It’s been busy the last couple of weeks. Things are back on track and here is my first entry in over a month.

Consider Oil:

We can guess where the economic recovery will take place, but no one can know for certain. However, when the economy recovers, no matter where it starts, oil will be in demand. Some encouraging facts:

• The average American consumes 25 barrels of oil per year. The average Chinese consumes 2. Yes, the new cars will be more gas efficient and so forth. Let’s just assume that Americans will only consume 20 barrels a year. If the Chinese were to catch up to America’s standard of living, they too, would consume 20 barrels of oil. China’s population is approximately four time that of the U.S. You do the math. The standard of living in Brazil, Indian and Russia are also on the rise and citizens in these countries will stress the supply of oil.

• While different sources studying the cost of oil production yield different results, it is fair to say that the cost is about $60 in low cost oil fields (the Middle East) and higher in oil sands (Canada). Peak oil theory suggests that we have already picked off the low hanging fruits. The cost of production will only climb up.

In a world where oil will be in high demand and production cost is high, you can invest in one of two ways. First, invest in a product that is long on oil. It could be something that tracks an index or simply goes long on oil futures. Another way is to invest in companies that supply oil discovery and drilling equipment and services. Their service will be needed to find that oil that’s scarce and hard to tap.

Remember that high oil prices do not automatically translate to high profits for oil companies. They’re facing an increasing marginal cost of production.

Areas to exercise caution:

Each economic boom is driven by a specific industry. You had your dot com boom in Silicon Valley in the US. Hong Kong had its real estate boom in the nineties. When one bubble bursts, the baton is passed on to the next industry. It’s much like fashion; one trend dies and another one is put in the spotlight. Eventually, those tight fitting jeans will be stylish again but that won’t happen until many fads come and go.

Given this, the financial industry, especially in the US, is one area you’d like to avoid.

• The basic business of a bank is to pay you a rate of r on your savings and charge r + x on loans. In the U.S., consumers are deleveraging, i.e. borrowing less and saving more.

• The quality of earnings is in question. Accounting rules require certain assets to be marked to market, but for illiquid assets, they may be marked to model. How accurate are these models? No one knows. Warren Buffett thinks the concept of mark-to-model is more like mark-to-myth.

• The financial industry has experienced years of deregulation which permitted innovative financial engineering to take place. The new era is tighter regulation. This means that banks will need to go back to the basic business of borrowing and lending and not package “funny” products that have done so well for them before the bust.

China , while full of potential in the long run, is one area to be careful with in the short run. China’s stimulus did not result in the desired effect of stimulating economic activity. Instead, it’s creating bubbles in the stock and real estate markets. The government doesn’t like what it’s seeing and has stated publicly that it will take measures to cool down the markets. If you have an investment horizon of less than five years, be careful when pumping money into the Dragon economy.

Other notes:

• Legendary investor Warren Buffett said that it’s about time the government stopped printing more money and be more disciplined with their spending. The U.S. government is spending 185% of what it takes in. The economy has gone through the worst part of the storm so there’s no reason to keep the printing press running.

• UBS is no longer the safe haven for tax evasion. Internal Revenue Service can (finally) access UBS’s client information.

• Li Ka Shing, Hong Kong’s wealthiest man, warns individual investors about the stock market’s current value.

Thank you for your comments Eric and I would like to apologize for taking so long with this article. For investment ideas, I must first establish a few things about my approach. First, I take the top-down approach. This means that I start with the high level looking at the big picture to narrow down of areas of possible interest whether it be in a sector region, industry or both. Secondly, I believe in value investing. From Ben Graham to Warren Buffett, this style has stood the test of time. Of course, this is not the only style that works, but it’s just the style that I prefer.

Talks of “Green shoots”

The general consensus is that the worst of the crisis is over and there are signs of “Green shoots” in our economic recovery. I agree that we are almost through with the worst of the crisis. By worst, I mean that the economy is no longer in free fall albeit the global economy is still contracting. U.S. unemployment is currently at 9.5% and experts see that it should top at 10.5%. We can almost put the wave of bankruptcies behind us. Prediction on when we’ll bottom ranges from the end of this year to Q2 of 2010.

I want to make it very clear that hitting the bottom should not be interpreted as the beginning of a rebound. The world is not riding through a business cycle but is amidst a paradigm shift. The economy will rebound again. The problem is timing. The economy collapsed before the next engine of growth was fully ready to be dispatched.

