Betting on Interest rate movements

Interest rates are now at historical lows across the board (here) , driven largely by the Federal Reserve's quantitative easing initiative. Yields on all forms of debt have been pushed down as the Fed continues to add Treasuries and other Securities to its balance sheet. At some point this will reverse and yields will start to rise, though it is anyone's guess when this will happen.

Given the Fed's intent to keep printing money until the economy "recovers", this quantitative easing could go for some time. We might end up in a replay of the situation in Japan, where a sluggish economy and low interest rates (here, and here) have persisted over many years. Though I think it is unlikely the US will face such an extended downturn - Japan's difference is that it has a rapidly aging (and soon to be shrinking) population, and structural rigidities in its economy that make it difficult to reconfigure itself to work within its new demographic reality.

When yields starting heading upwards, the shift is likely to be swift and sustained. There are a few ways to bet on this trend when it happens:

1. One way to profit from this movement when it happens, is to short bonds.
   
   
2. Another way is to buy put options on ETFs that track bond prices. As the move is likely to take months to years to play out, buying LEAPs on the ETFs tracking longer dated bonds will give you a larger window in which to catch and ride the yield upswing.
   
   This approach is relatively accessible to retail investors; just remember to read the LEAP product specifications (for example, 1 LEAP contract may represent an interest in 100 shares of the underlying "stock") Here are a couple of ETFs that track Treasury Bond prices:
   
   - iShares Barclays 1-3 Year Treasury Bond (SHY)
   - iShares Barclays 3-7 Year Treasury Bond (IEI)
   - iShares Barclays 7-10 Year Treasury (IEF)
   - iShares Barclays 20+ Year Treas Bond (TLT)
   
   
3. You can also buy put options on interest rates on the CBOE (CBOE) IRX, FVX, TNX, TYX

Investment Outlook 2011

2010 in review

The US stock market spent the better part of 2010 in mildly overvalued territory. As of December 2010, the S&P is hovering around 1200, and the overall market capitalization is around USD 14.2 trillion. The market capitalization ratio is around 100%. As we've seen in our post in October 2008, the fair value of the US market is around 70-80% of GDP, which in todays terms corresponds to the S&P at 960. (A good place to get an update of the market valuation is here at GuruFocus: http://www.gurufocus.com/stock-market-valuations.php)

History also suggests that market values will correct towards fair value, often overshooting in the process. But there is no guarantee that the past will repeat itself, and we must be careful not to drive forwards while using only the rear view mirror to guide us. The nature of the market and investor participation prior to the 1960s is different in some fundamental ways from today's market. Nonetheless, my bet is that the market is still overwhelmingly driven by human mob psychology, and that is something that has not changed throughout human history.

Market mob psychology has historically demonstrated the ability to allow:

- the market to fall to 50% of GDP. This would imply the probable lowest the S&P may fall to is approx 600. That's a 50% drop from here.

- the market to rise to 150% of GDP; this occurred very briefly during the 1999 dot com mania, and was an unprecedented all-time valuation high for the market. This would imply the S&P at being 1800, which is a 50% rise from here.

Wildly overvalued markets are often challenging for value investors, because almost all stocks can be overpriced. Similarly undervalued markets present a feast for value investors as the majority of stocks drop to fire-sale prices. Mildly overvalued or undervalued markets would typically present fewer investing opportunities, as individual stocks and assets become cheap because of poor investor sentiment arising from events such as bad press and unexpected (transient) earnings surprises.

However the market in 2010 did not manifest many such opportunities, because it demonstrated an interesting characteristic: a very high level of correlation across all stocks. This has commonly been referred to as the "risk-on, risk-off" behavior of investors. All stocks move up and down in unison, and individual stock picking thus becomes a very challenging task as every stock pick becomes a bet on the overall market movement. There are fewer opportunities to practice investing, the art of buying undervalued stocks whose prices then go up as their value gets realized in the market. One of the few opportunities that came up were the few times when high quality blue chip companies were trading at fair value.

