The Derivatives Mess
Posted by Eddy Elfenbein on February 28th, 2006 at 10:02 am

I meant to post this earlier. This WSJ article highlights the problems of the growth of derivatives on Wall Street.

Derivatives allow banks, companies and investors to transfer financial risk, much as homeowners buy insurance to shift the risk of repairing fire damage to an insurer. In the simplest form, Joe’s Manufacturing Inc. borrows $5 million at an interest rate that moves up and down with market rates, and then cuts a deal with Frank’s Investment Bank in which Joe promises to pay a fixed rate and Frank pays the variable rate.
The subspecies known as credit-default swaps allow banks that have lent money to, say, General Motors Corp. to shift risk of default to a risk-loving investor for a fee. As the market has evolved and drawn speculators, as well as banks looking to lay off risk, investors now place bets not only on individual firms, but on baskets of credits and on risks sliced and diced in increasingly complex ways.
You would think that Wall Street would have computerized this when the market started taking off a few years ago. But deals were, and often still are, done by telephone and fax. Detailed confirmations, important in avoiding nettlesome disputes later, weren’t completed. One firm confessed in June that it had 18,000 undocumented trades, several thousand of which had been languishing in the back office for more than 90 days. It wasn’t unusual.
That’s not all. One party to a two-party deal was routinely turning obligations over to a third party without telling the first one. It was as if you lent money to your brother-in-law and later learned that he had passed the debt to his deadbeat cousin without so much as an email. “When I realized how widespread that was, I was horrified,” says Gerald Corrigan, a former New York Fed president now at Goldman Sachs. “What it meant was that if you and I did a trade, and you assigned it without my knowing it, I thought you were my counterparty — but you weren’t.”
In LTCM’s case, each player knew the dimensions of its exposure; no one realized how exposed other firms were and how fragile LTCM’s strategy was. In the case of credit derivatives, the problem has been worse: Record-keeping, documentation and other practices have been so sloppy that no firm could be sure how much risk it was taking or with whom it had a deal. That’s a particularly embarrassing problem for an industry that has resisted regulation of derivatives by arguing that big firms would police each other.
Stocks, bonds and options traded on exchanges go through clearinghouses, which pick up the pieces when something goes awry with a trade. In this market, there’s no clearinghouse yet. Until recently, dealers didn’t even enter most credit-default-swap trades into a computer database to be sure both sides agreed on the terms.
Mr. Geithner, the Paul Revere of this story, began shouting about all of this before the end of his first year on the job. In an October 2004 speech, he noted that inadequate financial plumbing was “a potential source of uncertainty that can complicate how counterparties and markets respond in conditions of stress.” That’s central-bank speak for: The car is careening down the highway at 85 miles an hour and the lug nuts aren’t tight. If we hit a pothole, look out!

Fourth-Quarter GDP
Posted by Eddy Elfenbein on February 28th, 2006 at 9:01 am

GDP growth raised to 1.6%.
You wouldn’t know this from how people talk about the economy, but GDP growth is far more stable than most people realize. I often hear that the economy is “surging” or “crashing.” In reality, economic growth is a pretty stable trend that occasionally has some minor bumps.
Here’s a graph of real GDP growth over the last 60 years (red line) with a trend line line (black line).

Here’s a look at the trailing three-quarter growth rate of real GDP. I’m not sure why, but the nine-month view seems to work the best.
Notice how over the last 20 years, the economy has become far less cyclical. The peaks are getting lower, and the valleys are getting higher.

The Stalwart has speculated that as the overall economy has become more stable, the individual pieces have become more volatile. I think he’s right. Perhaps the price for collective security is the growth of constituent risk.

PhytoMedical Technologies
Posted by Eddy Elfenbein on February 27th, 2006 at 10:06 pm

David Phillips at 10Q Detective is unimpressed with PhytoMedical Technologies (PYTO.OB):

The 10Q Detective suggests that if PhytoMedical Technologies really wants to be taken seriously by the investment community—Perchance the Company could design a clinical trial that examines the safety and efficacy on the potential appetite-stimulating properties of a well-known plant-derived compound on the cachexia of cancer, HIV/AIDS symptomatology, and other wasting syndromes. This medicinal plant is called, cannabis sativa.
To be blunt (BA!)—given the Company’s current fundamental outlook—one would have to be smoking cannabis daily to even consider buying this stock.

I guarantee you’ll never read that in a Merrill research report.

The Future of Food
Posted by Eddy Elfenbein on February 27th, 2006 at 7:59 pm

Steven Milloy, the author of Junk Science Judo: Self-defense Against Health Scares and Scams, looks at the film “The Future of Food.”