American consumers – an engine with too much mileage

American consumers make up roughly 20% of the world economy and this group is financially ill. Timothy Geithner, the U.S. Secretary of State, was loud and clear when he stated that the world should not rely on U.S. consumers to lead the recovery. We all need to take this statement very seriously. Aside from fiscal and monetary policies, the success of any government stimulus plan rests on the general public’s confidence and policymakers have every reason to want to drive up public confidence. If policymakers are saying “don’t look at us, go find someone else to lead the economy”, mark their words for it.

U.S. consumers are changing their habits. The savings rate in the U.S. has not been positive for a long time. They are spending less and will very likely keep this habit after the crisis is over. For almost a quarter of a century, money has been growing faster than the economy by approximately 6% a year. With U.S. debt expected to reach 100% of GDP during Obama’s presidency, Americans have no choice but to continue to be thrifty for many years to come; this is the age of deleveraging. One columnist pointed out that this unwinding will continue until the year 2018.

China, the next engine?

With American consumers pulling the plug, the world is looking to China to lead the recovery. China has the world’s largest population and their GDP per capita is roughly 7% vs. the U.S. China’s standard of living will catch up to the U.S. The world economy has a lot of potential. If you’re a value investor, the next couple of years should be a good time to go shopping. However, there is a timing issue in the short run counting on China to lead us out of this mess.

While growth in China is strong, it is not invincible. For every 1% drop in spending by American consumers, Chinese consumers need to raise their spending by 5% just to keep world GDP from declining. In tough times, the mentality is to save as much as possible in anticipation of rainy days ahead. On top of that, the Chinese have a high propensity to save even in good times. Unless you can convince 1.3 billion Chinese people to go out there and spend 5% more, talks of China leading us out of this is more of a hope.

Here’s something that you should know about the Chinese economy; it is not fully market driven yet, the expected growth rate is 8% and the government is willing to use its reserves that it has accumulated from years of trade surplus to reach its target. Simply put, some of the growth from the world’s economic superstar is artificial. Many entrepreneurs have shut down their factories and shed many jobs in the process (and you expect Chinese consumers to go out on a shopping frenzy?) On top of this, China is imposing stricter environmental regulations, putting further pressure on the manufacturing sector. China has its own share of problems that it needs to deal with. This super engine is still under development.

The road to recovery

We can still expect the recovery to begin in China, but just don’t expect it to be explosive as it has been in the last decade. China cannot convert its export driven economy to a consumer driven economy overnight. Luckily for China, the government has ample foreign reserves (almost US$2 trillion) and they actually need to spend money on infrastructure. Also, with commodities on the cheap, one can hope that Chinese consumers will be more willing to open their wallets gradually. One concern is that global trade is breaking down, meaning that what happens in one country has less impact on others. Can we interpret a recovery in China as a recovery as a global recovery? I have my doubts.

So what does this mean to your portfolio? I will discuss it in part two.

I have been asked as to why it’s taking me so long with this article. Recently, I’ve been bogged down by some personal stuff. One of the suggestions that I got is to post weekly updates on key world events with some short commentary while I write the big articles. I think that’s a great suggestion. Please check back weekly for updates.

Thanks for your support!!

P.S. Thanks to Michael Jackson for everything he’s brought to this world. Rest in peace Michael.

The “B” word along with “GM” and “Chrysler” often appear in the same newspaper articles. Bankruptcy is failure. Bankruptcy is bad news. For now, let us define bankruptcy as a situation where an entity is in default with their debt obligations. When you see the “B” word again, just think of it as news that’s neither good nor bad. Think of it as just a piece of information.

Chapter 11

When you read about bankruptcy in the United States, you will probably see the term “Chapter 11” somewhere in the article. What exactly is Chapter 11? When an entity files for Chapter 11, it is actually under protection from its creditors and a complex restructuring process begins. The restructuring process attempts to fix the entity so that it will resurrect in a new form and “go back to business as usual”. It will involve creditors to forgive the entity’s debt, often exchanging for equity positions. It is not surprising that creditors that become shareholders reclaim a measly 20 cents on the dollar on the investments.

In the meantime, the entity could re-negotiate some other contracts that are outstanding. Chrysler was in constant talks with the Union to adjust their hourly wages to more competitive levels for example.