Looking forward : 2011

The economic environment is 2011 is likely to continue to be subdued as we continue working through the mis-allocation of resources during the bubbles between 2000 and 2008. The high levels of obligations to retirees and government employees (manifested as debt and unfunded obligations) will likely be a drag on the economy, as either (1) working people adjust to reduce their standard of living to make good on these promises made by the government to other sectors of society by transferring the results of their production to these other sectors, or (2) society adjusts to inflation which comes from monetizing the debt to break those promises made. The drag on the economy comes from the psychological effect on people who discover that their plans based on past promises or projections now have to be changed. As they feel poorer and/or find less rewards in production, they may reduce their level of economic activity (production and consumption).

But does the underlying economy really matter for investors? Stock prices will go up if everyone gets whipped up into a frenzy, whether or not the underlying economy is sound. How it matters is that the degree of activity in the underlying political economy can increase or decrease the probability that investor psychology will be triggered in one direction or the other.

What is 2011 likely to present to us: what are the known risks this coming year?

1. The risk of people recognizing that massive central bank money printing will lead to inflation.
   
   
2. The risk of people recognizing that private and sovereign debt will default explicitly or implicitly via inflation, either way leading to inflation or increasing yields; because of the large amounts of debt.
   
   
3. The likelihood that economic growth continues to be slow, as we work through the continuing economic readjustment from the housing and financial asset bubble.
   

The underlying longer term trends, that we have observed earlier, continue to play out:

1. reduction in availability of low cost resources (energy, commodities)
   
   
2. demographic trends: aging in the vast majority of developed countries, and China

How investor and mass psychology plays out over the coming year is uncertain, though the triggers for a market correction seem to be there.

Investing Playbook

Given the underlying economic landscape, and what seems to be latent triggers for a change in investor psychology leading to a fall in equity prices, we look towards investing in companies which have strong business positions and growth ahead of them. Their downturn resistant earnings streams should support their stock prices to some degree, and even driving a growth in prices once correction-psychology stabilizes. The key is to buy at fair prices, as it is highly unlikely that companies seen as low-risk, durable and world-leading will sell for cheap prices for too long, irrespective of how much the market corrects. It is unlikely for example, that WMT would go for less than 10 times earnings for any prolonged period of time. A study of the bear market in the 1970s would suggest this belief.

Other more transient, or in-the-moment approaches are likely to be tricky this year. The recent erratic risk-on risk-off nature of market psychology makes it difficult to make money by playing transient shifts in changing asset preferences. It also makes it difficult to make the traditional value investing play of buying assets below their fair prices, in the hope of markets recognizing their true value.

The one shift in preference that seems a possibly good bet is the shift away from debt instruments. Rising recognition of sovereign default would likely trigger a shift away from bonds and resulting in rising yields. This has been expected for several years, and it is still anybody's guess whether this will happen this year. But when it does, it is likely the shift will be swift and decisive, providing an opportunity to place a bet on the continuance of this shift after it has started.

Consumer food companies: profitability, debt burden, revenue diversity

Here's a cheat sheet for the profitability, revenue diversity, and debt burden metrics for several of the world's leading consumer foods companies:

Blend of reported numbers and estimates for FY 2009 / 2010 (USD millions)

	CPB	HSY	NSRGY	KFT	HNZ	GIS	K
Revenue	7,676	5,298	107,618	49,000	10,500	14,796	12,575
% from US	81%	86%	? 25%	?	44%	82%	68%
% from International	19%	14%	? 75%	?	66%	18%	32%
Operating Income, before interest expense (margin)	1,348 (17.56%)	761 (14.36%)	14,970 (13.91%)	5,814 (12.3%)	1,559 (14.8%)	2,861 (19.3%)	2,001 (15.9%)
% from US	89%	~90%	? 25%	?	53%	92%	86%
% from International	11%	~10%	? 75%	?	47%	8%	14%
Net Income (margin)	844 (10.99%)	436 (8.23%)	11,793 (10.96%)	2,376 (4.85%)	864 (8.2%)	1,535 (10.3%)	1,208 (9.61%)
Cash flow
Operating cash flow (before paying interest expense)	1,169	1,155	18,728	?	1,557	2,581	1,938
Interest expense (as a % of revenue)	112 (1.46%)	90 (1.70%)	794 (0.74%)	2,126 (4.34%)	295 (2.81%)	400 (2.70%)	295 (2.35%)
Operating cash flow (after paying interest expense)	1,057	1,065	17,934	?	1,262	2,181	1,643
Debt burden
Total debt (does not include liabilities such as accounts receivables, leases etc)	2,780	1,542	~23,404	30,030	4,500	5,375	4,836
Debt to operating income ratio	2.06	2.02	1.56	5.17	2.88	1.87	2.41
Debt to operating cash flow (bef int) ratio	2.38	1.36	1.25	?	2.89	2.08	2.50
Interest expense as % of operating income	8.3%	11.83%	5.3%	36.57%	18.92%	13.98%	14.74%
Estimated interest rate incurred on debt (guesstimate; does not consider different debt maturities)	4.03%	5.83%	3.39%	7.08%	6.56%	7.44%	6.10%

