Wednesday, February 24, 2010

Going defensive

I know that I should never ever try to time the market. Yet, at the moment it looks like the stock markets can run out of steam at any point of time. There are just too many things that can go wrong and spark a large scale sell-off. Therefore, I am seriously considering alternatives to my current positions.

Naturally, any good alternative needs to involve minimum downside and as much potential upside as possible.

I don’t like shorting stocks because you have basically limited gain prospect (100% if stock goes to zero), but unlimited risk (if stock rises). Naturally you can play with “stop loss” or such parameters with brokers, but still, at best, it is a short term bet. And I don’t like short term bets either because I don't have the time required to follow those and because essentially short term bets are the extreme case of trying to time the market.

Future of U.S dollar does not look that good. Neither does that of euro. Therefore it could be a good idea to take a position in Chinese Yuan. NYSE: CYB is one option for such position. However, this particular ETF has 0.45% expense ratio and what is essentially seems to be is a position in U.S. dollar with potential upside from appreciation of Yuan vs. dollar.

Going short U.S treasuries seems to be a popular trade. NYSE: TBT offers leveraged (200%) exposure to inverse of 20 year treasury index via an ETF. At some point of time this can be a spectacular trade. However, as they say “markets can stay irrational longer than you can stay solvent”. Also, it has 0.95% expense ratio and because it effectively multiplies daily changes in index by factor of minus two, volatility will hurt the performance badly. So essentially this is a short term bet, like most leveraged ETFs are.

OK, then what. Gold is at the moment the best defensive position outside stock market that I can think of.

Saturday, February 20, 2010

Fortum and the Nordic power play

Approximately 91% of power generation in EU countries by the Finnish utility company Fortum was carbon dioxide (CO2) free in 2009. This can be explained with the fact that 97% of its power generation in Nordic countries is based on either hydropower or nuclear power. Elsewhere, it uses primarily thermal plants for power generation. Some thermal plants, however, are also used to generate heat which doubles the efficiency of the plants and waste heat generation is minimised.

Picture: Fortum’s Loviisa nuclear power plant from air.

The cash cows

In Finland and Sweden, Fortum has 260 wholly or partially owned hydropower plants, two wholly owned nuclear power plants and several partially owned ones. These assets are the backbone of the company and deliver spectacular profits. Operating profit of the power division was over 51% out of its sales in 2009. Although the power division accounts only 48% of company sales it delivers 75% of all profits.

Fortum is well positioned to increase it’s share of CO2-free production capacity in Nordic countries as it owns 26,6% share in Teollisuuden Voima (TVO) that is currently building a 1600 MW nuclear reactor that is scheduled to go online 2012. It will be a significant addition as the existing four reactors in Finland have output of roughly 2700 MW. Two of the existing reactors are owned by Fortum and two by TVO. Therefore, Fortum either fully or partially owns all of the nuclear power plants in Finland.

The race for more nuclear power plants

Both Fortum and TVO have submitted an application for a decision-in-principle for the construction of one more reactor each. There is also a new player in the game applying for a reactor license: Fennovoima. Behind it are various Finnish entities with 66% stake and the world’s largest privately owned energy company E.ON from Germany with 34% stake.

The Finnish parliament is supposed to make a decision on the matter by summer recess. So far the political discussion inside the Cabinet of Finland has included all options from granting license to all three to granting none. The two extremes in the discussion are The National Coalition Party and The Green League latter of which opposes nuclear power in general. To me, currently the most likely outcome seems to be 1-2 new reactor licenses.

The proposed plants range from 1000 MW to 2500 MW in electrical output. Therefore, any positive decision will mean major increase of nuclear power generation capacity in Finland and in the Nordic region in general as only Finland and Sweden have nuclear power plants. In addition, Sweden did have a nuclear phase out policy in place for ending all nuclear power generation by 2010, but this turned out to be unrealistic and last year a decision was made to allow for replacement of existing reactors.

The need for additional power generation capacity comes from the chronic deficit in Finnish power generation capacity. At the time of writing this article, 18% of demand (2371 MW) was covered by importing electricity from Russia, Estonia and Sweden according to Finngrid. Going forward, the deficit is expected to grow larger.

Finland, Sweden, Norway and Denmark form a single power market. In cold winter days the demand is at its peak and the price of electricity in the Nord Pool spot market surges. Lately, production stalls at Swedish nuclear power plants have also contributed to higher than average energy prices. The Nordic power grid is also connected to Germany and in fourth quarter higher prices in German market resulted in net export from the Nordic area to Germany.

Solid dividend payer

Fortum operates in Nordic countries, Russia and in the Baltic Rim area. Activities cover the generation, distribution and sale of electricity and heat and the operation and maintenance of power plants. 74% of power generation and 39% of heat generation by Fortum occured in the Nordic countries in 2009.

With market cap of EUR 16.74 billion it ranks as second out of all Finnish companies. This makes it a “must have” for many mutual funds and index funds exposed to Finland, Nordic countries or the utility sector in Europe. The Finnish state owns 50.76% of Fortum shares and considers it as strategic investment.

Group sales in 2009 were EUR 5435 million and operating profit totalled EUR 1351 million. Earnings per share were EUR 1.48 having been 1.74 the year before. P/E (2009) is 12,7. With the proposed dividend of EUR 1.00, the dividend yield is 5,3%.

Picture: Fortum’s past dividends.

Note: Market cap, P/E and proposed dividend yield are calculated using Friday 2/19/2010 closing price 18.84 EUR per share at Nasdaq OMX Nordic Helsinki market.

Monday, February 15, 2010

Financial crisis 2.0

“After all, you only find out who is swimming naked when the tide goes out.”

