Know When to Fold ‘Em


To kick things off, let’s start with an interesting bit of research that is doing the rounds in the financial media. From Business Day:

The world’s largest mining groups have written off about 90 per cent of the value of mergers and acquisitions completed since 2007, according to a report by Citi which is critical of a range of deals in recent years.

The US-based investment bank says the figure calls into question the companies’ capital allocation strategies, and warns that more write-downs are inevitable, particularly in coal.

Calls into question? CALLS INTO QUESTION!

There’s no question about it. The capital allocation strategies were a debacle. Bull markets are generally disastrous for long term share holders. The best you can hope for in a bull market is for your board and CEO to grow organically and not waste capital on takeovers and empire building.

That’s because, in a bull market, companies nearly always pay over the odds for assets. Once the reality of the acquisition sets in, it becomes apparent that this excess value created during the boom needs to be written down.

Here’s how it works. Take Rio Tinto, for example. At the height of the boom in 2007 it offered a ridiculous price for Aluminium producer Alcan. The offer was way above the value of Alcan’s net assets. This excess amount is known as ‘goodwill’.

So when the merger takes place and Alcan’s assets go onto Rio’s balance sheet, there is a big fat ‘goodwill’ entry to house the boom time excess…happily funded by Rio shareholders of course.

But then aluminium prices took a dive. Rio couldn’t even make a decent return on Alcan’s original net assets, let alone its wildly inflated takeover value, which includes the goodwill.

Like waking up the night after a big session on the booze, a sheepish board (and usually new CEO) try to erase the memory of the boom time stupidity and write down the value of the assets, including most, if not all, of the goodwill.

This is what the long term share price damage from such a ‘strategy’ looks like…

Source: BigCharts

Click to enlarge

This is Rio’s share price over the past 10 years. From start to finish, it hasn’t done much at all.

Making matters much worse, Rio debt funded the original purchase. But then, under immense pressure when the GFC hit, it had to issue millions of shares at a massive discount to repay the debt!

If a board as well credentialed (said partly tongue in check) as Rio managed to stuff things up, just about anyone can. This is why management competence and understanding of how value is created is so important.

The message here is this: if your company’s CEO or board go on a boom time acquisition spree, get ready to dump the shares. You can be almost certain it will end in tears.

But there certainly isn’t a boom in the commodities space right now. The fact that miners have written off 90% of the boom time largesse tells you we’re much closer to the bottom than the top. Citi’s analysts warn that there is more to come in the coal sector.

I would add the iron ore and LNG sector to the list too. In my view, iron ore prices are heading back below US$50 a tonne…and then some. Only the majors will survive, which means there’s a lot of pending asset writedowns in the junior iron ore sector.

And the LNG sector is shaping up as another debacle for Australia. During the boom years, the majors paid up for the juniors who held much of the coal seam gas reserves in QLD. Then, they spent up big on building LNG plants to send this gas to China and Asia.

Much of this investment was predicated on oil being US$100 a barrel. But those assumptions don’t look so rosy now. Business Day reports:

Serious doubts have arisen over the ability of the biggest customer for Origin Energy’s $24.7 billion liquefied natural gas project in Queensland to take delivery of the gas, leading to speculation the Chinese buyer may seek to delay the start-up of the mega-venture and causing a hit to Origin’s 2015-16 earnings.

There’s a deluge of Aussie LNG due to hit the market next year and beyond. Will there be enough demand at the right price to justify the massive investment in LNG capacity?

I doubt it. Which means writedowns will come.

Perhaps a good way of looking at it is this: during a bull market, sell the companies doing the acquiring. But in a bear market, buy the companies doing the acquiring.

In bull markets companies overpay for acquisitions and in bear markets they tend to underpay. As a general rule, it really is that simple.

So if you follow the resources sector, take a close look at companies that are brave enough to buy distressed assets today. They could be tomorrow’s stars.

Keep your head while others are losing theirs

There’s a lesson in this for today’s property investors. Check this out from yesterday’s Financial Review:

A third of all second-hand homes sold in the first three months of the year went for twice their purchase price while 10 per cent sold at a loss, a quarterly report by property research group, Corelogic RP Data has found. 

Properties held for a longer term sold better with sellers raking in an average gross profit of $230,633. 

This equated to profits during the first quarter of the year of $13.8 billion! We’re rich!

But much of this profit just goes back into the sector, as investors ‘re-leverage’ or homeowners ‘trade-up’ by taking on more debt with their increased equity.

It’s pretty clear we’re in bubble-like conditions though, especially in Sydney and Melbourne. So if you’re an investor up to your gills in debt and negatively geared properties (is there any other type?) think about the miners and their wilful ignorance in paying top dollar at the height of their boom.

It doesn’t matter what market it is. Frenzied exuberance doesn’t last. That doesn’t mean property prices are about to crash. For that to happen you would need to see higher interest rates or another global credit crunch. Neither of these seem likely at this point.

But some suburbs have clearly gone nuts. Sydney and Melbourne are redefining the term ‘million dollar views’. Just don’t get stuck with too much ‘goodwill’ on your balance sheet.

Knowing when to fold ‘em

Thanks to hyperactive central banks, nary a day goes by without mention of a bubble emerging somewhere or other.

The latest bubble focal point is the Chinese stock market. Thanks to the old adage that you can never inflate the same bubble twice in succession, Chinese stocks are on a tear. This is thanks to the People’s Bank of China’s (PBoC) attempts to prop up the previous housing bubble and stop it from smashing the economy.

The liquidity created by the PBoC went straight into Chinese stocks. Liquidity begets liquidity, which is why bubbles take on a life of their own and go much further than most people think possible.

On this reasoning, China’s bubble might be just getting started. I asked quant trader Jason McIntosh what he thought about the price action in Chinese stocks, which you can see in the chart below.

Source: StockCharts

Click to enlarge

This is what he sent me:

Trends are one of the planet’s great wealth generators. You can link just about every fortune to some sort of trend. Yet many people fail to reap the profits that a trend can produce.

You see, trends have a habit of surprising people. They often last much longer than just about anyone can imagine. This can lead to fear that a reversal is imminent. The result is; many people cash their chips in early. Some even look for opportunities to short sell the market.

The secret to amassing a lot of money is to maximise a trend. Forget about picking tops. It’s all about riding the trend.

Chinese stocks are a great example. People have been calling “bubble” for many months…yet it keeps climbing higher. Sure, this market could reverse and fall hard. But it could also keep rising.

The key to successfully profiting from a trend is your exit strategy. You want to stay in a move as long as possible. That’s how you maximise your gains. But you also need an exit plan. I’ve seen many people ride a trend all the way back down.

I use what we call a trailing stop. It’s an exit point that rises with the market. A trailing stop’s job is to get you out when the market turns lower.

There’s a bit of strategy that goes into placing a trailing stop — more than I can go into today. Although I will say this. You need to give the market room to move. Nothing trends higher in a straight line. You need to allow for moderate corrections along the way.

If you’re in long Chinese stocks, I’d stay that way. I would set a trailing stop at around 3900 and let the market do its thing.

If you want to learn more about Jason’s trading strategies, you can sign up for his free video tutorials, here.


Greg Canavan

Ed Note: This article originally appeared in the Port Phillip Insider

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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2 Comments on "Know When to Fold ‘Em"

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slewie the pi-rat
slewie the pi-rat
1 year 4 months ago
slewie’s ‘FLATION Report ~for US Tuesday ~US Dollars only BLOOMBERG COMMODITY INDEX 100.7; +0.7; [+0.70%] US Dollar INDEX 95.4; +1.0 after watching the EURO get bought on every rumor, for a week, seeing it get sold on the news was not too surprising, to this observer. nobody seems quite sure what the actual news IS, but it appeared to me that the ECB [Draghi] told Greece [Tsipras] to go to Greece and get Plan A passed, by Parliament, and the ECB would keeps the banks open and the checks in the mail. for now. then, Tsipras goes to Greece and… Read more »
John Hutchinson
John Hutchinson
1 year 4 months ago

I note you use the Rio/Alcan example to demonstrate the idiocy of CFO’s and their keenness to overspend their Shareholders capital in a Bull market, however you could have used Woolies/Dick Smiths or (just today) Collin’s Foods/Sizzler and an untold number of others.
The way some are spending another Tech Wreck, must surely be around the corner.

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