Bankruptcy proceedings can be a messy business as there are many parties of interest involved. The creditors will want a bigger share of the company. Workers will want to keep their wages and benefits. The Bankruptcy Court decides on what is fair or not. Otherwise, the process will never end.

Chapter 7

There is no need to write much about Chapter 7, though it is a term that is less heard of. This is when an entity’s assets are liquidated and paid out to its stakeholders according to the pecking order; you know, secured debt holders get first dip, then the unsecured debt holders, and then the shareholders. Each level would get something only if the level above has something left for them. For this reason, shareholders can be fairly sure that there is nothing left for them. After the liquidation process is complete, the entity is forever gone.

Bankruptcy and the Detroit Big Three

Chrysler has filed for bankruptcy, GM is not far away, and Ford says it has enough cash to burn for just another year. I think bankruptcy is actually helping Detroit to take the fast lane in getting out of its darkest days.

Chrysler and GM are or will soon be under Chapter 11 protection. This means that stakeholders believe they will benefit by turning the company around instead of dumping everything at fire sale price before they lost everything. Think of the Chapter 11 process as a student who is failing his classes in school, but the teachers believe that she still has the potential and imposes disciplinary actions on her. Chapter 7 is equivalent to expelling the student because she is hopeless.

Chapter 11 will definitely help Detroit migrate to the next automotive era, but this does not mean that they will shine like the stars that they once were. Detroit failed to realize that they had entered an era of innovative competition, especially in the arena of fuel efficiency. Toyota got a head start in Hybrid technology, and the Germans dominate in diesel. Unless they catch up very quickly, they will be making products that don’t stand out and will survive because they managed to cut costs from restructuring efforts. As discussed in my last article, innovation will drive the next winner and this company in Los Angeles has a very promising technology. The U.S. auto industry might shine again if L.A. meets Detroit in a productive way. They also need to establish a bigger presence in China where the auto industry is experiencing explosive growth.

Was it right to bailout the Big Three? What about the Banks?

In response to K’s comments, I agree with you that the laissez-faire approach would’ve saved the taxpayers a lot of money. If we are looking at the issue purely from a financial point of view, it is not hard to tell that the government is subsidizing Detroit and not investing in it. And yes, if the Big Three are out, the parts suppliers will go out of business and cause even more unemployment. The decision to bail them out is based a political decision, not a financial one.

If I were part of the think tank, I would not recommend bailing out the Big Three. If the patient is gravely ill and surgery is inevitable, operate on the patient. Why prescribe her with a few months of pain killers and then perform surgery that would have to be done anyway?

The financial industry is a different story. Ben Bernanke is counting on his quantitative easing plan to revive the economy and needs the banks around to do the work for him. Let’s say that all but one bank stayed afloat. The Fed could push the rates as low as they like, but it doesn’t mean that the only bank would follow suit because there is no competition. This happened in Canada when the banks refused to follow the Bank of Canada’s lead after the latter had cut its rate. The more banks there are, the stronger the Fed’s army.

These zombie banks still have value in them as vehicles to help circulate money in the economy. Once the economy stabilizes, the Fed can make the switch to a laissez-faire approach and let the market decide who can stay. By bailing out the banks (at least temporarily), the U.S. government is acting like a market player because they are pursuing their self interest of maximizing GDP and hence, their tax revenues.

In the end, you still can’t beat market forces.

Henry Ford would probably sigh and shake his head if he saw what was happening to the American auto industry.  The industry is not just about jobs but has long been a symbol of American prosperity.  It has served well in the past as an indicator of economic health in the pre-financial tsunami era.  With the Obama administration granting GM and Chrysler 60 and 30 days respectively to restructure, it would appear that much of what we know about the industry can only exist in our memories and museums. 

Car sales is a direct function of oil price

My friend PH explained to me why all levels of the industry, from salespeople that work on commission to management in Detroit, love to sell big cars.  Gas guzzling SUVs have a higher profit margin than the practical Chevrolet Cobalt, which is on GM’s line-up because they need to satisfy fuel efficiency and environmental regulations.  SUVs enjoyed a few years of popularity when Detroit thought they have proven the world wrong by thinking that Americans wanted small cars.  Detroit was right – for a while, until the price of oil kept rising and rising with almost no friction.  New buyers didn’t want SUVs and existing owners were eager to get rid of theirs.    