Produced by Deborah Koons Garcia, the widow of the Grateful Dead’s Jerry Garcia, the movie’s overriding themes are allegations that biotech crops and food are unsafe and that a government-industry cabal is foisting dangerous products on an unwitting public.
Nothing could be farther from the truth.
Biotech crops and foods are among the most thoroughly tested products available. No other food crops in history have been so thoroughly tested and regulated. Before biotech products are marketed, they undergo years of safety testing including thousands of tests for potential toxicity, allergenicity and effects on non-target insects and the environment.
‘The Future of Food,’ for example, dredges up the 2000 scare involving a biotech corn that had not yet been approved for human consumption but that was detected in Taco Bell taco shells. A few consumers, egged on by anti-biotech activists, alleged the corn caused allergic reactions. But the movie glossed over the fact that the U.S. Centers for Disease Control and Prevention tested those consumers and reported there was no evidence that the biotech corn caused any allergic reaction in anyone.
Another long-buried myth excavated by Garcia was that biotechnology harms biodiversity. But so far it doesn’t appear to represent any greater risk to biodiversity than conventional agriculture and it actually seems to have some demonstrable beneficial impacts on biodiversity. An infamous biodiversity scare featured in the movie involved Monarch butterflies. The scare occurred during 1999-2000 when the media trumpeted alarmist results from two laboratory studies reporting that biotech corn might harm Monarch butterfly larvae. Subsequent field studies soon debunked the scare, reporting that Monarch larvae actually fared better inside biotech cornfields than in natural areas because of less pressure from predators. Needless to say, Monarchs in biotech cornfields also did much better than those in conventional cornfields sprayed with insecticides.
The movie claims that once biotech crops are planted, control over them is lost and they ‘contaminate’ non-biotech or organic crops. This is misleading since 100 percent purity has never been the reality in agriculture. Biological systems are dynamic environments, meaning that regardless of the method of production — conventional, organic or biotech — trace levels of other materials are always present in seed and grain. Since all commercial biotech traits are fully approved by U.S. regulatory agencies, their presence — in large amounts or trace amounts — is fully legal and safe.
With respect to organic farmers, the Department of Agriculture’s rules for organic products specifically say that the certification of organic products is process-based — meaning that if the proper processes are followed, the unintended presence of non-organic or biotech traits doesn’t disqualify the product from being labeled as ‘organic.’
To date, biotech crops haven’t harmed organic farmers. The coexistence of biotech, conventional and organic corn, soybean, and canola has been effectively working since 1995, when the first biotech crops were introduced. During that period, in fact, both biotech and organic farming have grown remarkably.
Garcia wants movie viewers to overlook the fact that U.S. regulators — including the Department of Agriculture, Environmental Protection Agency and the Food and Drug Administration — have established a robust framework and rigorous process for evaluating biotech product safety. Developers spend years generating data for one product to be submitted for approval.
A major take-home message of the movie is that consumers should demand labeling of biotech foods. But this would only increase the cost of food production while failing to provide any meaningful information to consumers. Biotech crops have been determined by regulators to be essentially equivalent to those of conventional crops. Corn is corn, in other words, no matter what anti-biotech activists would have us believe.
While emphasizing ‘scare,’ the movie overlooks biotechnology’s advantages. Biotech crops require less tilling. This reduces soil erosion; improves moisture retention; increases populations of soil microorganisms, earthworms and beneficial insects; and reduces sediment runoff into streams.
The movie mocks biotechnology’s potential value to the developing world, characterizing the argument as one designed for public relations use. But biotech crops such as ‘golden rice’ could help with the severe Vitamin A deficiency that afflicts hundreds of millions in Africa and Asia, ¬ including 500,000 children who lose their eyesight each year.
As pointed out by Greenpeace co-founder Patrick Moore, now a vociferous critic of the activist group, ‘Greenpeace activists threaten to rip the biotech rice out of the fields if farmers dare to plant it. They have done everything they can to discredit the scientists and the technology.
‘A commercial variety is now available for planting, but it will be at least five years before Golden Rice will be able to work its way through the Byzantine regulatory system that has been set up as a result of the activists’ campaign of misinformation and speculation,’ Moore said. ‘So the risk of not allowing farmers in Africa and Asia to grow Golden Rice is that another 2.5 million children will probably go blind.’
Garcia’s ‘The Future of Food’ is steeped in the Greens’ tragic campaign of misinformation. Many long-time anti-biotech campaigners helped her make the movie, in which not a balancing thought or counter-opinion is presented.
The ‘Future of Food’ purports to be a ‘documentary’ – a movie that sticks to the facts. It doesn’t. Hollywood will need a new Oscar category for this one. How about ‘crockumentary’?