ADP Investment Thesis / Stock Analysis

ADP is in the business of handling human resource and payroll processing operations for its customers. It is part of the data processing or back room operations outsourcing industry. This industry has been around for some time, and cuts across many industries and business functions. For example: Public listed companies outsource their shareholder and investor relations services to companies like ComputerShare; Financial institutions outsource their banking and payments back room operations to firms like BR, FISV, JKHY, and FIS; and many companies outsource their accounting and back office functions to service providers like WNS and Genpact. Companies can even outsource their payments processing to service providers like TSYS.

ADP's business and competition

ADP handles three main types of business operations: (1) the processing of company payrolls, (2) hiring employees and attaching them to customer companies (the business of being a Professional Employer Organization), and (3) the handling of core business processes of auto dealers.

ADP's 2010 revenue was approximately USD 9b, and its closest competitor PayChex had 2010 revenue of approximately USD 2b. There are a number of other competitors, though none close in size to ADP, such as

Hewitt Associates ,

AdminisStaff , and

ReyRey (Dealership software)

The economics of the outsourcing business

The value proposition of business operations outsourcing is that the outsourcer is somehow able to carry out the outsourced operation better than the company can. This implies two things:

1. that the process is not a competitive differentiator. Otherwise, the firm would cede its economic position over time.
   
   
2. the process itself must be one subject to an economic effect (such as the "economies of scale", "economies of experience", or "the tragedy of the unregulated commons"), so that by operating the process for many companies, the outsourcer can deliver more value to each individual company than if the individual company were to do it itself. Otherwise, there is no value to outsourcing the business process, unless it is for accounting (expense vs capex, expense vs overhead) presentation or business strategy/focus reasons.
   
   If follows that if this is the case, then any company that does not subscribe to an outsourcer's services will be disadvantaged compared to similar companies that do use an outsourcer's services. When outsourcing truly adds value, then it almost tautologically creates a self reinforcing feedback loop. Companies who use the pooled services get benefits they otherwise could not obtain on their own, which leads to other companies also joining the pooled services so as not to be disadvantaged, which further leads to even more benefits to pooled members.

We can validate whether an outsourcer is truly creating economic value by reviewing the long term business record and retention ratios of the industry, covering at least 3 contract renewal periods. This will negate the artificial growth in cases where outsourcers do well in the short term (as companies try them out) but where the true long term benefit is elusive. An outsourcing industry and/or an outsourcer that grows and is profitable over the long term suggests evidence that: (1) the process it operates is not a competitive differentiator for its clients, and (2) there are factors that allow it to enjoy economic effects by pooling client operations.

In the case of human resource and payroll outsourcing, the long term record of ADP and PAYX (PayChex) suggests that the operations do indeed add value for their customers. The question for us then is whether this will persist into the future; whether future technology, laws, tastes and zeitgeist will allow the ecological niche that they occupy to continue to exist.

The ecological niche sustaining the PEO and HR payroll outsourcing industry

Over the course of history, changing tastes, technology, demographics, cultures and political economy allow conditions to arise that make room for new types of businesses. These ecological niches come and go over the epochs of history.