You know how the story unfolds.  Consumers switch to fuel efficient cars where the Japanese and more recently, the Koreans, dominate.  Toyota dethrones GM as the world’s number one car maker.  Oh, don’t forget, with the financial tsunami, there is a behavioural change that keeps executives in Detroit up every night; more and more people are taking the bus to work.   

The end of the U.S. auto industry or the beginning of a new era of leadership?

While I’m not a big fan of American cars, I would say that the U.S. has all of the ingredients that it needs to become a leader in the next auto age.  Some dinosaurs became extinct, but others evolved into crocodiles and alligators that are alive and well today.  Whether the Big Three can turn into crocodiles will depend on many variables such as consumer attitude towards cars, the pace of economic recovery and government policies.  Some things we can be certain of though.  We can be sure that the supply of oil is finite, and environmental regulations will only become stricter.   As we sober about economic woes, let us not forget about the hole in the ozone layer.

If we want the luxury of relying on a personal vehicle wherever we go like we did for the most part of the 20^th century, we need to power up our cars cheaply and in a manner that won’t stink up the environment.   Electric cars have the potential to address both of these questions.

Tesla Motors

Based in California, Tesla Motors designs and builds high performance electric cars.  If you still believe electric cars can only hold enough charge to take you to and from the grocery store at a maximum speed of 40km/h, it’s time you’re in for a little surprise.  Tesla Motors is already working on the prototype of their second product; the Type S.  Requiring only 45 minutes to recharge, the Type S can travel up to 500 km on a single charge and accelerate from 0-100km/h in 5.6 seconds.  Running on electricity presents significant savings to your wallet and to the environment (we already have the technology in place to dispose of batteries safely).  I suggest you visit their website at http://www.teslamotors.com  to learn more about this company and their products.  By the way, if you live in a house, you can consider buying a solar panel powered charger to power up your car.  The solar power charger gives you enough power to 80km/h a day, giving many commuters the opportunity to literally drive for free.

Obstacles to the path to the new era

While the future of electric cars is promising and exciting, there are obstacles that will slow us down to a new future or simply prevent us from getting there.  If you frequently drive long distance between towns, you will probably dismiss the idea of an electric car because you wouldn’t want to be left stranded in the middle of the road.  The good news is that it only takes five minutes to swap batteries.  This is about how much time you would spend pumping gas in your car.  The problem is that we have plenty of gas stations and we don’t have any battery swap stations unless companies (maybe even governments?) are willing to invest capital to develop such infrastructure.  The U.S. has tried for a very long time to cure its addiction to oil and the Obama administration has committed to spending on infrastructure.   Obama had said explicitly that he would invest in infrastructure to both stimulate the U.S. economy and make the U.S. less reliant on foreign oil.  The big question is whether the new infrastructure will be in favour of electricity or some other alternative energy like hydrogen or bio fuels.

Thanks everyone for their comments.  Many of you are in disbelief or disagreement that there's no or little risk of inflation with all of this money printed out of thin air.  I picked up the latest issue of The Economist magazine and year to year consumer prices have increased for most countries.  A few things to clarify:

As much focus is placed on America’s unemployment rate which is poised to hit 10% this year, investors with long term horizons are already taking their binoculars out to see what the world will be like in the post-crisis era.  Their main concern is whether all of the money that governments around the world have been pumping into the world economy will result in hyperinflation;  inflation that runs out of control.  Let’s first try to understand inflation a little better, and then we’ll look at whether the dynamics of the current environment are in favour of an era of high prices. 

Inflation – a bad name until now:

Inflation has gotten a lot of bad press in the past.  On the milder side, we have the oil shock that the U.S. experienced in the 1970’s.  In the 1920’s, the damage that inflation had inflicted on the Germans was simply ruthless.  It cost 60 German Marks to buy 1 U.S. dollar in 1921.  In two years time, it cost 4,200,000,000,000 Marks to buy 1 U.S. dollar. 

U.S. inflation in the month of February was positive after consecutive months of price decrease.  The market embraced this as “Some good news finally”.   So... what happened to inflation being the ultimate evil? 

Understanding Inflation:

Inflation does not cause any problems.  It is the result of our day to day economic activities; it is when supply cannot meet demand.  This can happen when consumers demand too much or when producers cannot supply enough.

Small doses of inflation are good for the economy and are necessary for economic growth.  Inflation gives businesses pricing power and when businesses make a profit, they hire more people who will end up buying more products and services.  Businesses then hire even more people and invest more in equipments to meet the additional demand.  This cycle needs to be sustained to keep the economy growing while ensuring that it doesn’t run too fast to avoid bubbles from forming.  Canada has a target inflation rate of 2%. 

