Detroit Bankruptcy on Munis

Friday’s big news in the markets (outside of the concerns over MSFT and GOOG) was the bankruptcy of the City of Detroit.

This Chapter 9 filing was a long time coming, in my opinion, and should not be a surprise. But some investors might be wondering–will the effects  spill over to the municipal bond sector overall?

In a word, no.

Detroit is a very unique situation (and not in a good sense). It has very little tax revenues, infrastructure is depleted, and its population is near-poverty level. That’s a toxic mix for any municipality.

But it does underscore the importance of due diligence. Investors who own muni bonds must be very selective:

1. pay attention to credit rating

2. think about the macro and micro–economic factors around the country

3. look up the local economy–is business booming? What’s the tax revenue outlook?

4. consider the overall debt load of the municipality

If those are a bit more work than you bargained for, consider a muni bond fund if you’re looking for current income and capital preservation. Some decent ones include SWNTX (Schwab Tax-Free Bond Fund) and PRINX (T. Rowe Price Summit Municipal Income Fund).

Read This Before Investing in Emerging Markets

(This article originally appeared in the Epoch Times)

By Warren Song & Frank Yu

While the phrase “diversify your portfolio” has become a cliché, it holds true in most cases. However, investors should exercise caution when investing in stocks of publicly listed companies based in emerging markets, especially the so-called BRIC nations of Brazil, Russia, India, and China.

In theory, diversification means holding investments from several sectors, types of securities, and geographical locations. But stocks from emerging markets, for the most part, should have lower valuations than those from developed countries, especially compared to U.S. equities. Generally speaking, returns on investments in emerging markets have been largely disappointing.

A few factors should be considered when valuing stock from any emerging market company:

  1. Its home country’s government and legal systems are just, stable, and free of corruption.
  2. The public company’s priority is to work on behalf of the shareholders.
  3. The company is competitive—has value—relative to those in developed markets.

Companies from India and China (including companies listed in Hong Kong) are at a severe disadvantage when measured with rule No. 1 mentioned above. And when factoring in rule No. 2 and 3, most companies from developing countries fall short when measured against competitors from developed nations (of course, there are exceptions).

To illustrate this, we will use China as an extreme example.

In China, corruption is so widespread that among management levels of public companies, there are hundreds of thousands of employees who are the children and relatives of Communist Party and government officials.

Let’s use the U.S.-listed China Petroleum and Chemical Corp., or Sinopec, as an example (NYSE: SNP).

Management typically is appointed by China’s State Council, and this creates a conflict of interest because as a publicly listed company, it should serve the interest of shareholders, not cater to the ruling elite.

In Sinopec’s case, it has a negative reputation within China due to its poor environmental record. Also, because many employees cannot be terminated, productivity is low—far lower than at U.S. competitor Valero Energy (NYSE: VLO). Despite Sinopec’s underinvestment in exploration and research, it still lacks meaningful free cash flow. If China introduces real market-based financial markets, Sinopec would have trouble competing.

While Sinopec was used to illustrate the above points, most other Chinese-based public companies are either state-owned or controlled by local governments in one way or another. As such, the objective is often to increase revenues so the related officials can use such figures (similar to aggregating China’s GDP growth rate) to climb the political ladder to higher-level positions in the government. In addition, they borrow heavily. The end result is industrywide overcapacity, heavy price discounting, vanishing margins, ballooning accounts receivable, and finally stock value destruction and investor disappointment.

Let’s take a look at the price-earnings (P/E) ratios of emerging market firms. Some investors argue that there are quality companies in emerging markets with low P/E ratios, which is an indication of value.

But the P/E ratio alone doesn’t tell the entire story. One thing to remember while investing is that valuations are relative. If you compare the stocks to yields of 10-year government bonds of those countries, the stocks will immediately seem overvalued.