Lowe’s Vs. Home Depot
Posted by Eddy Elfenbein on February 27th, 2006 at 2:19 pm

Lowe’s reported great earnings today. Stephen D. Simpson looks at the battle between Lowe’s and Home Depot:

For those who would suggest that home improvement retailing ultimately has to be like The Highlander (“in the end, there can be only one…”), I’d observe that Wal-Mart and Target have profitably co-existed, as well as Office Depot, Staples, Wal-Mart’s Sam’s Club, and Costco.
All that said, it’s clearly true that Lowe’s is the pluckier and faster-growing of the two concepts. Sales in the fourth quarter climbed over 26% (nearly 8% on a comp-store basis), and earnings per share rose nearly 36%. Certainly those numbers outstrip what Home Depot managed to accomplish.
And there are certainly aspects of Lowe’s model that could be seen as working better than Home Depot’s. Lowe’s is generally thought to have better customer service, and the notion of trying out metro/urban stores is interesting.
By the way, Home Depot still has superior returns on capital. Home Depot also has a leg up in terms of international expansion and is moving aggressively into service businesses and MRO/industrial supply. So in this Fool’s opinion, comparing Home Depot and Lowe’s is no longer a fair straight-away comparison.

Good Day Today
Posted by Eddy Elfenbein on February 27th, 2006 at 12:57 pm

If the market holds, the S&P 500 will close at a four-year high. The S&P 600 Small-Cap Index (^SML) and S&P 400 Mid-Cap Index (^MID) might close at new all-time highs. Plus, all 20 stocks on the Buy List are higher today.

Failure Never Felt So Good
Posted by Eddy Elfenbein on February 27th, 2006 at 11:21 am

Attention corporate weasals. Don’t try to get anything past Michelle at Footnoted.org. It just ain’t gonna fly.

And speaking of former executives, there was also this little snippet buried in Morgan Stanley’s (MS) proxy, which was also filed late Friday. Again, while the broad-brush details were known, such as Philip Purcell’s $44 million bonus, the blow-by-blow was included in the proxy (do a search for CEO settlement to find it quickly). Among the pearls are that Purcell’s secretary, which the company has agreed to pay for as long as Purcell lives, will cost the company $1.8 million and that donations to Purcell’s favorite charities (again for life) will cost the company $2.9 million. And there’s another $3.1 million for benefits the company will provide the former executive, again for the rest of his life.
Indeed, failure never felt so good.

And it pays well too.
Can you order Michelle’s book? But of course. I’ll be here when you get back.

Owning a Toll Booth
Posted by Eddy Elfenbein on February 27th, 2006 at 11:15 am

GroovyStocks on Intel (INTC):

According to Yahoo Finance, shares of Intel are now trading at 14.7 times trailing earnings and 14.1 times forward earnings with an EV/EBITDA ratio of 6.7. We think these are very reasonable multiples to pay for such a high quality company.
Sticking with Yahoo’s numbers, INTC has an operating margin of 31.1% and a profit margin of 22.3%. Return on assets is 15.7% and return on equity is 23.2%. The balance sheet has $12.8 billion in cash and $2.4 billion in debt, or over $10 billion in net cash. If you know another place where we can buy such high profitability and returns with balance sheet strength even half as good, please let us know!
Intel’s size gives it a huge competitive advantage. Here’s a quote from Columbia Business School professor Bruce Greenwald that sums the matter up:
“When Intel goes after the next generation chip, because it’s got some degree of customer captivity — which is crucial to scale advantages — Intel can expect, if it’s successful, to get 10 times as many customers as AMD. That means Intel can spend 10 times as much on developing and marketing the new chip. That’s the advantage of scale. So who’s going to win that race every time? Intel.” (Related Post)
We view owning Intel as owning a toll booth: (almost) every time somebody buys a computer you collect a fee. Sounds like a good business to us!

Back Where We Started
Posted by Eddy Elfenbein on February 27th, 2006 at 10:34 am

Price chart of Intel (gold line) and Microsoft (black line) over the last eight years:

Confessions of an Economic Hit Man
Posted by Eddy Elfenbein on February 27th, 2006 at 9:44 am

The latest offering from the Grassy Knoll gang is “Confessions of an Economic Hit Man” by John Perkins. The book has become a bestseller. In it, he claims that the world is governed by big, evil corporations who use “a combination of bribes, assassins and seductive women to enslave the poorest countries.” In contrast, Sebastian Mallaby uses a combination of facts, reason and logic to expose this nonsense.

Perkins likes to say that of the world’s 100 biggest economies, 51 are companies. This old chestnut is based on a fallacious comparison of companies’ sales to countries’ gross domestic product: Whereas GDP measures the amount of value added in an economy, sales lump together a firm’s value-added with inputs bought in from suppliers. According to an apples-to-apples comparison done by the United Nations, just two of the world’s top 50 economies were companies in the year 2000. Of the top 100 economies, 29 were companies.
That may still sound like a lot, but remember that companies compete against each other. In the world as Perkins dreams it, the top 100 or so firms are joined in a shadowy conspiracy. But the reality is that Exxon Mobil schemes to undermine BP and Shell, and General Electric plots against Siemens and Hitachi. Countries don’t face a united corporatocracy. They play firms off against each other.