On the other side of the coin, businesses will cut cost when prices fall to maintain a profit (or just to break even).  Layoffs are almost an inevitable part of cost cutting measures and when people lose their jobs, they consume less, prices will fall further, and the economy enters into a deflationary cycle.   Authorities will tell you that they would much rather battle inflation than deflation.  They can easily manage inflation with monetary policies such as raising interest rates, requiring banks to maintain higher reserves, etc. 

On the other hand, deflation, which is associated with economic contraction, cannot always be fixed by the simple act of pumping more money in the system.  Governments need to go out there and actually spend money to kick start an ailing economy.  Under stimulation will not work, and over stimulation will cause unwanted inflation.  Given the difficulty in finding the right balance, I argue that governments would rather err on the side of inflation and deal with it later than have deflation persist.  Inflation of 5% or even 10% will cause people to think twice before buying that BMW or going on vacation.  But, they will at least have enough to get by.  If people don’t have a job, it doesn’t matter how cheap things get.   

The Current Situation:

The Obama administration will be pumping U.S. $787 billion into the economy by means of tax cuts and expenditures.   U.S. GDP was valued at $14.26 trillion dollars in 2008 with an annualized drop of 6.2% in Q4.  Excluding multiplier effects, the package is worth only 5.5% of GDP.   In other words, the stimulus package can only undo some of the price fall over the past few months at best; no threat of inflation here.

Some take the signs of inflation in February as indication of the U.S. economy bottoming out.  While I also take it as good news, I also take caution not be overly optimistic and jump the gun on major purchases or investments.  Let’s borrow those binoculars from the long term investors and look back a couple of months.  From August 2008 to February 2009, prices actually dropped 5% for the urban consumer in the U.S.  The Inventory to Sales ratio was 1.25 in Jan. 2008 vs. 1.43 in Jan. 2009, suggesting that businesses are struggling to move inventory out of their warehouses.  In an economy where over 70% of GDP relies on consumer spending, we should be more concerned with the risk of falling into a price deflationary spiral than speculated hyperinflation that may not be any real threat in the end.   On a global scale, the G20 summit came up with a resolution to make $850 billion available to the IMF.  That money is worth only 1% of world GDP so again, it shouldn’t raise a red flag for inflation. 

The U.S. government has injected capital into financial institutions shot after shot.  With the unemployment rate flying like there’s no gravity, that money is not going to start circulating in the economy anytime soon.  People need to have income in order borrow.  When people have income, they will get loans to buy a house or a car; you don’t need to force them (in fact, you can’t force them).  It shouldn’t work the other way around where you let credit run loose in hopes of stimulating spending and create new jobs.  This is how we got into this mess in the first place.  We probably won’t see the loans market being very active until unemployment eases and by then, the banks will be much more stringent with their lending practices.  The same idea can be applied to U.S. government scooping up US$300 billion of bonds to help kick start the loans market.  It won’t work. 

The Outlook:

Oil prices have fallen to the $50 range and the CRB Index (measuring the price of commodities) has fallen by 31% year to year (I took the values as of Mar. 27).  With eager job seekers, businesses that face a shrinking market for their products are also seeing their costs come down.  As businesses that can’t compete throw in the white towel, surviving businesses will be presented with cheap raw materials, available labour and enough market share to make a profit (with low prices, you will need to rely on volume to generate enough revenue).  Once they make a profit, they will hire more people, who will spend more money, and we enter another boom cycle.

Don’t forget that this is not a cyclical recession but one that rewrites the rulebooks.  Export driven economies will no longer be able to rely on American consumers.  Americans will not spend beyond their means and may even start to save money again.  Whether we will reach the bottom and stay flat (aka an “L-shaped” recession) or bounce back up will largely depend on whether the next wave of consumers that many speculate is in China will be able to lead the way.  We cannot be certain of China’s ability to lead the next boom.  But, we can be sure that the risk of deflation is real, the risk of hyperinflation is only probable and distant, and with interest rates at historical lows, any inflation can easily be corrected. 

How does this relate to your investment portfolio?  I need some time to give it some thoughts and I’ll share them with you in my next article.

Stay tuned!

Hello!  Thanks for your questions.  Let me address them one by one: