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Wednesday, March 30, 2011

You Know What Really Grinds My Gears

Being a former Rhode Island resident I have come to appreciate the good natured ribbing that the creators of Fox’s Family Guy weave in to their episodes. The title of this missive refers to an episode where the main character Peter Griffin gets a job with the local TV station as a “social commentator” about what essentially ticks him off, very similar to the “As Sue sees it” parody on Fox’s Glee, which some of you may be familiar with especially if you have tween or teen kids.

So what is it that is grinding my gears today? Wow that is a loaded question.  Let’s start with one item that I had written about in a prior article. In my article entitled “Gold Doesn’t Have to Weigh A Ton” I discussed the Central Fund of Canada (NYSE : CEF) as a potential way for one to get exposure to bullion that is backed by real allocated assets. Everything has been going along swimmingly with CEF and then we hit a long overdue correction and CEF performs somewhat worse than Streettracks Gold (NYSE:GLD) which as attributable to the fact that CEF tracks both silver (which is more volatile) and gold whereas GLD only tracks the price of gold. Additionally, CEF carries a premium to the actual underlying assets that it represents as there is demand for this closed end fund.

So today it is announced that CEF, under a shelf offering dating back to the end of 2009, is issuing a little over 16 million Class A shares. The offering is at $22.30 a share which would net CEF $360 million. This is where you can hear the gears starting to mesh. If you read the internet message boards and talk to investor’s they do not seem to grasp the fact that this is not a dilutive deal. The proceeds from this sale are going to be used to buy more allocated gold and silver for holding by the fund. This deal allows the fund to grow in size to handle more demand as well as places additional bids in the market while the price of the metals is consolidating their recent runs. Both of the above stated factors will be accretive to CEF holders not the other way around.

The asset the company is purchasing will not affect CEF’s income since that is not what this fund does. Instead CEF is about holding bullion in an allocated liquid form and not income so there is no dilution since each share owns the underlying asset. CEF’s Achilles heel like bullion is that it makes money for you primarily if bullion prices are rising although the premium of this closed end fund can be an extra kicker at times. A common stock holder has to worry about dilution as a company can issue far more stock than the earnings can support at least from a growth and or valuation perspective. When companies dilute by issuing excessive shares the stream of earnings is spread much thinner and consequently the shares tend to fall to bring the valuation in to line as in compressing the PE ratio .

Of course what got me really frosted about this deal is that they announce the offer price well below the market price causing a drop in the price of CEF. Now granted it is temporary just like the last time CEF offered stock through the shelf offering on file, but there is no doubt that with the strength in the metals markets that the entire allotment would have been bought at market price. The fact that ”the big boys” (underwriters) exercised their overallotment of 1.8 million additional shares suggests that the demand is there for sure. Furthermore this issue is not some IPO that the underwriters are going to unload after a quiet period and all the hype brought to you by a squealing Erin Burnett on CNBC the day it can be pawned off on Joe Six Pack.

The underwriters acquired these shares and the overallotment because they know that will get more for them selling them off in the future and they must be confident because they have no CNBC cheerleaders whooping and hollering to hype the shares like let’s say Government Motors (NYSE :GM), I see the public who bought that dog anywhere near the hype period is underwater today. I wrote various missives on my own blog regarding GM that you can read here, here and here if you are so inclined.

In my opinion CEF short changed themselves several million dollars by not pricing closer to the actual market price when they knew full well the strength was present to mop up this offering leaving lots of cash on the table that could have been used to acquire even more underlying assets. That folks “grinds my gears”.

You see the same kinds of things take place in another of my holdings but on a much more frequent basis. I am referring to Annaly Capital Management (NYSE : NLY) which for those of you who are unfamiliar with the issue is a REIT of sorts. They have a special twist on the REIT as they borrow short and buy mortgages playing sort of a spread trade. I know you are thinking what? Is Roger smoking crack? How can he be buying a REIT with real estate the way it is today and all the problems like the “robosigning” scandal and homeowners not paying their monthly payments. Well the twist is that about 85% of Annaly’s portfolio of mortgages is US Government guaranteed for payment meaning that the default risk is pretty well contained. The risk to Annaly and others like them such as Chimera (NYSE : CIM) is not so much mortgage defaults as rising short term rates, since these companies borrow short and lend long so to speak. The short end can rise to some degree but there is a breaking point where the rates will bust the business model that is unless government backed mortgage interest rates rise at least as fast if not faster than short term rate. In the mean time the shares pay a hefty dividend in the neighborhood of 14% which is nothing to sneeze at especially in this market.

What grinds my gears about Annaly is that every time the shares appear to be getting traction and look as if they could move up in value and allow the investor to achieve some capital gains in additional to nice dividend income a secondary offering is announced. What gets me however is yesterday’s news in which Annlay who owns 25% of Cerxus Investment (NYSE : CXS) is buying 5 million shares in CXS’s secondary offering. CXS rejected a bid by Starwood Properties (NASDAQ : STWD) which was at a 20% premium to their share price and instead has opted to go with the secondary priced at $11.50 a share.

