Gold: an attractive long term investment at the current prices?

Recently gold prices have touched a new record, almost reaching 1200$ per ounce. As usual, when some kind of asset reaches record prices, be it stocks, bonds, real estates or commodities, it gets a lot of attention from the media and the investors community.

But why gold prices have risen so much in the last 8 years, rising to 1200$/ounce from 300$/ounce, an advance of 300%? Are fundamentals responsible for this advance or is there also some kind of speculation behind it? At today prices can we expect to get satisfable returns from gold as a long term investment?

I will try to give my answers to those questions.

Historically, gold has 2 distinct properties which distinguish it from all the other commodities and assets:

- It is an inflation hedge: it's nominal return mimicks the inflation rate over long periods of time

- It is perceived like an hedge against financial crisis and geopolitical instability, meaning that, at last teorically, gold will mantain it's value or even increase it even during an economic depression or wars.

Having avoided financial disaster in late 2008/early 2009 i believe that right now the second property matters little for the market.

The first one could be much more important in explaining the sharp rise in gold prices during 2009. The record amounts of fiscal and monetary stimulus that goverments injected in their economies to prevent a new depression and deflationary pressures could have unpleasant after effects, specifically in the form of high rates of inflation in the next years.

Let's take a look at a graph which shows gold prices in nominal and real terms from 1914 to these days:



By looking at this graph, you may understand why i think that the most important fundamental in explaining gold intrinsic value from a long term perspective is inflation. Of course supply and demand, particulary investment demand, affect gold prices, but they affect them more in the short-medium term than in the long term. In the long term what will affect the prices of gold is inflation, because gold performance will tend to mirror inflation. At last in an economy that works well over the long term like the US economy.

If gold performance mirrors inflation over very long periods of time, over a sufficently long period of time gold real yield must be 0% or at least be very close to 0%. Siegel in his work, "Stocks for the long run", shows that over a 200 years time span gold has had a real return near 0%. This strenghtens my thesis.

This doesn't mean that gold real return in the short-medium term can't be higher/lower that the historical mean which is near 0%. That's because gold prices, like the prices of all the other assets be them equities, bonds or real estate, are affected in the short-medium term by emotional and speculative forces which can push the asset away from it's intrinsic value to overvalued/undervalued valutations. But because these factors are only temporary, over a sufficiently long run period their effects disappear and there is a ruturn to the historical mean real yield.

We can see from the graph that gold is undervalued and can be a good long term investment when it's real return has been negative. Like in 1997-2001, because in the 1914-1997 period it had been underperforming inflation.

That's not the case right now. The bull market of the last 8 years has changed drammatically the situation: today gold nominal return has overperformed the inflation rate in the 1914-2009 period, and it's real return in that period has been much higher than 0%. Gold has been more expensive in real terms only the the period between the '70s and the '80s, when it seemed that the FED had lost it's control on inflation. After that period you can see that it's performance has been pretty disappointing.

This means that gold today is already discounting a sharp increase in the inflation in the next years and beacause of this by purchasing it at todat prices you may lose a substantial part of it's hedeging properties.

That's why i think that at the actual prices gold is overvalued.

Personally to protect myself from inflation i prefer goverment bonds which are indexed to the inflation rate. Differently from gold they also offer an income in the form of the coupons in addition to the hedging of the principal. Over a sufficiently long period of time this makes a substainstial difference.

Shorting long term Bonds: Db X-Trackers II Short Iboxx Sovereigns Eurozone Total Retun Index ETF

I have put this ETF in my portfolio at 112,9 with the idea to double my position if it's price falls of another 4%-5%.

The reason is simple: the actual market phase which started in march 2009 presents a strong anomaly: normally when equity and High Yield bonds jump sovreing bonds suffer, because of the unwinding of the "fly to quality" and the subsequent huge transfer of liquidity between asset classes with different risks. This time around instead every asset class is rising in price... corporate IG and HY bonds, equity, sovreing bonds... like if a schizophrenic response is following the generalized plunge in assets prices of 4Q2008 and 1Q2009, which was equally abnormal and caused mainly by psicological reasons.

If in march the misprincing in equity seemed pretty clear, now the mispricing in european sovreing bonds is equally evident.
The market is betting on low inflation and a very low level of interest rates for a long time due to a weak recovery in the economic activity, while i consider more likely a solid rebound in economic activity and an acceleration of inflation in 2010-2011.

If in march the mispricing on equities seemed pretty obiouvs, now the mispricing on european sovereign bond seem almost as obiuvs.


As we can see from the graph european governemen bonds reached their cycle lows in mid 2008, a few months before the daflut of Lehman Brothers, when commodities reached record high prices and the European Central Bank was determined to fight inflation during a phase of high uncertainty for the european and world economy.