ADP's industry was made viable with the arrival of computers, which allow data processing to be subject to the economic effect of economies of scale. Because once a mainframe was purchased, the incremental cost of processing an additional unit of data is marginal. (As compared to pre-computing age, when this data processing was done by people) The high capital investments needed in mainframes, software and data processing technology magnified the economies of scale effect in this business.

The secondary force contributing to this industry's viability was that HR and payroll practices were becoming increasingly standardized across companies, and that for regulatory and other reasons, these processes were becoming increasingly burdensome to operate considering that they did not confer competitive advantage to the company.

This created the ecological niche for PEO and payroll processing companies. ADP and PAYX executed well, and are now the two dominant players in this industry. It is not uncommon for a few firms to dominate in industries that enjoy economies of scale or other economic effects that favor size and/or experience. (Conversely industries such as construction aggregate quarrying, cement manufacturing and flour milling, that do not allow for economies of scale or have products which are not cost effectively transportable, tend to be fragmented and have many small players. Michael Porter's book "Competitive Strategy" discusses this at some length)

Valuation and business prospects of ADP

(aka: How comfortable are we capitalizing the next 20 years of ADP's earnings; and what are those earnings going to look like?)

The need for payroll processing and operating HR processes is eternal. But the earnings quality, ability to earn supernormal profits, and the strength of ADP's business depends on:

(1) The sustainability of the ecological niche in its current form, and

(2) ADP's competitive position within this niche

(3) ADP's prospects for growth

Sustainability of the ecological niche: Whether this ecological niche will continue to exist in its current form depends on:

1. Whether data processing will continue to be a high capital cost endeavor that enjoys economies of scale. As long as the capital investments needed to achieve the current operating costs that ADP is achieving is relatively high compared to each individual company's operating budget, then the ecological niche will continue to exist in its current form. There are 2 foreseeable threats to this:
   
   (a) The lower cost of computing, driven by the increasing maturity of distributed systems and middleware, as well as online Cloud Platforms like Amazon EC2 which make it easier for a competitor to start a hosted software/data processing operation without incurring huge upfront capital expenses. This could open the door to a more fragmented industry with many small players, which would erode the competitive advantage that ADP's size confers to it today.
   
   (b) The structure of the economy changes and the number of SMEs/SMBs decreases meaningfully compared to the number of large enterprises. Large enterprises are more likely to be able to afford the capital investments needed to run their own operations at a scale where they would enjoy economies of scale.
   
   
2. Whether the cost of processing payroll/HR is going to get more complicated and the penalties for lapses more severe. In other words, will there be increasingly complex rules and laws to obey, with increasing costs / penalties for compliance failures or errors in processing. If the rules for HR and payroll processing become simpler, with few penalties / business costs for processing them wrongly, then the cost-benefit of outsourcing this work to a dedicated service provider will become less attractive.

The major megatrends that we know of today, namely (1) the adoption of

Internet technology and the Internet generation mindset, (2) increasing

Oil and Energy prices, (3)

Aging demographics, and (4)

China and India joining the world economy, are unlikely to affect this ecological niche.

Sustainability of its competitive position: ADP's competitive position in the current ecological niche is excellent.In an industry which enjoys economies of scale/experience, being the largest player allows you to operate at the lowest cost and offer the best prices to your customers. And price is likely to be one of the primary deciding factors for ADP's customers, since the processes being outsourced are relatively standardized and not a source of competitive advantage. In this regard, being almost 4 times larger than its next nearest competitor PAYX, ADP has a wide competitive moat.

Where is the growth going to come from: By most estimates, the vast majority of businesses in the United States (and the world) have not yet outsourced their payroll and HR operations. This leaves enormous room for growth, whether or not the macro economy does well.

What can go wrong / How ADP can screw it up

Assuming ecological niche remains as it is, the one thing that could torpedo ADP's earnings stream is if ADP messes up. The fundamental business value that ADP provides is that of cost-effectively handling business processes for businesses. In most cases, it is probable that the most competitive player is the one with lowest cost, and best record of risk mitigation.