Take Russia for example. Its 10-year government bond yield is almost 8 percent. Move a typical Russian company with a P/E ratio of around 10 to the United States, and its valuation will immediately halve given the fact that the U.S. 10-year Treasury (risk-free) yield is 2.7 percent. This is due to the huge risk difference between the Russian equity and U.S. Treasuries. Conversely, if U.S. Treasury yields suddenly jumped to 8 percent, the U.S. stock market would see a major movement from current levels.

Emerging market firms also typically have lower free cash flow amounts compared to their U.S. counterparts. In China, for example, many public companies have minimal or no free cash flow when applying U.S. accounting standards.

We’ve used China and Russia as general examples. Similarly, Brazilian 10-year government bonds yield more than 11 percent, and for India, the figure stands at more than 10 percent.

Investment of one’s own money is a serious matter. Imagine your portfolio holdings are like your children. You’d want each and every one of them to receive the best education possible, instead of sending three of them to China, Russia, and Brazil just for the sake of diversification.

Warren Song and Frank Yu are contributors to the Epoch Times.

Stocks Calm as Earnings Season Nears

Major market indices closed higher on Friday–with the S&P and Nasdaq both gaining 1%–as Wall Street headed home for the 4th of July weekend.

Stocks jumped after the US Government reported 195,000 new jobs for June, a sign that the economic recovery is here to stay. Perhaps a bit more unnerving is that bond investors took the report as a precursor that the Fed may taper its quantitative easing, and raise interest rates. As such, Treasury yields on 10-year bonds creeped up past 2.7%.

With another earnings season to kick off on Monday (aluminum producer Alcoa will report after market close), it’s hard to predict which direction stocks will go from here. On one hand, analysts have already priced in effects of the sequester, so companies may exceed their earnings consensus. But considering that more positive news usually equates to the Federal Reserve edging closer to ending QE, stocks may yet disappoint.

But since there already seems to be a bond sell off underway, perhaps it’s time to get into the corporate bond market. Especially since yields have increased–while official interest rates haven’t budged–short maturity bonds may be a better deal than stocking away cash at the bank.

A Lesson in Patience

On June 20, the Dow Jones Industrial Average fell 354 points on a double whammy of Fed speculation and specters of an oncoming Chinese banking crisis. Investors were worried about the sudden market collapse, and talking heads on CNBC were equally pessimistic, commenting of an impending bear market.

So… what’s a person to do? The next day I started hedging my positions and incorporated a partial short S&P position in my portfolio. The thinking at the time was that, while I wasn’t going to sell anything, I was going to profit a little off the (consensus) bear market that was suddenly upon us.

Welp. Since that day, the Dow has been up 7 sessions in the last 10. And my short position obviously has been stifling gains.

The moral of the story is that one should stick to one’s convictions. In fact, the US economy has been on a solid recovery. The real estate market has steadily recovered, unemployment has subsided (today the US economy announced 195,000 job additions), and other economic indicators such as consumer sentiment are also on the rebound.

Given that, there’s very little real reason why the US market tanked (and Bernanke has since tempered expectations of a rate rise). Prudence should have won out against knee-jerk reaction on that one.

Using Cultural Advantage to Generate Above-Average Returns

The article originally appeared on The Epoch Times

(By Warren Song & Frank Yu)

Professional investors typically use the S&P 500 Index as a benchmark to measure their portfolio’s investment performance.

As the S&P includes companies operating in all sectors, it is a good proxy to track trends of the overall global economy. But by investing in a few U.S. companies that are uniquely positioned to lead their fields internationally, an investor’s portfolio can have a leg up on the S&P 500 in terms of performance.

Tuning out short-term gains and losses driven by geopolitical and macroeconomic events, stock performance is usually determined by a company’s industry, and its long-term competitive advantages within its industry. Since today’s global marketplace is the most transparent in history, let’s identify a few companies that should have distinct competitive advantages in their global industries for the next 10 to 20 years. These advantages will ensure that their revenues and profits can grow consistently in the long term (exceeding inflation). We know companies like these will, in the medium- and long-term, generate higher returns for shareholders compared to the S&P 500 Index.

