Author Archives: Scalper1

Survival Skill: Distancing Yourself From Counterparty Risks

In a recent article entitled, Whatever You Do, Avoid Major Mistakes , I suggested that investors study-up on the subject of counterparty risk. Under a constructionist definition , the term equates to default risk as defined by the inability of a party to live up to its contractual obligations. The failure of a debtor to meet its obligations under a credit arrangement is a counterparty risk as is failure to perform under a swap or option agreement. A Broader Definition Needed However, for investors, a broader definition of the term is more appropriate to reflect that: a) counterparty risk arises when a major player(s) in a firm’s value-chain fails to perform whether contractually or not, b) the mere thought or mention of default gives rise to counterparty risk, and c) counterparty risk reverberates out from the source of the problem such that it can involve not just two, but multiple parties serially / simultaneously. This more encompassing definition explains a lot of what is going today: China’s faltering economy has seriously disrupted supply chain relationships beginning, notably, with miners as close as Australia and as far away as South America. For example, questions have been raised about Rio Tinto (NYSE: RIO ), Glencore ( OTCPK:GLCNF ) and Freeport-McMoRan (NYSE: FCX ) three of the largest mining companies in the world. The collapse in oil prices has now reverberated well away from drillers to servicing, pipeline, storage and tanker companies, landlords and hoteliers housing field personnel, banks, municipalities, states, and even countries. Take, for example, Kinder Morgan (NYSE: KMP ), the Royal Bank of Canada (NYSE: RY ), or Statoil (NYSE: STO ) / Norway. The gadget business that is over-saturated with products amid slackening demand has created problems along the value-chain including between the likes of Samsung ( OTC:SSNLF ) and Qualcomm (NASDAQ: QCOM ). Bricks retailers such as The Gap (NYSE: GPS ) and Aeropostale (NYSE: ARO ) are beating their brains out over fashion style and space utilization resulting in downstream impact to shopping center REIT’s as in the case of CBL & Associates (NYSE: CBL ). Distancing Yourself from Counterparty Risks It’s therefore understandable that some investors are scared. Stocks and bonds that they thought were fairly valued and perfectly safe are tanking. Moreover, fears are being whipped up by the likes of hedge fund managers who actually have lost their a$$ and are looking down the barrel at significant redemptions. Some would have us believe that the world is going to hell. It’s not. I personally see no reason to sell everything and to blow up an income stream in order to protect principle in these extremely volatile markets. BUT, if you haven’t already, the time is rapidly passing to put more distance between your portfolio and counterparty risks. This begins in one of two ways: a) By stepping back to consider macro changes that are developing / underway and how they may affect your holdings, or b) By taking a micro perspective and ‘looking back through’ your portfolio to ‘see’ what negative consequences may be coming at you from interrelated sectors. The idea is to get away, as quickly as possible, from ground zero. On my end, earlier this year, I took three actions to put more distance between our portfolio and counterparty risks: 1) I sold Corning (NYSE: GLW ) not because I don’t like the company – I really do – but because of concerns about the weakening gadget business, 2) I divested our positions in Chevron (NYSE: CVX ) and Royal Dutch Shell (NYSE: RDS.B ) even though as integrated companies they have fared a lot better than ‘pure plays’ in the oil production business, and 3) I bailed on JPMorgan Chase (NYSE: JPM ) believing that they have not been completely forthright about their exposures to oil and related sectors. In other words, I have concerns that, like other financial institutions, JPM may not have a handle on their counterparty risks. At the same time, I am sitting tight with positions in industries / companies that are more insulated from counterparty risks and whose demand for their products and services is relatively inelastic – military defense contractors, water management firms, and pharmaceutical companies. Also, I continue to make investments in what I feel will be growth areas such as in the fight against migrating tropical diseases. Two Directions to Alpha Like everyone else, I have suffered losses so far this year. However, by moving away from counterparty risks, my losses have been 3 to 4% less than comparable indices. Remember, just as alpha-level performance is doing better than the market when it is up, it is also doing less bad when the market is down. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

