Good Reads

When it comes to links, I believe in quality over quantity. Here's some of the best of what I read this week:

Reuters reports on the major commodity trading houses (here). Seems like their volume would really move markets. Given that a lot of these firms are traders as well as producers, it is possible that are classified as "commercial hedgers" in the CFTC commitment of traders data. Maybe this is why Peter L. Brandt pays so much attention to this classification?

FT Alphaville brings a unique take on deleveraging (here).

The London Stock Exchange is padding their bottom line by lending to Italian banks in need of liquidity (here). While the way the have structured the lending (as a depositor rather than a creditor, thereby placing their claims higher in the capital structure) is prudent, regulators must hate this as it is another possible channel for contagion.

The Economist considers the challenges facing Mario Draghi, the new head of the ECB (here). A little dated, but well worth the read.

Boeing delivers 32,000 pound, $15.7 million bunker-busting bombs to the U.S. Air Force (here). Given all the recent rhetoric surrounding the IAEA report on Iran's nuclear weapons program and the possibility of an Israeli air strike, the timing of this release is interesting. Granted, the first of the bombs were delivered relatively recently.

Forecast Fails

As a user of the (excellent) Bloomberg data terminals at work, I am by default a recipient of the (generally crappy) Bloomberg Markets magazine. I usually keep them on hand for when I have been thinking too hard and need to read something inane while my brain reboots.

This month’s edition had an article titled “The World’s Best Financial Stock Pickers” which detailed the sell-side analysts – complete with awkward, contrived photographs – who had the best record calling financial stocks since January 2009.

The best team was Citigroup, who “made 26 accurate calls on the 43 financial stocks they follow”. 60 percent. That was the best of 212 firms - not very impressive. Despite having a section on “How We Crunched the Numbers”, the authors were not clear on what constituted a correct call in their methodology. This is unfortunate because it does not allow us to determine whether flipping a coin is more accurate than all that analysis. That being said, this gem implies that maybe the Citi team was better than the 60% implies: “on average, the 212 firms ... got 1.3 stock recommendations correct out of every 16”. I don’t know if that’s a typo, but it sure makes me sceptical of the next bounce I see off of an analyst upgrade.


Note: As an aside, there a few members of my organization who consider Bloomberg Markets to be more insightful than much higher-quality publications such as The Economist. Such a conviction is generally an excellent indicator of the intellectual capacity of its possessor.

Long Groupon

Yup I said it. To my knowledge, I am the only person out there who has said it - the coverage of GRPN in the blogosphere is universally bearish.

Not only that, but all of the available supply of securities have been sold short at very high lease rates (here - technically in order to go short you have to locate someone who is long and pay them an annual return for the privilege of shorting their stock).

Additionally, I hate this stock. They are spending way too much to add customers, their business model is easily replicable (which means that margins will inevitably shrink), and their valuation bakes in growth rates which I consider an impossibility.

So how do I end up recommending a long position? For one, assuming that no other investors are willing to lend out their shares, there will be no more selling pressure from the shorts (as well as a non-negligible risk of a short squeeze). Two, I don't think there will be immediate clarity on the strength of the bearish arguments - it will take a couple of quarters of reporting for the market to reach a consensus. In this period, I expect significant volatility in the stock's price.

Finally, the nature of my long position is important. I purchased a very small amount (1% of capital) of July 2012 $30 calls this Monday for $1.10 apiece (mid-price is currently $1.70). The skew in pricing between puts and calls was pretty outrageous - at the time similarly out-of-the-money puts were trading for about 4.5X the price, tilting the odds in my favour. This position exposes me to asymmetric payoffs: a small loss if the stock falls (the most likely scenario) and a large profit if the stock defies gravity and rises.

In sum, my thinking here is that this stock will experience considerable volatility over the next few months (look at LinkedIn's price history for a guide). As a result, there is a considerable probability that Groupon could appreciate from here. Even if this move is only short-lived, my options will move in a similar direction. Timing the exit from this trade will be difficult, and there is a considerable probability that I end up holding the options as they expire worthless. However, due to the asymmetrical payoffs of this trade, I consider this a positive expected value situation.

Disclosure: I am long July 2012 $30 calls. I also went short AMZN via Jan 2012 $200 put options after they failed the retest of resistance at $220 yesterday - see previous post here.

EZPW Beats Earnings

In my last post, I laid out a synopsis of the bull case for EZCorp. It didn't take long for my views to be validated - EZCorp posted Q4 earnings of 72 cents last night, beating expectations by two cents. International growth was strong (especially in Mexico) and is poised to be a driver of considerable earnings growth moving forward. They also guided for $3.05 to $3.10 in earnings for 2012, mildly above analysts' expectations of $3.00.

The stock is up 2.5% today outperforming the market by 6%. So far so good on this call.

Disclosure: I remain long EZPW

Warren Would be Proud

In this environment, there are a lot of good buys on the market. EZCorp is my favorite of them. EZCorp is a pawn shop operator with operations concentrated in the United States, and aggressive growth internationally, particularly in Canada and Mexico.