Annaly has announced its intention to acquire the 5 million shares at the secondary offering price of $11.50 and resulted in a roughly 4% drop in Annaly. So let me get this straight the omniscient financial media decided that an investment by NLY in to CXS of 5 million shares at $11.50 for a total of $57,500,000 warranted and explained a 4% drop. Dear reader I want you to take a look at the logic here a $57.5 million dollar investment by Annaly represents 4 tenths of one percent of their market cap, even if they had to write it off for a total loss this is tantamount to a rounding error. It frosts me that the market cap could decline by ten times the investment amount and the media would proclaim this as the rationale. Is it possible that they missed the fact that Annaly happened to go ex-dividend with a statement that the dividend was $.62 a share or roughly 4%? Rocket scientists like those so well listened to in the financial media really grind my gears….Think for yourselves people.

This brings me to the next item that grinds my gears which is Japan. No not the country or the people but the investment writers who are advising people to position themselves in Japanese equities. No doubt the continuing saga of the Japan earthquake and tsunami is still fresh in everyone’s mind especially with the nuclear disaster story making headlines on the morning news every day. Although it is not wall to wall coverage of the Japan crisis it does pop up in some way every day. Just yesterday living here in Boston, MA several thousand miles from Japan there aired on local news reports that some radioactive isotopes from Japan had been detected in water samples. This announcement spurred all kinds of talk and worry evident on the local news talk show programs even though the level of radiation detected posed zero harm to any living creatures man included.

Some investment writers have decided that the Japanese stock market is a good investment as many of the Japanese companies have strong fundamentals such as low price to book value a popular metric for value investors. Indeed the Japanese stock market initially tanked right after the big earthquake and has since recovered a portion of those losses and I hope that they do going forward. Just like the old stock market adage states “never try and catch a falling knife”, which is advice well suited to the current state of Japan. The very arguments of valuation and price being made are misleading as there are so many unknowns that could cause both prices and valuation metrics to fall further. I have also heard that one should by Japan because it is such a disliked place to invest and to a contrarian that is all they need to hear, but one could be right and have to wait a long time for the trend to play out while capital could be more productive elsewhere.

The reality of the situation is that things are not under control in Japan and we still don’t know if they will get worse. In my opinion there is no rush to go out and buy Japanese equities as of yet because things have not gone from bad to less bad yet. Sure the Japanese are going to have to rebuild but as I mentioned in my article “Ramblings on Japan and QE” as the economist Henry Hazlitt pointed out rebuilding is not economic growth. The point is that there will be companies that do well in and outside of Japan as a result of the rebuild, but the economy or markets of Japan will probably not fare as well. It upsets me that the media is so irresponsible as to paint this situation with such a broad brush when a fine brush is needed.

In the case of Japan at least the first phase of recovery will be most beneficial to the “picks and shovels” type companies.  One company for you to take a gander at is an old line Japanese firm established in the late 1800’s by the name of Kubota (NYSE ADR : KUB). Kubota manufactures farm and industrial machinery, water and environmental systems and infrastructure products (like steel pipe).

If you take a look at Kubota’s website you can see that their product line up is very well suited to what Japan needs to rebuild. Although they have some larger earth moving equipment they appear to concentrate on the smaller end of the machinery spectrum so I would consider them to be complimentary to CAT or JOYG. Not every project in Japan will require the “monster” machines produced by the likes of CAT or JOYG. They have a pretty good sized niche they can play in and niches can be highly profitable.

In one of my former lives I ran a machine manufacturing company that produced hot chamber die casting machines. The company I ran was a niche player because we produced machines in the low to mid tonnage range. The tonnage refers to the amount of hydraulic pressure used to squeeze the two halves of the die together as the molten metal is injected under pressure. The bigger the casting the higher the tonnage required. Being in the low to mid tonnage range afforded us a slice of the market virtually ignored by the major players and as a result the margins were very good since there was not a significant amount of competition to push prices down.

As I alluded to earlier Kubota is a multiline manufacturer and their spectrum of products fit the recovery theme very well and other divisions can provide infrastructure and rebuilding products. So while they cannot compete head to head with CAT or JOYG in the large machine space they have many other facets that will also be in high demand. Additionally their valuation metrics stack up very well against the likes of Caterpillar (NYSE :CAT), John Deere (NYSE: DE) or even my favorite Joy Global(NASDAQ : JOYG). Kubota is a local Japanese company and stands to benefit from its proximity to the disaster, market presence, local name recognition and potential government largesse. Moreover, on a valuation basis Kubota is attractive as it is trading for 1.4 times book value versus the American competitors that all trade for 6 times book. Additionally, Kubota sports a 55% debt to equity which is lower than all but JOYG who clocks in at 26%. Kubota’s PEG ratio is 1.15 which suggests that the company is under priced.

From a chart perspective, Kubota was developing a nice chart and then the disaster struck. Kubota’s stock price has corrected and is working on a base to try and recapture the 50 day moving average. Even with the events that occurred Kubota barely pierced its 200 day moving average and quickly bounced above it indicating to me that “strong hands” were not deterred from holding on to or even buying more of the shares. At this moment I cannot recommend Kubota because I believe that the stock needs to back and fill more of the price action to allow time for a proper base to form. I would put Kubota on my watch list and once it crosses back over the 50 day moving average on good volume an entry position could be initiated.

1 comment:

Latasha said...

IJWTS wow! Why can't I think of tihnsg like that?

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