How Regulation Promotes Short-Termism

Every so often some prominent individual in the investment community reaches the erroneous conclusion that earnings guidance is the root of all evil. The latest to promote this idea is Larry Fink, CEO of BlackRock (NYSE: BLK ). BlackRock, which has $4.6 trillion in assets under management, claims to be the world’s largest investment firm. Fink has held the top post ever since he co-founded the company in 1988. He is rumored to be at the top of Hillary Clinton’s list of candidates for Treasury Secretary, should she win the presidential election. Fink might even be petitioning for the job. CNN Money recently pointed out that he is beginning to sound a lot like Clinton herself, even to the point of using the same terminology. Both of them are on the warpath against what they call “short-termism” in corporate America. Fink penned a letter on February 1 to the CEOs of major corporations and used that term in the very first sentence, calling it a powerful force that is afflicting corporate behavior. Frankly, I can’t argue with much of what he says. I agree with him that there is too much attention paid to how a company performs over the short term and not enough paid to how it does over the long term. I consider myself a long-term investor, and I much prefer to see the companies I invest in managed with a long-term perspective in mind. For example, management can easily boost earnings in any particular quarter simply by slashing capital expenditures or by cutting spending on research and development. Yet doing so comes at the cost of long-term growth. I take exception, however, to Fink’s call to CEOs urging them to put an end to quarterly earnings guidance. This is not a new position for me. Because I feel so strongly about this issue, I devoted an entire chapter to it in my 2008 book, “Even Buffett Isn’t Perfect.” I favor guidance for a number of reasons. First, it comes straight from the horse’s mouth. Guidance is provided by the very people who are running the company. These people know better than anyone how the company is likely to do. I want to hear from them in as specific terms as possible. I don’t take what they say at face value. But I do want to hear what they have to say – then it’s up to me to judge what to make of that information. Second, studies show that analysts’ earnings forecasts are not particularly reliable to begin with… and it turns out they are even less accurate when guidance is not provided. Third, although some investors believe that executives are more likely to take actions that will increase company value over the long term if they don’t have to deal with the pressure of living up to quarterly guidance, studies on the topic uncover no evidence that companies increase capital expenditures or investments in research and development after they eliminate guidance. Fourth, studies also show that there is a negative stock price reaction when companies announce that they will no longer provide guidance. Interestingly, although management usually says they are eliminating guidance because they believe it is in the best interest of investors, it turns out they usually eliminate guidance when the company is having financial difficulties. What’s even more interesting is that these very companies often change their minds and begin providing guidance again when business conditions improve. There is one critical issue I wish everybody would understand. While it’s true that there is too much focus on short-term results, this isn’t the result of guidance. The reason investors pay so much attention to quarterly earnings in the first place is that the SEC requires corporations to report their financial results every quarter. That’s right. Short-termism is a direct result of regulation. So if you really believe that short-termism is a problem, instead of urging CEOs to stop providing guidance, it would be more effective if you urged the SEC to end the quarterly reporting requirement. To be clear, Larry Fink is not in favor of that. Neither am I. Perhaps this is the greatest irony of all. Our country recently went through a financial crisis that was in part caused by a lack of transparency. In response, regulators implemented all kinds of new rules specifically designed to increase transparency. Eliminating guidance, however, does exactly the opposite. It reduces transparency. To say that we’d be better off with less guidance is the equivalent of saying that we’d be better off with less information. That’s simply nonsense. As I said earlier, research studies show that there is a statistically significant loss in share value when companies eliminate guidance. These studies also show that companies that eliminate guidance continue to underperform for as long as a year. So if you own shares in a company that has regularly provided guidance and then stops doing so, you might want to think about getting out of that investment. On the other hand, if you are invested in a company that has never provided guidance, you need not worry. Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ) and Alphabet (NASDAQ: GOOG ) (NASDAQ: GOOGL ) are two companies that have performed well over the long term. Neither one has ever provided guidance.