In order for a brand to have staying power, a few things must be satisfied:

• The company must be an industry leader; it must be a pioneer in that industry.
• The company must have a competitive advantage over others in the same industry.
• Most importantly, the company must represent something (or have a continuing vision) that consumers will covet long term.

In the global lens, the American way of life is often romanticized and coveted, and this is especially true among people in developing countries where much of the future growth will come from. In this article, we’ll examine three industry-leading companies that can best utilize those ideals to long-term success. Let’s call them the “cultural advantage” portfolio.

There are three companies that obviously fall into this “cultural advantage:” Costco Wholesale Corp., McDonald’s Corp., and Texas Roadhouse Inc.

Growth of Club Stores
Seattle-based Costco (Nasdaq: COST) has a few distinct advantages. The club store concept has taken off globally: big space, lots of brand name choices, members only, and the best prices. In addition, it’s the first name that comes to mind in this sector.

Wal-Mart Stores Inc.’s Sam’s Club brand is a distant No. 2 in term of sales per square foot, compared to Costco. Wal-Mart, however, which has had its share of labor controversies, is almost the opposite of Costco on labor issues, as Costco has a reputation of higher pay, good benefits, and low employee turnover. These factors make it nearly impossible to elevate Sam’s Club’s reputation above that of Costco.

The barrier of entry in this field is almost insurmountable. There is just no real estate space available in many of the ideal markets anymore, and because Costco owns the land and buildings of most of its stores it doesn’t have to worry about rent or real estate price hikes, whereas the cost for any would-be competitor to acquire new land will become prohibitively expensive, in addition to the big disadvantage of lacking scale at the outset. Costco’s recent successes in Japan, Taiwan, and the U.K. have proven its leading status.

Fast Food is King
McDonald’s (NYSE: MCD) is the clear leader in the global fast-food industry and will remain so for a long time because of its valuable real estate holdings (owns nearly 50 percent of its real estate and property). In addition, this industry is here to stay—in economic prosperity or decline. The reason is that as people all over the world spend less time cooking at home, the fast-food industry will likely be an integral part of workers maintaining high productivity rates.

Another big reason is that the global income gap will become wider and wider over time and more middle-class families will shift from fast casual dining to fast food. In addition, people in higher income brackets will maintain their fast-food intake because of convenience and time constraints.

Some other companies have enjoyed success in isolated regions (such as Yum! Brands in China), but because they are not industry leaders (nor do they have the typical McDonald’s association with America), they will not be able to pose a real challenge to McDonald’s in financial terms. Younger upstart brands in this sector can grow to a certain extent, but will not pose a serious challenge to McDonald’s in the long term.

No Messin’ With Texas
Right now, the state of Texas (and its cultural associations) invoke more goodwill from people around the world than the United States as a whole. To many, Texas represents the true American spirit in the eyes of global viewership: the Wild West, the fight with Mexico for freedom, small government, low taxes, oil boom, business friendliness, low housing prices, open roads, and the list goes on.

The restaurant chain Texas Roadhouse (Nasdaq: TXRH), even though it was founded in Louisville, Ky., captures this spirit well. It incorporates the Texas spirit into the entire operation of its restaurants: from the food, music, and drinks, to the way waiters and waitresses dress and dance. Texas Roadhouse not only has tremendous growth opportunity outside the United States, it also has room to grow within the domestic market. This is really a very smart concept.

Culture is the most endearing distinction between countries and the most admired country in the world can always enjoy this advantage.

The American sports culture is also very popular abroad, so athletic apparel and footwear maker Nike Inc. is also a possible candidate. One problem is that in this field, barrier of entry is relatively low, so its advantage over its competitors, such as Adidas AG and relative newcomer Under Armour, may not be permanent.