- Warren Buffett, 2001 letter to Berkshire Hathaway investors

When making the comment Mr. Buffett was speaking about insurance business in post 9/11 world and the very complex chains of reinsurers after reinsurers. “A single weak link can pose trouble for all”, he said. He might as well have been speaking (today) about investment banks or banking system in general.

As pointed out by many, subprime crisis might have been just a “prelude” to a much bigger crisis. As the “tide” is slowly going out more and more entities appear to have been “swimming naked”. Not just banks, but entire countries. Many countries were heavy on debt even before the crisis. Now all eyes are on Greece, but the deficit & debt problem is far more widespread than that.

It is not just so called “PIIGS countries” (Portugal, Ireland, Italy, Greece and Spain) that may in for trouble. Also other European countries, Japan and USA have significant debt levels and budget deficits. Check out this chart.

In his recent article titled ”A Greek crisis is coming to America” Harvard professor Niall Ferguson painted a gloomy picture of a potentially rolling debt crisis. I was compelled to listen to “Moonlight sonata” by Beethoven while reading it. And that masterpiece has some pretty seriously sad and anticipating sound to it.

Basically Mr. Ferguson says that what we might be witnessing is a beginning of fiscal crisis of the whole western world far worse than what followed the subprime tsunami. To me the most striking claim was that the “US will never again run a balanced budget”. So I just had to look it up. And sure enough, CBO projects large deficits throughout 2020. What might make US situation even worse is anticipated second round of mortgage defaults.

Markets are nervous and who knows what might set of the next panic. Hopefully all this goes away as I’m still pretty heavily exposed to stock markets right now. In anticipation of some sort of recovery hiccup I have sold the riskiest assets that gained heavily in 2009 and reinvested to more defensive index funds and stocks.

Sunday, February 14, 2010

Nobody predicted the financial crisis?

Have you bumped into claim that ”no one predicted the financial crisis”? I have, several times. It is easy to prove the claim wrong by finding just one who did so: Peter Schiff.

He is probably not the only one, but since I recently completed reading his book “Crash Proof 2.0”, I will concentrate on him in this post. The book I read is 2009 update on a book “Crash Proof” that was published before the crisis in February 2007. The 2.0 version is otherwise same except contains additional 2009 commentary in the end of each chapter.

By following the link you can read six first pages from the book. They pretty much summarize the problem described in the book. Chapter 6 of the book deals with exactly the problem that caused the crisis.

It is disturbing to see how well Schiff described the problems in US housing and lending market well in advance. It is also disturbing to see clips from CNBC and FOX where they basically laughed in his face when he indicated that there were serious problems brewing in housing market and in the bank sector.

However, the book is not about the financial crisis we all came to know so well. It is about something far worse. It is about downfall of the US economy and the US dollar.

In retrospect, and especially after reading the book by Schiff, I can not understand why the housing bubble was not spotted or burst long time ago. Rather embarrassing for all those economists, politicians and reporters who regularly follow, study and comment financial issues. Perhaps that is why claims like “nobody predicted it” are made.

Friday, February 12, 2010

Gold Fever!

The price of gold has gone up a lot in 10 years. Many say it’s a bubble, many say it isn’t. Some say the mania phase is still ahead and give target prices that are multiples of the current spot price (~1090 dollars per troy ounce at the time of posting). I tend to agree with latter group (no bubble) and that is why I have exposed my portfolio partly to gold and gold miners.

Lately I have been taking hits because of this strategy as gold price has gone down and stocks of gold miners even more so. However, I intend to stick with the strategy because of the fundamentals backing gold. There are many reasons to own gold or any tangible things right now. In my mind, two of the biggest are fear of inflation and fear of another, a far more serious financial meltdown than experienced so far.

The measured inflation seems quite low right now, but my fear of inflation comes from “quantitative easing” (money printing) that has been going on for some time now. Please check the money supply charts from:

Compare them with the 10 year gold price chart below. Feel the connection?

Hardly scientific proof, but kind of makes you think..

If you are not familiar with the concept of fiat currency, why money printing is a problem or how this all relates to gold price, please check out this FAQ:

Currently all eyes are on Greece, but most western economies have debt issues. Budget deficits are not sustainable forever so something has to be done sooner rather than later. No growth goes on forever even though everybody seems to be obsessed with getting growth back on “track”. As if it would be “the silver bullet” to fix it all. It could be, but I don’t think so.

Seriously, a lot of manufacturing operations have moved to east permanently. They aren’t coming back any time soon. Also, lots of R&D is being moved to same direction. Growth in the past does not in any way guarantee that we have such thing far into the future. There is no such law for REAL growth anyway. Naturally, if inflation is 3% the economy better grow the same or then it is actually shrinking. So that explains partly the obsession with growth..

At any rate, the easiest fix to budget deficits, bank crisis etc. “surprises” will be more money printing for those who can do it. That equals serious problems at some point of time somewhere in the world. Be it asset bubbles or inflation or something else. Who knows?

So why should a private investor like myself care about any of this?

Well, exchange rates like USD/EUR have impact to bottom line of most companies. Some companies benefit from weak dollar, others suffer from it. However, the most interesting question is that in which currency you want to hold your long term investments.

This is where the barbaric relic comes into play. Even though gold is not used broadly as currency right now, it has been used as such in history and may be used once more. It is the ultimate benchmark for currencies. Or do you think that the central banks are sitting on it just for fun of it?

Since I don’t like to put my eggs in one basket only, I try to avoid getting too much exposure into any currency or gold for that matter. The problem with gold is that it does not yield anything – it is simply a tool to preserve wealth and take part in speculation regarding its value vs. fiat currencies. Betting on Chinese Yuan might also pay off someday, but when?

As most of my portfolio still is allocated to Europe and US, I am stuck with euro and dollar. But it does not hurt to acknowledge the problems that may lie ahead for fiat currencies.