The gold period for these securities started after the failer of Lehman Borthers, thanks to central banks reducing interest rates and to a strong fly to quality on the stronger issuers (France and Germany), caused by a fears of a new great depression and deflation threats.

I don't know for how long the rise in the price of these securities can go on, but i know one thing: it can't go on forever.

After putting down the basic idea after the investment, let's take a look on the charateristics of the ETF.

In my opinion it's not an instrument adequate for long term investment, because it shorts a total return index (this means that the coupons are reinvested in the index). But i think that it can work for medium term investments of no more than 4-5 years, if used in a rational way.

To compensate the fact that it shorts a total return index the ETF is remunerated by an interst rate than is 2 times the EONIA interest rate minus the cost on management of the fund (0,15% of total asset under management).

The medium maturity of the securities that compose the index is 8 years, so it pretty sensible to the change in long term interest rates.

To confirm this we can look at the long term graph of the Iboxx short Eurozone index, Iboxx Eurozone Index and 8 y EUR yield benchmark:


Looking at the period between 2005 and mid 2008, during which the ECB raised interest rates, you can see a significant appreciation of the Iboxx short eurozone index.

Stock analysis: Geox spa - the breathing shoe's corporation - part 2

Let's continue our analysis by looking at the company reclassified cash flow statement:



Cash flow from operations contracted 28,5% to 83,557 m from 116,758 m, mainly due to reduction in other non cash items and an increase/decrease in other current asset/liabilities.

This contraction, coupled with heavy net Cap Ex (94 m - a record for the company) mainly allocated to new store openings (especially flagship stores in key strategic locations), caused the free cash flow to turn negative to -10,74 m from 74 m in 2007.

The negative free cash flow and the 62 m the company payed in dividends had a considerable impact on company's net financial position, which was partially mitigated by the gains in the fair-value of derivative contracts used to hedge against currency fluctuations.

The surplus in the net financial position decreased to 58,2 m from 106,7 m. This actually isn't bad news since keeping a lot of cash for long periods of time without investing it or distributing it destroys value for the shareholders. For 2009 Geox has decided to reduce the Cap Ex to around 45 m and to keep the dividend unchanged in order to maintain a solid financial profile.

The increase in the net operating working capital (NOWC = inventories + accounts payble - accounts receivable) soaked up 42 mln of cash flow. The net revenues/NWC ratio increased to 22,9% from 21,7% , this impacted negatively the ROA. The increase in the ratio is caused by inventories growing more than net revenues:





Looking at the balance sheet we can observe that inventories grew 22,3%, accounts receivable 15,3% and accounts payable 17% against an increase of 16% in sales.

PROFITABILITY:

As a result of reduced profit margins and invested capital expanding more than revenue Geox profitability fell in 2008:

- ROA2008 26% vs ROA2007 32,7%
- ROE2008 27,5% vs ROE2007 34,5%
- OCF2008/PN2008 vs OCF2007/PN2008 32,7% (OCF = operating cash flow)

Although it's slowing due to the recession and it's effects on consumer spending, profitabilty remains on very high levels. In fact high retuns on capital invested and efficient capital allocation is one of the things i like about the company.



As a final consideration we can observe by looking at these figurest that Geox autofinanced it's exceptional growth in the past five years with it's solid cash flows while managing to mantain a solid financial position and good returns on invested capital during the years. This isn't a so common thing in the italian corporation scenery, and is a good testament to the company and it's management.

Stock analysis: Geox spa - the breathing shoe's corporation

Geox spa is one of my favourites blue chips on the Italian stock market. Geox creates, produces, promotes and distributes patented shoe and apparel products all over the world. It operates in the men's, women's and children's classic, casual, sports and fashion business.


Geox main competitive advantages are:

1. Technology: constant focus on the product with the application of innovative and technological solutions developed by Geox and protected by patents.
2. Focus on the consumer: cross-market positioning for products, with a vast range of shoes for men, women and children in the medium to medium/high price range (family brand).
3. Brand recognition: strong recognition of the Geox brand thanks to an effective communication strategy and its identification by the consumer with the "breathing" concept.
4. Internationalization: a growing presence on international markets thanks to easy replication of a business model already tried and tested in Italy.
5. Distribution: a network of monobrand Geox Shops in Italy and abroad which has been developed according to each country's distribution structure and calibrated to the widespread network of multibrand clients. The goal of both networks is to optimize market share and, at the same time, to promote the Geox brand to end-consumers on a consistent basis.
6. Supply chain: a flexible delocalized business model with considerable outsourcing, capable of efficiently managing the production and logistics cycle while the Company maintains control over critical phases of the value chain, so as to ensure product quality and timely deliveries.
   

