Tuesday, January 31, 2012

The Economy Stimulus Story

In the midst of the European sovereign debt crisis, I would like to share with you a story that I came across a few years ago about the economy and how it is stimulated through spending. Here's the story:

The story started with a rich tourist came to a town in which everyone
living there was in debt. The tourist put down a 100 Euro note for the hotel owner as a deposit while he went round to check the conditions of the rooms. With the 100 note on hand, the hotel owner quickly ran to pay off his debt – his supplier, the butcher. The butcher received the money and he quickly settled his debt with the pig grower. Next, the pig grower used the receipt to pay off his debt with his supplier of feed and fuel. And this supplier ran to pay off his debt to his creditor - the prostitute, and finally, the prostitute went to the hotel owner and settled her debt with the hotel owner with the same 100 Euro note.

The hotel owner then put the 100 Euro note back on the counter as it was the deposit of the tourist. The tourist decided not to stay and took his money back.

After all these drama, amazingly, the whole town is now without debt and everyone looks to the future with a lot of optimism. In the final sentence of the story, it says: “This is how the United States Government is doing business today.”

“Does the story make any sense?” I’m sure most of you are pondering hard about this story. In fact, I’m truly amazed that this little story has embraced a number of important economic concepts that I’m going to explain next.

First, the story has brought out one major economic theory - the Keynesian mulitiplier theory. The initial 100 Euro note has changed a number of hands, from the hotel owner, to the butcher, to the pig grower … and back to the hotel owner. Starting with 100 Euros, the economy has created 600 euros worth of market transactions. In order for the Keynesian multiplier theory to function, the initial 100 Euro has to be an autonomous (independent) injection in the form of investment, government spending or exports to the economy. In this case, the rich tourist’s 100 Euro note is treated as exports because the rich man is a foreign tourist, the money is considered as an outside independent source of injection to the economy. (For simplicity, I have left out the multiplier formula here)

Next, we come to the most important concept of the multiplier theory that says that the injection of money creates round after round of spending. In other words, the cycle of ‘one man’s spending creating another man’s income’ repeats itself round after round just like the story.

But the story says each of them “pay back” their individual debt, not “spending” as stated in the multiplier theory. I would argue that the spending has been performed before each one received the 100 Euro note, which means they spend first and pay later. Just like most of us are doing now.

So, did the people in the town really get rid of their debt? The answer is “Yes!”

Because during each round of spending, income is created at the receiver’s end. This means that no matter what is the source of income (be it borrowed money or earned money), the economy is stimulated in the form of more economic activities created by the many rounds of spending. As long as the rate money earned is faster than the rate of debt increased, by theory, we can settle the debt. But in real world, most government in the world is building their debt at a much faster rate than the collection of taxes because in a democratic society when the government is elected based on people's votes, the ruling party tends to run into budget deficits.

Hence, this is how most of the governments in the world are doing business today!

How to value a mining company

By Paul van Eeden

I received an interesting question about company valuations from one of my newsletter subscribers that I thought I would address as a Commentary. It is a multi-part question that will take more than one Commentary to address; this week is part one: Valuing Mining Stocks.

Mining is a finite business. Mineral deposits contain a certain amount of ore and when that ore is mined out the deposit is depleted, no matter what you do or wish.

That is in stark contrast to say, an auto parts manufacturer, who can adapt to new demands and specification changes and (hopefully) stay in business for many decades. When you value an auto parts company, you can compare the company's price to earnings, price to cash flow, operating margin and net profit margin (among other things) to the company's peers to assess whether the stock in question is relatively cheap, or relatively expensive. You can also get a sense of whether the stock is cheap or expensive in an absolute sense by looking at the book value per share and comparing things like the profit margin and dividend rate to prevailing interest rates. But, embedded in all this (except book value per share) is the implicit assumption that the earnings and cash flow are for all intents and purposes infinite. When you are dealing with a business that can be reasonably expected to continue in a similar fashion for many decades, earnings per share, cash flow per share, dividend rate, etc. are meaningful. That is not the case with mining.

Take a hypothetical mining company that has only one mine as an example. Let us assume that mine is going to produce for another five years before the ore will be depleted. Now, let us say that the company's price to earnings ratio is ten. A hypothetical auto parts manufacturer also has a price to earnings ratio of ten. Based on just this one metric, we cannot differentiate between the two stocks. Let us also assume that the prevailing ten-year interest rate is five percent.

This means that you can invest your money in a ten-year bond and earn five percent per year while taking relatively little risk (other than the risk of interest rates rising, which could negatively impact all the investments under consideration and is therefore not considered).

The auto parts manufacturer has a price to earnings ratio of ten. That means for every dollar's worth of stock you buy, you expect to earn ten cents, or ten percent, in earnings. It does not really matter for our purposes whether those earnings are retained by the company or paid out as a dividend since, either way, the earnings accrue to the benefit of shareholders. Furthermore, you can reasonably assume that the auto parts manufacturer is going to be in business for several more decades and, because you have done lots of due diligence, you can also assume that the future earnings are likely to be the same as the current earnings. So, if you buy the auto parts stock, you will earn ten percent per year as opposed to five percent on your bonds. The auto parts stock is probably riskier than a bond; however, if you can make twice as much money it might be tempting.

