Stock talk for the main street investor.
Apr 15 2010

Interactive Brokers

I’m a few days late. I apologize to my three regular readers.

Last time I wrote I talked about how increased volume on exchanges is helping NYX and how this can act as your personal tax on Wall Street. I also mentioned their biggest risk factor being the rebates demanded by market makers. Let me explain how this works and how Interactive Brokers (IBKR) fits in.

When you go to buy or sell a stock there has to be a counter-party to take the other size of the trade. These are market makers and they sit on the bid/ask of almost every stock. For instance if I’m a market maker in Starbucks (SBUX) as it’s currently trading I will buy at $24.77 if you want to sell or I will sell at $24.78 if you want to buy. You as the investor lose that $0.01 spread as a payment of liquidity to the market. This may not seem like a lot but if you trade 100 shares at a time, multiple times per minute, the profits add up quickly.

On top of this spread premium, the exchange actually pays market makers to trade. So the exchange charges you (the price “taker”) a fee, which is part of the cost for your broker, and part of that fee goes to the market maker as a price of providing liquidity. This liquidity fee is currently in the range of $0.002-$0.003 per share. This is how banks make a lot of money trading.

This is also why I’m looking at IBKR. They have two basic functions in their business, brokerage and market making. Gross margins in the market making business are over 60% and brokerage is nearing 50%. IBKR has done an outstanding job of building the electronic infrastructure to automate most of their business activities which allows them to focus on gaining more customers, growing 30% in the last two years.

I like the trends, the business model and I’ve heard great things about their majority owners. The challenge is valuing the company. Earnings can be very choppy in trading activities especially in challenging times like the last two years. Their current P/E of 18 is reasonable given their upside potential. I also like that they’re market value is only about 1.2X book value. Look for more stable earnings as the market settles down.

Disclosure: The Mayor has no position in IBKR or NYX.

Apr 11 2010

Your Personal Tax On Wall Street

It’s become apparent that Wall Street runs the world. Whether it be bailouts or incredible pay packages, they’ve gained enough power to seem nearly untouchable. So, lets make some money from Wall Street. One of the trends on Wall Street is investment banks moving more of their business into trading activities. They join hedge funds as frequent traders trying to take a little profit from every transaction. So how do we profit from this change in activity?

One way is by owning the exchange these traders use. NYSE/Euronext (NYX) is one of the largest exchange operating the New York Stock Exchange, Amex, Arca and Euronext. These exchanges provide a venue for people to trade stocks, bonds, futures, options, etc. They charge very low fees per trade and depend on volume to make their business operations profitable. A strategy that plays into the hands of trends in the market. In 2003 about 5 billion shares of stock were traded on the 10 largest exchanges, a number that has ballooned to nearly 35 billion in 2008. This is similar to trends in futures and options.

Though trends are to higher volume there is also increasing competition. Exchanges provide nothing more than a place to trade and are sensitive to prices and thereby losses of either buyers or sellers, who have very low switching costs. This is the reason for consolidation in the industry over the last few years. I believe this consolidation reasonably insulates the industry from new competition as the existing exchanges have sufficient users on both sides of the market and there is very little innovation that could steal these users.

Since this is a two-sided market there is a money side and a subsidy side. The subsidy side is the active traders who provide liquidity the market needs to provide buyers and sellers with a competitive market. The pricing pressure mentioned above is related to the amount of payment (yes, they get paid to trade) these liquidity providers receive. This is the biggest risk factor in their business, although I think it is manageable.

NYX is paying a 4% dividend currently and management has committed to increasing this in future quarters indicating confidence in their performance. A forward P/E of 11 is very reasonable and considering they’ve beaten estimates the last four quarters the company seems reasonably priced.

Tomorrow I’ll talk about playing subsidy side of the market with Interactive Brokers.

Disclosure: Author has no position in NYX.

Apr 6 2010

Utility Banks May Be The Best Solution

Last week I attended a talk by Andrew Cecere, CFA of US Bankcorp. He was a straightforward man, who I found to be very impressive.  He spoke about how US Bank had avoided many problems other banks had in the financial crisis by keeping their structure and funding simple. He also spoke about how the worst thing that could happen to the banking industry is over regulation, which would lead to a utility style financial system. This regulation would kill innovation at banks.

As an engineer, by training, and having worked at 3M, an “innovative” company I find talk of innovation by bankers a vexing topic. Innovation in financial services generally means complexity, finding ways to bend the rules and increased leverage. No matter who you think may be at fault for the credit crisis I would argue that it would not be possible without bank innovation. Credit default swaps, option ARMs, balloon mortgages, over the counter derivatives among other products are the innovations banks have made in the last 20 years. And these products are also what brought the system to it’s knees. I challenge anyone to find an innovative and new product created in the past 20 years that has been a positive for the market.

My argument is not that these products are inherently bad, although they may be. I’m simply trying to say that innovation at banks is bad. It only leads to disaster because it allows for a false sense of security while increasing underlying risk. Holding a CDS against a bond gives the sense of “insurance”, but there’s not assets backing that “insurance”, so therefore, IT”S NOT INSURANCE.

