Great Depression; indeed, world industrial production, trade and stock markets are diving faster now than during 1929-30. Fortunately, the policy response to date is much better.

The parallels between the Great Depression of the 1930s and our current Great Recession have been widely remarked upon. Paul Krugman has compared the fall in US industrial production from its mid-1929 and late-2007 peaks, showing that it has been milder this time. On this basis he refers to the current situation, with characteristic black humour, as only “half a Great Depression.” The “Four Bad Bears” graph comparing the Dow in 1929-30 and S&P 500 in 2008-9 has similarly had wide circulation (Short 2009). It shows the US stock market since late 2007 falling just about as fast as in 1929-30.

Comparing the Great Depression to now for the world, not just the US

This and most other commentary contrasting the two episodes compares America then and now. This, however, is a misleading picture. The Great Depression was a global phenomenon. Even if it originated, in some sense, in the US, it was transmitted internationally by trade flows, capital flows and commodity prices. That said, different countries were affected differently. The US is not representative of their experiences.

Our Great Recession is every bit as global, earlier hopes for decoupling in Asia and Europe notwithstanding. Increasingly there is awareness that events have taken an even uglier turn outside the US, with even larger falls in manufacturing production, exports and equity prices.

In fact, when we look globally, as in Figure 1, the decline in industrial production in the last nine months has been at least as severe as in the nine months following the 1929 peak. (All graphs in this column track behaviour after the peaks in world industrial production, which occurred in June 1929 and April 2008.) Here, then, is a first illustration of how the global picture provides a very different and, indeed, more disturbing perspective than the US case considered by Krugman, which as noted earlier shows a smaller decline in manufacturing production now than then.

Figure 1. World Industrial Output, Now vs Then
Source: Eichengreen and O’Rourke (2009).

Similarly, while the fall in US stock market has tracked 1929, global stock markets are falling even faster now than in the Great Depression (Figure 2). Again this is contrary to the impression left by those who, basing their comparison on the US market alone, suggest that the current crash is no more serious than that of 1929-30.

Figure 2. World Stock Markets, Now vs Then
Source: Global Financial Database.

Another area where we are “surpassing” our forbearers is in destroying trade. World trade is falling much faster now than in 1929-30 (Figure 3). This is highly alarming given the prominence attached in the historical literature to trade destruction as a factor compounding the Great Depression.

Figure 3. The Volume of World Trade, Now vs Then
Sources: League of Nations Monthly Bulletin of Statistics, http://www.cpb.nl/eng/research/sector2/data/trademonitor.html

It’s a Depression alright

To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimize this alarming fact. The “Great Recession” label may turn out to be too optimistic. This is a Depression-sized event.

That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. What matters now is that policy makers arrest the decline. We therefore turn to the policy response.

Policy responses: Then and now

Figure 4 shows a GDP-weighted average of central bank discount rates for 7 countries. As can be seen, in both crises there was a lag of five or six months before discount rates responded to the passing of the peak, although in the present crisis rates have been cut more rapidly and from a lower level. There is more at work here than simply the difference between George Harrison and Ben Bernanke. The central bank response has differed globally.

Figure 4. Central Bank Discount Rates, Now vs Then (7 country average)
Source: Bernanke and Mihov (2000); Bank of England, ECB, Bank of Japan, St. Louis Fed, National Bank of Poland, Sveriges Riksbank.

Figure 5 shows money supply for a GDP-weighted average of 19 countries accounting for more than half of world GDP in 2004. Clearly, monetary expansion was more rapid in the run-up to the 2008 crisis than during 1925-29, which is a reminder that the stage-setting events were not the same in the two cases. Moreover, the global money supply continued to grow rapidly in 2008, unlike in 1929 when it levelled off and then underwent a catastrophic decline.

Figure 5. Money Supplies, 19 Countries, Now vs Then
Source: Bordo et al. (2001), IMF International Financial Statistics, OECD Monthly Economic Indicators.

Figure 6 is the analogous picture for fiscal policy, in this case for 24 countries. The interwar measure is the fiscal surplus as a percentage of GDP. The current data include the IMF’s World Economic Outlook Update forecasts for 2009 and 2010. As can be seen, fiscal deficits expanded after 1929 but only modestly. Clearly, willingness to run deficits today is considerably greater.

Figure 6. Government Budget Surpluses, Now vs Then
Source: Bordo et al. (2001), IMF World Economic Outlook, January 2009.


Conclusion

To summarize: the world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-30. Looking just at the US leads one to overlook how alarming the current situation is even in comparison with 1929-30.


Topics: Economic fundamentals, Globalization, Macroeconomic policy
Posted by Yves Smith at 1:26 AM



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Market Performance Around Recessions

Market Performance Around Recessions

Some define recession as two successive quarters of negative real economic growth. Others use a more general framework of a decline in economic activity lasting for more than a few months with visible declines in GDP, employment, production and income.

The average length of recessions for the past 50 years has been 11 months. So as an investor, you can’t confirm if we’re in a recession until we’re almost halfway through it. For those deciding whether they should hold on or sell their holdings… take a look at the performance of the S&P from past recessions.

By looking at the numbers for the last nine recessions, we see some surprising and encouraging figures.

1. The largest market losses, as you would expect, are in the beginning of any recession.
2. The largest gains come from staying invested through the entire period.
3. The numbers show market timing would have given you an 8% gain at best and a -3% loss at worst.
   

For the last 50 years, the average return for the S&P 500 has been around 12.5%. Investors focused on the long term, who didn’t panic and who stayed fully invested in the market, found themselves with an average return of 42.4%. With those returns, it’s understandable why a great investor like Warren Buffett likes to see the market shake out from time to time. Here’s a look at one of Buffett’s most recent buys… and how to profit by following in his tracks.



More on this topic
(What's this?)
World Economy Falling Faster Than in 1929-1930 (naked capitalism, 4/6/09)
How Buffett Has Failed the True Test of Leadership (The Enlightened American, 1/27/09)
Buffett Bargain Hunting Despite 2008 Losses (Money Morning, 2/12/09)

Read more on Warren Buffett, U.S. Economic Cycles at Wikinvest

http://www.investmentu.com/IUEL/2008/May/warren-buffett-investing.html