Geox is the 1st shoe brand in Italy and the 2nd in the world. Since the start of 2008 the company is a member of the S&P/MIB index, the leading blue chip's index for the Italian stock market.

Let's take a look at Geox 2008 results (the images are taken from Geox 2008 financial statements):



Net sales were up 16% thanks to new store openings. Comparable DOS (directly operated stores opened for at least 1 year) sales were up 3%.
The rise in sales was not enough to offset the strong increase in general and administrative expenses, caused mainly by new store openings, especially flagship stores.
As a result EBIT margin contracted to 19,1% from 23,4%.
Net profit margin contracted less to 13,2% from 16% thanks to a lower tax rate (29,2% in 2008 vs 31% in 2007) due to a one time fiscal item.
EBIT and net income were also negatively affected by asset impairments by 2 mln and 5,9 mln respectively. Diluted EPS were 0,45 in 2008 vs 0,48 in 2007, a contraction of 6,25%.

Let's take a closer look at sales:



Geox is trying to further expand it's sales by selling apparel equipped with it's breathing technology in addiction to shoes. Due to it's high growth rate apparel is becoming increasingly more important as a source of revenue for Geox. In 2008 it generated 9,4% of net revenues as opposed to 6,7% in 2007, with a grow rate of 62,5% compared to 12,5% for shoes.

Geox main market is it's home market, Italy, which generated 37,3% of it's sales in 2008. In the last years the company successfully expanded in other European countries like Germany, France, Spain, Austria, in the US and in emerging markets (rest of the world). If you look at past balance sheets you can see than the company is progressively expanding the percentage of revenue generated outside Italy. In 2008 it continued to purse this strategy with important Cap Ex (capital expenditures) - roughly 94 mln euro - committed to opening new DOS (especially flagship stores) all over the world.

As you can see in the image the percentage of sales generated in DOS sales has increased in the last year, increasing to 15,8% from 13,1%, while the percercentage of revenue generated in franchising stores remained stable at 16%.

...to be continued...

Why Volatility isn't an adequate measure of risk

Nowadays, the most popular indicator of a security's risk is volatility. As we all know volatility measures how much the price of a security has fluctuated in the past. People see volatility as a risk indicator because, they say, if you buy a high volatility security you will expose yourself to a greater drop in the security value than if you buy one with low volatility. That's true, but the price movements that occur in the short term hardly tell something about the intrinsic risks of a business.

It's no surprise that this statistical concept has become so popular in modern markets dominated by traders which operate with very short time horizons. Those market players generally don't act on a value basis and don't know the characteristic of the business they buy or sell, instead their operations are based on their ideas of future price movements. To them, a simple price fluctuation based indicator like volatility appears very useful. They use it to estimate the potential loss/gain of a trade.

Unfortunately for them they learned the hard way one of the shortcomings of volatility: what happens tomorrow may be really different than what has happened in the last day, month or year. In 2008 while stock kept falling volatility drastically increased, reaching peaks not seen since 1987 in September-October after Lehman Brothers bankruptcy. Short term investors experienced bigger adverse developments in market prices than what they had estimated using volatility, beta and VAR. That's why many traders and hedge funds were utterly crushed by the market in the meltdown after September 15th.

The volatility of the S&P 500 is now higher than in 2006-1H 2007, but it's price is much lower. If one values risk on volatility he would come to the conclusion that the S&P is now much riskier than in 2006-1H2007. This is against any sound reasoning. How in the world can you assume a higher risk if you buy something at a much lower price?

Let's suppose than in year T you estimate that the stock of X corporation has an intrinsic value of 100. It's market price is 110 and it's volatility 20%. In year T+1 it's price falls to 60, it's volatility increases while it's intrinsic value is little changed. By buying something worth around 100 at 60 you would have an adequate margin of safety reducing significantly the risk of permanent losses, still volatility indicates than the risk of the security has increased! The intelligent investor understands that this is total nonsense and uses other reasonable methods of risk measurement.

The last problem with volatility is that it doesn't tell nothing about the intrinsc business risks. You will have to study the business until you understand it and read the financial statements to have a grasp of the intrinsic risk of a complex thing like a corporation.

Exploiting market fluctuations: the metaphor of Mr. Market

One of the best explanation of the market's behavior and the correct way to exploit it is Benjamin Graham's metaphor of Mr. Market.

Let's suppose you own a small amount of shares in a private business, which you payed 10000$. One of your partners, named Mr. Market, everyday tells you what he thinks your interest is worth and offers you to buy you out or to sell you an additional interest on that basis.

Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Other times on the other hand he let's his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short or silly.