I learned a long time ago a good innovation makes things more simple than they were before. Take any product Apple makes as an example of good innovation and making things more simple than they had been before. None of the innovative products I mentioned above do anything to make the banking system more simple and therefore are inherently bad innovations.

Banks as utilities may not be such a bad idea. Innovation at banks has proven to do nothing but cause problems.

Disclosure: The Mayor does not have a position in any financial institutions.

Mar 29 2010

Today – Buying Dreamworks

I bought a small amount of Dreamworks (DWA) on Friday after I got scared the stock wouldn’t stop going up. My reasoning was, if How To Train Your Dragon came out with good numbers and the stock went up I would be happy with a gain on my small position. If the stock dropped I would be able to scoop up more shares and bring my average cost down. The latter happened today after Wall Street was disapointed with $43.3 million in box office during opening weekend.

I was more concerned about the reaction from movie goers and the long term effects on Dreamworks. So far, so good. Reviews are outstanding from critics and movie goers. The 3D is apparently outstanding and the story line is good as well. Expect the word to spread through elementary schools like wildfire.

I could go into why a “disappointing” opening weekend by Wall Street standards doesn’t mean anything but I’ll leave you with one thought on how much I trust those idiots. Avatar had a “disappointing” opening weekend. That turned out OK.

Disclosure: Author is long DWA.

Mar 23 2010

Why Ford Scares Me

Ford (F) has had quite a run over the last year. The stock has risen from $2.51 to $13.90 because of the remarkable turnaround Alan Mulally has engineered. The sales organization is more efficient, cars are more stylish and the union has made concessions without going into bankruptcy like GM.

As impressive as this is I’m worried about Ford’s continued success. Last year, their first profitable year in four years, they only operated with a 2.3% net margin. As a result there is very little margin for error in their operations. Even the profit Ford had wasn’t all that surprising with 83% of profit occurring during the cash-for-clunkers quarter.

To find a year that gives indications Ford can be a $45 billion company you have to go back to 1998 when gas was about $1/gallon, Explorers were flying out of showrooms and Ford was raking in money on financing. A lot has changed since then.

I’m not calling a fall in Ford’s stock but I am pointing out the risk involved in owning Ford. All might be rosy right now but one bad accelerator could put them on an entirely different path.

Disclosure: Author has no position in Ford (F).

Mar 8 2010

Can You See 3D?

Alice in Wonderland made $116.1 million in it’s first weekend and the IMAX explosion continued it’s strong performance with $15 million of that. It appears that 3D and IMAX will be real main stays in this summer’s box office which is a good sign for Dreamworks, who has two movies opening this spring.

Dreamworks (DWA) beat earnings estimates by 36% in the December quarter and after a 2009 with very few product launches 2010 is set up to be much better. How to Train Your Dragon has very low expectations so will likely only surprise on the upside. The last Shrek movie will complete this franchise in theaters but spin off products like a theatre show are now launching.

Dreamworks has shown the ability to develop creative movies and their push to adopt new technologies quickly give them an attractive position in the film industry. Also attractive are their relatively low cost productions. An animated film, unlike a major motion picture, doesn’t pay actors large fees or a percentage of revenue. This gives all of the up-side to the studio itself. With an expanding customer base internationally and increasing ticket prices for 3D movies this upside is potentially huge in coming movies.

The fast adoption of 3D gives Dreamworks more revenue from each customer to the tune of $2-3. This additional revenue comes from a fairly small investment in the case of an animated film. If you’re already digital, how hard can it be to convert to 3D? These higher prices reduce the risk of a flop in the box office since less customers gives you the same revenue.

Valuation is reasonable at 24 times current earnings and 15 times next year’s projected earnings. Analysts have been raising estimates recently and I believe there’s still upside in 2010 and especially 2011 when more movies are due out. Dreamworks has beaten earnings soundly each of the last four quarters, which tells me the analysts don’t know what to do with this stock.

Disclosure: Author does not own any DWA but may in the very near future.

Feb 25 2010

Investing In ETFs May Be Dangerous

Over the last two years the ETF market has grown incredibly fast and new products seem to emerge every week. You can invest in the Case-Schiller Housing Index, India stocks, bonds, etc. But there are products anyone who is not trading these securities regularly should stay away from.

Products offering multiples of the daily movement of an underlying like oil. The problem with this is over time they will all go to zero. It’s simple math that people fail to consider. If a stock oscillates from $10 to $11 ten times and you own a 2x multiple even though the underlying has not moved at all you will have lost 16.8% of your value.

Beware when investing in these products. Always read the prospectus of any ETF carefully before buying.

Disclosure: The Mayor does not have a position in any ETFs.

Feb 23 2010

Risk In Financials

Investing in financial stocks may seem like a low risk endeavor. For hundreds of years banks have been a relatively safe investment so it would be easy to assume this will be the case into the future.

But complexity in the financial services sector has grown exponentially over the last 10-20 years to the point where CEOs of these firms have no real way of knowing the risks their companies are exposed to. If they did understand the risks Lehman wouldn’t have failed, Merrill Lynch would still be independent and we wouldn’t be in the financial mess we’re in today.