In fact, they do quite a bit more than pawning, but all of their operations are focused on providing financial services to the "under-banked" lower class. Due to the paucity of competition in this sector, they enjoy enormous margins and are growing quickly - if they come in-line with guidance on 8 November (they rarely miss), EPS will have grown at a compounded rate of 30% over the last 4 years! Even if you halve this growth rate moving forward, with a P/E of 12, you get a PEG of .80 - great value.

This company is also run very prudently: conservative accounting, no debt. Their expansion and acquisitions have been financed entirely by internal cash flow. Since they are reinvesting so much cash into their business, Price/FCF is not a good valuation metric, but their CFO over the last 12 months is $337M, yielding a Price/CFO of 4.15. I know, kind of an odd metric, but the bottom line is that they are generating a ton of cash.

This stock has been killed over the last few months. It sold off hard after missing revenue expectations by one cent last quarter (they met earnings). Combine that with a broad sell off in global equity markets and an analyst downgrade, and you have a stock trading at nearly a 40% discount to where it was in July.

What are the catches? The biggest one is that the publicly-traded class B shares are non-voting. This means a substantial discount (maybe 25%?) must be applied to valuations of comparable firms. This also necessitates closer monitoring for signs of agency problems between voting and non-voting equity holders. There have also been concerns of regulators cracking down on some of EZPW's business lines. However, with the current deadlock in Washington, I do not foresee the realization of any regulatory risk events until sometime in 2013 when next administration begins implementing their agenda.

Bottom line is that this is a big-time growth stock trading close at a value stock valuation - huge upside. Applying a 15X multiple (very reasonable for a company experiencing as much growth as they are) to next year's earnings of $3 gives you a conservative price target of $45. I would not be surprised to see this stock trade at or near this level over the next 12 months, as multiples expand and earnings continue to impress. Over an even longer time horizon, as EZPW's market cap and volume increases, it will meet the investment standards of the larger institutional investors, and multiples should expand further, making this stock a great long-term play.

Disclosure: I am long EZPW

BAA II

Bad Asset Allocation: more tech.

Amazon is one of the few original dot-com companies that actually became a viable business. That being said, this stock is massively overvalued. Trading at 112X trailing earnings, this stock is priced like a small cap hyper-growth stock. The only problem is at this size, it can't grow like a hyper-growth stock, leaving it with a PEG of 7.While I do love Amazon (I buy pretty much all of my books there), this valuation cannot last. They have less than $1B earnings propping up a $100B market cap - absurd, and their forecast for Q4 earnings is -$200M to $250M.

Historically, shorts in this stock have been crused. I am still unsure when to put on my short, but am looking for a good entry point. I will let you know when I find one.

Disclosure: I am not presently short AMZN, but may initiate a position in the next 72 hours.

On Greek CDS

I am quite a strong advocate of the most recent European bailout package. However, there is one aspect of it which I cannot countenance: European policy makers' pathological obsession with avoiding triggering Greek CDS.

By keeping the 50% writedown of privately held Greek debt strictly voluntary, it appears that this absurd fixation will be satisfied - the ISDA has indicated that they will not consider this a credit event. Beyond 'punishing the evil speculators', I am struggling to figure out why this issue is a focus of the Eurocrats.

I have detailed DTCC's numbers for the net notional exposures outstanding to various European countries (here), and they have fallen further (to $3.67 billion) since that post. Compared to the size of the 'voluntary writedowns', this is peanuts, so these exposures are not the motivation. I suppose it is a possibility that there is a huge over-the-counter exposure (ie not accounted for in DTCC's figures) held by some sort of European AIG, but I cannot imagine this is the case, as who would purchase non-standardized contracts if they had the choice of their centrally cleared counterparts?

The hushed-up incident of the suppressed European Commission policy paper which indicated that CDS provided liquidity to sovereign debt markets (here) erased any credibility policy makers had, leaving me to assume that it is in fact as simple as 'punishing the evil speculators'.  That is insane. What about the (presumably stupid) speculators who took the long side of these contracts when Greece was clearly bankrupt? Shouldn't they be punished? Or, what if the long side recognized Greece's insolvency but placed a bet that any bailout package would not include a CDS trigger - for some reason I find that deeply unsettling.

More important than the motivation are the ramifications, and with some guidance from Macro Man (here) and FTAlphaville (here), I have isolated what I consider to be the three most significant implications:

1. This will spell the end of the sovereign CDS market. When a 50% haircut doesn't trigger payout, then who will trust these credit products moving forward? Macro Man has suggested long-term bond futures as a viable alternative to CDS for hedging purposes.
2. If sovereign CDS cannot be trusted as a hedge, any holders of peripheral sovereign debt who had hedged via CDS will now be second-guessing the safety of their positions and will be incented to sell their remaining peripheral sovereign debt holdings, thereby pressuring funding costs for these countries.
3. What will this mean for the capital positions of banks which have hedged positions via CDS? Basel II gave relief on capital requirements positions hedged with CDS, but if the hedges are now (arbitrarily) bunk, this becomes a serious question. 

And that is only what immediately comes to mind; there may be more (as yet invisible) implications. The bottom line is that this policy is both populist and reactionary. Those three words in a sentence make me shudder. The thought of financially-illiterate European policy makers attempting to fine-tune financial markets should be reserved for my nightmares.