Then you look at the mining stock and notice that it, too, has a price to earnings ratio of ten and, therefore, you can also make ten percent a year if you bought that stock. But you would be wrong. The mining company's mine only has a five-year life ahead of it. So, if it has a price to earnings ratio of ten it means that for every dollar of stock you buy you get ten cents in earnings. But the earnings are only going to last another five years, so your total earnings per dollar of cost will only be fifty cents — - half of what you paid for the stock — - and then the mine is depleted. That's why comparing a mining stock to other investment opportunities on the basis of price to earnings, price to cash flow, or dividend yield is complete nonsense. It is just as futile to compare mining stocks to each other based on these metrics because mining companies have different mine lives in their operations.

The only reasonable way to evaluate a mining company is to look at the net present value of the potential future cash flow, discounted at an appropriate discount rate. You have to take into account not just the cash flow that the mine(s) is generating, but also sustaining capital costs (including future exploration and development costs) associated with keeping the mine in production. Assuming you can derive a suitable cash flow model for each mine that a company owns you can then calculate the net present value of future cash flow by using an appropriate discount rate to represent the geological, political, social and financial risks. If you sum all the net present values together, add any other assets on the balance sheet and subtract any debt, you will arrive at the net asset value per share. In a rational world you would expect to pay no more for a mining stock than its net asset value per share — - how do you expect to make money if you consistently pay more for stocks than what they are worth? But, in the real world, mining stocks almost always trade for more than the net asset value of their constituent mines, and for a good reason.

Mining stocks also offer leverage to commodity prices. Take a gold mining company as an example. Assume we have a company that mines gold for a total cost of $400 an ounce, and let us pretend the gold price is $500 an ounce. The net present value of the mine would be calculated based on the $100 margin. If the gold price increases by 20% to $600 an ounce the net present value of the mine will double, since the margin would now be $200 an ounce. Thus the value of the company increased five times more than the increase in the gold price. Most people buy mining stocks because of this leverage.

What should be immediately evident is that if you pay more for mining stocks than what they are worth, on the speculation that the price of the underlying commodity will increase, you are merely gambling on the commodity price. Fortunately there is a way to quantify the premium that one should pay for a mining stock to incorporate the leverage it has to the underlying commodity price. There is a formula called the Black-Scholes Model that can be used to calculate the "option" value of a mining stock [Editor's note, you can find more information on the Black Scholes model and further links at http://en.wikipedia.org/wiki/Black-Scholes ]. What should be done is to calculate the discounted net present value of the all the company's mines and then add the "option value" of the mines as calculated by the Black Sholes formula to obtain a more realistic asset value per share. By adding the optionality of mining shares to the net present value of the mines themselves we can account for the fact that mining shares trade at a premium to their net asset value because of their leverage to the underlying commodities.

If you calculate the net asset value of a mining stock as described above you will get a result that can be used to compare different mining companies to each other, and mining companies to investments in other sectors. Unfortunately, very few mining analysts employ the Black Sholes model to calculate mining net asset values, so for most people buying mining stocks really comes down to blind speculation on commodity prices.

Thursday, January 19, 2012

Price Patterns of Stocks

By looking at stock charts, an investor can spot different price patterns of stocks. Today I'll illustrate 2 famous chart patterns here.

Head and Shoulders
A head and shoulders formation, by its name, consists of a head and two shoulders. The left and the right shoulders represent two smaller rallies before and after the big head (big rally).

Reverse Head and Shoulders

Trend Reversal Point

Draw a line connecting the two troughs at the base of the head. This line is known as the neckline. When the neckline is breeched on the right shoulder, it sends a warning signal to traders that the price is going to plunge.

Similarly, for the reverse head and shoulders, we draw a neckline to connect the two small rallies beside the head. Once the price surge passes the neckline on the right shoulder, it indicates a positive move in the price.

In order for the trend reversal to materialise, the violation of the necklines in both cases has to be supported by an expanded volume at the right shoulders.

Double Top

A double tops formation consists of two peaks, like a Twin Tower. The two peaks may not be of the same height. The interesting part about this price pattern is that when the price is forming the second rally, its volume is lighter than before (the first rally). This shows that investors have lost their buying interest and the rising price may not be sustainable.

Trend Reversal Point

Draw a line at the bottom of the trough between the two tops as shown in the above. As soon as the line is violated at the right peak, followed by an expanding volume, the stock will experience heavy selling by investors.

Double Bottom

Double bottoms has a similar effect as the double top, but in the opposite way. Here, you’ll see two troughs with volume declining in the second bottom.

Trend Reversal Point

Draw a line at the peak between the two troughs. When the line is violated at the right trough with an increasing volume, investors are snapping up the stocks and pushing the price higher.

However, there is no guarantee that when the trendline is violated, the prices will move accordingly. Sometimes they are just a temporary interruption in the prevailing trend. It could be a false alarm, or whipsaw, for the trend reversal.

Last but not least, when you see a big chart pattern forming infront of you, its a warning sign that there is going to be a big price movement as shown in the chart below.

Happy investing,

Pauline Yong