Complex products which are relatively new to the market have created much of the mess of accounting for risk. These products are so thinly traded and hard to value that only models can be used to create an accounting value. This leads to firms valuing their balance sheets with models they’ve created themselves.

The problem with this is that a model is only as good as it’s input assumptions. Like statistics, you can make a model say anything you want. If I re-modeled all financial institutions with very conservative estimates today I could make every one of them look insolvent.

The other thing that is scary with financial institutions is the way they calculate risk. Most times assuming a daily, weekly or monthly return is somehow normalized based on previous returns. This assumption puts a 1 in 10,000,000 chance that something like the housing collapse happens. The problem is, in reality these rare events happen every 5-7 years.

So are the models wrong? I don’t know, I just don’t understand them well enough to feel comfortable with their risks. Experts with years of experience have amassed incredible losses thinking they understood the risks in financial institutions. Main Street investors shouldn’t make the same mistake.

If you do need exposure to financial stocks I would stick to conservative banks like Wells Fargo or fee based asset management firms like BlackRock (BLK) or T. Rowe Price (TROW).

Disclosure: The Mayor has no position in any stock mentioned.

Feb 15 2010

What To Do With The Dollar

As the Fed discusses how to take liquidity out of the market and stop inflation from running rampant I’d like to discuss why we shouldn’t be as worried about a weak dollar as the talking heads would make us believe.

Lets start with the case for a strong dollar. When the dollar is strong we are able to buy more goods from other countries effectively benefiting from their cheap labor and natural resources. Consumption in the US goes up, imports increase, standard of living goes up, everyone is happy.

And just like every leveraged business plan or mortgage backed security this is a great plan… until it’s not. When unemployment is hovering around 10%, people are underemployed and real wages are frozen or falling we need to shift our focus from consuming more to employing more.

What we effectively do when the dollar is strong is move jobs from the US to overseas where labor is less expensive. In recent years this has pushed not only low skilled manufacturing jobs but high skill R&D, accounting, engineering, etc jobs overseas. A weaker dollar will make these moves less attractive and bring jobs back to the US where the consumption is occuring.

US multinational companies will no doubt have a different outlook. They would see profit pressures (some would see benefits) and may raise prices or have lower margins. As this is a stock blog I must admit this wouldn’t be good for the short term stock market returns. But right now I’m more worried about Main Street’s employment issues than keeping rich investors rich.

In my opinion a weak dollar would help Main Street the most, even at the expense of Wall Street. Long term though, I think it would be in everyone’s best interest to level the playing field just a little bit. For the world’s sake it is important for the US to have a strong economy and strong employment. When we don’t, everyone is a little bit uneasy.

Feb 8 2010

Blowing In The Wind – Vestas

There are very few ways to play the growing wind market. Big turbine suppliers like GE and Siemens are so large and diverse you would hardly notice if their wind units performed well. Utilities are tied to regulated power prices and power generators usually sign long term power purchase agreements with utilities before building wind turbines effectively turning them into fixed income investments.

But there is one large player in the market, Vestas Wind Systems (VWDRY.PK). Vestas manufactures wind turbines in Europe, China and the US. They have a 23% market share, according to the latest survey. Before the slowdown in 2009 the wind market grew more than 50% in the US during 2008 and at a compound rate over 35% for ten years prior.

Vestas is projecting tripling sales by 2015 and is already on par with natural gas for cost of energy. Higher oil and natural gas prices along with a requirement to capture carbon from coal plants in 2015 will drive demand for wind turbines which provide a constant cost of energy.

New technologies like off-shore wind turbines are a growing section of the market and Vestas has installed 51% of the off-shore turbines as of March 2009. They are working on a new 3MW off-shore turbine for 2011 and a 6MW turbine is in R&D. A turbine that size could power over 1,600 homes. The reason larger turbines are important is they become more efficient as their size grows.

Operationally I’m impressed in Vestas commitment to research projecting 2,000 R&D employees by the end of 2010. They have also committed to the US market by building some of their largest plants in Colorado.

All is not rosy in the wind market though. The credit crisis and low costs for traditional energy sources has hurt demand in 2009. Anticipated government actions to spur “green” development has failed to materialize and has negatively affected Vestas business. These dynamics have caused a dramatic increase in Vestas working capital and effectively hurt their cash position.

While these concerns are real I believe it is also the reason Vestas is currently trading at a reasonable P/E ratio of 12 on their full year 2008 results. When 2010 earnings are announced on Wednesday I expect that ratio to rise slightly at current prices but improving EBIT margins, sales growth and positive future economic and industry trends make this stock undervalued.

Another company to watch in the sector is American Semiconductor. They are a supplier of wind turbine parts and have major contracts in China where wind is growing extremely quickly because of government investment. I’m watching them closely but does not have a valuation as attractive as Vestas.

I have posted a link below to an article the NY Times did on China’s growing wind industry.

Disclosure: I do not own Vestas or AMSC.