If you know the business you own and you have an idea of it's value, you won't be influenced by Mr. market opinion on the value of your 10000 $ interest. Instead you will take advantage of his misjudgements by buying from him when the prices appears too low and by selling him your stake if the price appears ridiculously high. The rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about it's operation and financial position.

The value investor is in that very position when he owns a listed stock. He can take advantage of the daily market price or leave it alone based on his judgements.

Price fluctuations have only one significant meaning for the value investor: they provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market fluctuations and pays attention to his dividend returns and to the operating results of the companies he owns.

Never let the opinion of the general public influence your action. Stick with what you know and take advantage of the market's foolishness.

"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and your reasoning are right" - Benjamin Graham

The automotive sector crisis and two thoughts on Fiat spa

The automotive industry is in a very serious crisis. The US automobile market has been literally collapsing forcing the US Government to step in and save GM and Chrysler with a multi billion emergency loan. Ford is not in a much better situation, having burned more than 5 billion dollars in the 4Q 2008 alone. The Japanese automakers (Toyota, Honda, Nissan) which have a very important percentage of their sales in the US are also under pressure. Their situation is worsened by the strengthening of the yen against the dollar and the euro which is caused by the unwinding of the carry trade and the fall of interest rates in both US and Europe. Toyota has lost its AAA rating and has announced that it now expects an operating loss in 2009.
The European market has also experienced weakness in 4Q 2009 and major players now expect global sales to shrink by 20%-30% percent in 2009.

Right now I'm bearish on both equity and bonds of those issuers, but I'm following the sector because i think that some opportunities could arise as soon as late 2009 or in 2010 since many issuers could be downgraded by the rating agencies (we may even see some fallen angels, corporations which lose Investment Grade status and become High Yield issuers, with usually very negative consequences for their outstanding bonds) and the default of a big player in the industry could happen, putting considerable pressure on the price of automotive bonds.

Fiat spa (the main Italian automaker) released 4Q&FY 2008 results some days ago, i think that some figure are especially interesting to understand what's going on so let's give them a look (the pictures are taken from Fiat spa presentation for the analysts):


Let's take a look at Fiat cash flow in 2008 (click on the image to see the enlarged version). As you can see the company, despite it reported record trading profit in 2008, generated an operating cash flow of only 156 m euro. The reason is the adverse development in NWC (Net Working Capital = Inventory + accounts receivables - accounts payables), which absorbed 3,604 m euro of cash. We will return on this later.

Capital intensive business like this need very huge investments to continue to operate and to remain competitive, Fiat had a very heavy CAPEX (Capital Expenditures) in 2008: nearly 5 billion euro. The pathetic operating cash flow could do nothing to cover this absorption of cash and Fiat net industrial debt increased by a whopping 6,304 m euro.

This level of cash burning is obviously not sustainable, if things don't improve soon they could have difficulties in refinancing their debt and honoring their maturing obligations.
The problem is that what has happened in the US is now happening in the European market: auto sales are plunging. EU auto sale fell 27% in January 2009.
The EU market will shrink by roughly 20% in 2009 according to estimates, and it may non recover in 2010.
Fiat trading profit in 2008 could transform in a substantial loss in 2009, and the cash burning process will probably go on. Additional cash could be soaked up because of adverse developments in NWC (the more the net working capital increases the more it sucks up cash, the opposite is also true: the more it decreases the more it frees up cash).

Let's take a look at the development of Fiat's NWN in 2008:

Take a look at the increase in inventories as the revenue goes down. Like many other competitors Fiat is tryng to reduce inventories while sales are falling by temporary shutting down production in factories.
So we should expect inventories to fall, reducing NWC.
Trade receivables follow revenue, so we should expect them too to contract reducing NWC.
The problem is that trade payables are falling too due to the production stoppage.
The increase in NWC due to the fall in trade payables could more than offset the decrease in inventories and payables.
That's why i think that NWC could soak up cash again in 2009.

So you end up with a negative operating cash flow and you have to finance the CAPEX, which will be more conservative in 2009 than in 2008, but will still be there.

This means that debt will increase even further.

Lets take a look at the breakdown of Fiat net financial debt:

The net financial debt increased to 17,9 billion euros in 2008. Fiat draw 2 billion of committed lines in 4Q 2008, exhausting all it's remaining credit lines.

17,9 billion of debt becomes a problem when you are going to generate negative cash flow, especially if you have heavy short term maturities:


Fiat has 4,8 billion of total cash maturities in 2008 and 3,9 billion in cash & marketable securities. The only way it can repay them with a negative cash flow is by renegotiating them or contracting new debt.

Right now Fiat is negotiating a 3 billion credit line with some big Italian banks.

The next quarters will tell us if that's enough to cover it's financial needs.