The forseeable ways which ADP could stumble and cede business to competitors are:

1. ADP loses customer data or otherwise fails to deliver its services properly, causing a flight of confidence to other service providers, or
2. ADP fails to keep up changes in HR / payroll regulations or new business process needs, and allows a competitor to grow by servicing the new requirements, or
3. ADP's management forgets its source of competitive advantage and allows its cost position or pricing to gradually drip upwards, creating room for a competitor to sneak it and steal its customers.

Is a rights issue good for shareholders / Should I participate in a rights issue?

One way that companies raise capital is by issuing shares through a rights offering. Some shareholders see rights issues as a "gift" from the company, because the exercise price is usually below the market price of the shares in the market. They view a rights issue as the company giving them a special "by invitation only" opportunity to buy shares a discount to its market price. Others see a rights issue as a sign that the company's investment merits are deteriorating because the company is either being forced to adopt a lower-debt funding structure that reduces the shareholder's return on equity, and/or is becoming more capital intensive.

This post explains how both perspectives can be valid depending on the conditions surrounding the way the market views the company.

Case Study: an example of a rights issue and how it affects shareholders

Here's a simple, but representative, example that illustrates the mechanics behind a rights issue:

You buy one (1) share of a company with the following financial structure:

Total shares issued: 1,000

Shareholder's equity: $2,000 ($2 per share)

Earnings: $1,000 ($1 per share; ROE=50%)

Market price: $10 per share (PE ratio of 10; PB ratio of 5)

The next day, the company makes a 1:1 rights offer with an exercise price of $5 per new share. This gives the company the following financial structure immediately after the offer is exercised:

Total shares issued: 2,000

Shareholder's equity: $7,000 ($3.50 per share)

Earnings: $1,000 ($0.50 per share; ROE=14.3%)

Does it make sense for you as a shareholder to participate in the rights offer? If your primary concern is in maintaining your voting power, then you need to subscribe to the rights issue in order not to have your stake diluted. Otherwise you will end up owning a smaller percentage of the company.

However if your primary concern is the value of your stock holdings, then it depends on how the market values the company: whether the market values the company as a multiple of its earnings, or as a multiple of its book value.

• If the market values the company as a multiple of its book value, then a rights issues is beneficial to an existing shareholder only if the exercise price of the rights shares are above the Shareholder's equity per share of the original shares.
  
  
• If the market values the company as a multiple of its earnings, then a rights issue is beneficial to an existing shareholder only if the company can employ the additional capital at an ROE similar or greater than the ROE enjoyed on the company's existing shareholder's equity.

Here's why:

(A) Companies that are valued by their PE ratio.

In the best case scenario, the capital raised can be used with a ROE of 50% (the original ROE achieved by the company), then the company will end up earning $3,500 or $1.75 a share, and can be valued at $17.50 if the PE ratio remains at 10. If the company cannot put the new capital to such productive use, then the price of the shares should be lower because the earnings are lower.

Assuming this best case scenario, how then would a shareholder fare? A shareholder which bought 1 share originally at $10 (which he could have sold for $10), would have put in an additional $5 to subscribe to the second share. By contributing $5 out of his/her pocket, he now has 2 shares each worth $17.50, for a total of $35. The additional $5 contributed has resulted in a gain of $25. What has effectively happened is that the company has offered the opportunity to (1) invest $5 in a venture that has a ROE of 50%, and (2) benefit from the market's propensity to capitalize those additional earnings at a certain PE ratio. The shareholder has gain of $35-$10 - $5 = $20 ($35 of shares after the issue, $10 for the initial share purchase, and $5 for the rights exercise price)

Businesses that are lumpy step functions (like property developers) where there is a need for huge amounts of funds for each "project" can end up raising rights issues often. While they can try to keep retained earnings until they reach the critical mass needed for a project, many avoid doing this because during the interim years, the retained earnings just sitting there will be a drag on ROE and result in unhappy shareholders.

However in the worst case scenario, the company needs the additional funds just to continue operating as it is. Then the rights issue would be extremely bad for all shareholders. In this scenario, the company would continue earing $1,000, or $0.50 per share (since there are now 2,000 shares after the rights issue, instead of the the original 1,000 shares). The fair value price of the share would then be $5, assuming the PE ratio of 10 is maintained.

An investor would then be worse off. He originally paid $10 for one share. Then had to to pay $5 for the rights issue. In effect, he paid $15 for 2 shares, and the 2 shares are now worth $10 in total. A loss of $5 for the shareholder. In reality, if the ROE of the business dropped, the fair value of the company in PE ratio terms would also drop, which would further reduce the value of the shares. This is a simple mathematical relationship in the Discounted (Extractable) Future Earnings model for valuing any asset.

So in summary, whether or not you are financially better off depends on the ROE at which the company can employ the new capital being raised:

• (a) if the company is raising funds for a new venture, then the funds raised had better earn returns that justify the current share price.
  
  
• (b) if the company is raising funds to continue operations, because it cannot access debt, then your ROE is dropping and the fundamental investment merits of the company have changed.

(B) Companies that are valued based on their book value.

The amount of gain for a non-participating shareholder depends largely on how much higher the rights exercise price is to the book value per share of the original shares.

In the best case scenario where shares are issued at a price higher than current book value per share, you would have benefited even if you had not participated in the rights offering. Let's see how this works: your original share would now be worth $17.50 each and you would have a gain of $7.50. What has effectively happened is that you've gotten a free ride, because the rights shares buyers are effectively subsidizing you. Buying the shares on the open market, you paid $10 each share which had $2 of underlying shareholder equity, without actually injecting any equity into the company. Whereas the "buyers of the new rights shares" are injecting $5 for every new rights share they are being given. This $5 they have injected will increase the value of your "original shares". In other words, there is new additional shareholder's equity for your shares, that is being paid for by the new buyers.

But if the company has issued the rights at an exercise price of $2 (the book value of the original shares prior to the rights issue), the company would have $4,000 in shareholder's equity. There would be no gain for you in book value per share terms. So the market value of your stock holdings would be unchanged.

In the worst case scenario, the company has issued the rights at an exercise price of $1 (below the book value of the original shares prior to the rights issue), the company would have $3,000 in shareholders' equity. The book value per share would have dropped to $1.50 per share, and the market value of your existing shares would be diminished. In this case, it pays to subscribe to the rights, since the premium of the market value of your new shares over their exercise price would counter the loss in market value of your current shares. Whether or not this completely compensates for the drop in value of your existing shares depends on how far below the book value the new shares are issued at.

So in summary, whether you benefit depends on whether the shares are issued at an exercise price equals to the book value of the current shares, or if it is greater/less than it. If it is greater, than you may benefit even if you don't subscribe to the shares. If it is less, then you may need to subscribe to the shares just to minimize the losses in the market value of your existing shares.

Short-term trading opportunities when a rights issue occurs and trades on the secondary market

In the short term after a rights issue is announced, the immediate question that strikes many investors is: is there money being left on the table, when a company is selling new rights shares at less than its market price? Strictly speaking the answer is no, because the current share price is simply a reflection of the returns on the capital /book value already in the company. The rights issue will have changed this calculus, because the key question going forward is what is the ROE on the new capital / the new book value per share after the rights issue.

However this line of thought is sometimes the reason why the existing/new shares may continue trading at their prevailing prices. (In other words, the market can't figure out the "correct share price" after the rights-issue) This can create a short-term windfall for existing shareholders, because the rights may trade at over-valued prices. When this occurs, shareholders who subscribe to the rights can sell the rights. Likewise, the market may clear at a a too-low "post-rights-issue" price, and the rights trade at a unfairly low price. This creates a buying opportunity for new investors to take an ownership stake in the company at a discounted price to the market.

The key in both situations is that you must have a clear idea of how the market values the company over the long run, and whether the rights exercise price creates a beneficial or detrimental situation for you as an existing shareholder (see our earlier analysis). That will allow you to figure out the price that the shares would likely trade over the longer term after the rights-issue, and allow you to see if a mispricing has occurred which you can take advantage of. Of course, be aware that the mispricing may continue for quite a while, even after the rights issue exercies, because it takes a while for the company to actually deploy the capital and earn the return which you think it should be earning.