Trading Obama: Solar Stocks, GM Debt, Ambac Calls, Lorillard and Goldman Puts

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Includes: AMBC, CSIQ, ESLRQ, FXE, GM, GS, HQCL, JASO, LO, STP, TSL, XGM, YGE
by: Greg Weston

Long Solar

President-Elect Obama and virtually all the Democrats who have won congressional races have promised to invest in clean energy. I have a somewhat perverse interest in watching out-of-state candidates’ campaign commercials. Something like 50% or more of Democrats’ ads feature these promises, together with pictures of windmills and gleaming solar panels on a sunny day. I expect that they will keep their word. It’s both good policy and good politics.

Many good solar stocks are trading at small fractions of recent highs and shockingly low forward P/E ratios, in particular the polysilicon companies. I like Yingli Clean Energy (NYSE:YGE), Solarfun (SOLF), Trina Solar (NYSE:TSL), and Canadian Solar (NASDAQ:CSIQ). While all of these stocks are sharply up the last few days, YGE trades at only 4 times 2009 earnings estimates, and TSL at 2.5 times 2009 estimates. Suntech (NYSE:STP) is a bit more expensive at 5x ’09 earnings, but deserves its premium because it has strong economies of scale, lots of sales in the less mature United States, and is relatively more established overall. The sector is volatile, but offers incredible potential for medium to long term investors and the possibility of quick gains once Democrats formally take power and get to work on their first energy bill. Even with a narrow Democratic majority in the current Congress, solar subsidies were extended and increased.

Two more polysilicon stocks, Evergreen Solar (ESLR) and JA Solar (NASDAQ:JASO), appear to have lost a large amount of money and loaned stock when Lehman Brothers collapsed. While they are also attractively priced, their relative price does not seem to reflect this risk, so I’d avoid them for now.

There were two main causes of the big solar sell-off earlier this year: big declines in oil prices and warnings from analysts about problems securing financing. The problem with the oil argument is that solar does not compete directly with oil. One powers homes and businesses, the other planes, trains, and automobiles. Solar is most directly in competition with coal and natural gas, both dirty power sources on which we will soon see new taxes and regulations.

I am also not worried about financing. Even if private investment capital for solar dries up (possible but doubtful), the Chinese government showed that it will stand by its burgeoning solar industry when it recently extending a large line of credit on favorable terms to YGE, which was then followed by more financing by a private Chinese bank. Moreover, the biggest customers of solar companies are financially stable electric utilities that are required by law to generate power from renewable sources. They will not let their suppliers collapse for lack of financing, and in the event of a cash crunch are another source of solar company financing.

More recently there are talks of supply gluts and a drop in demand that could impact earnings as much as 50%. Again, I am not worried. Drops in finished panel prices will be accompanied by drops in raw material prices. To the extent there is a mismatch between the two, it will necessarily be temporary. Further, tech manufacturing is the other major user of polysilicon, and demand for electronics is elastic.

Finally there is a worry that earnings will be hurt by a strong dollar because solar sales are concentrated in Euro-denominated currencies. While this is a valid concern, it is not a reason to be scared away from solar. Instead if this worries you, you can easily hedge solar stocks Euro exposure by pairing your solar investments by shorting the Euro. This can easily be done by shorting the Euro ETF (NYSEARCA:FXE).

Long GM Debt

GM is too big to fail. Obama and Democratic leaders in Congress are not about to let America’s biggest industrial enterprise and biggest private union employer go bankrupt on their watch. Doing so would destroy the balance sheets of many banks and hedge funds that own GM debt or are short GM default swaps, possibly send the federal Pension Benefit Guarantee Corporation into insolvency, and cause a cascade of bankruptcies among suppliers and foreclosures among individuals in Michigan, Indiana, Missouri, and Ohio, big swing states where GM’s operations are concentrated.

I expect a large equity investment in GM next year by the government that will be very dilutive to shareholders, but will bring big profits to investors like me who bought senior GM bonds (XGM) at current extremely distressed prices. GM senior debt is also convenient to buy for retail investors. It trades on the NYSE under the ticker XGM, and right now is yielding 33%. Talks are already underway between Big 3 representatives, the UAW, Speaker Pelosi, and auto state congressmen.

Speculating on Inflation Volatility

If the deflation scenario many are talking about plays out, Goldman Sachs (NYSE:GS) is sunk. In fact, I’d argue that the company’s current mark to market book value now is less than zero. (Just to be clear, this does not mean I think GS is worthless. It has a lot of value that’s not captured in its book value.) Goldman debt, like GM’s, is probably way too big to fail, but that doesn’t mean that common shareholders won’t be largely wiped out. I just don’t buy the story that GS was able to eliminate its housing and credit market exposure before these markets collapsed. It was too highly leveraged to permit it to fully hedge its housing and credit market exposure, and we would have seen GS post lower profits compared to its peers as a result of these hedges before the market started to turn. Gigantic profit margins are possible for buyers of 2010 Goldman puts at strike prices between 10 and 30.

Conversely, if the US economy is reflated by more and more bailouts, tax cuts, and spending, there is a chance that policy makers will overshoot and overinflate the economy. Goldman is already pretty richly priced, so I would not go long GS calls as well, even though they would do pretty well if reflation measures overshoot. Instead Ambac (ABK) strikes me as the #1 beneficiary of such an overly aggressive fiscal and monetary policy. Ambac Jan 2010 calls are cheap right now.

It’s almost inconceivable that both out of the money GS puts and ABK calls pay off. But I think both deflation and government attempts to prevent it overshooting are underappreciated possibilities. Inflation is great for debtors, and as the insurer of debts, if ABK returns to only one third of its early 2007 prices, the calls will return 2000% to 3000% . That’s a lot better than you would do with other inflation hedges like the gold ETF (NYSEARCA:GLD) and even leveraged plays like futures and miners.

Essentially the paired GS put/ABK call trade is a bet on money supply volatility. If you followed my previous SA calls to short financial stocks like Redwood Trust (NYSE:RWT), Crystal River Capital (CRZ), Downey Financial (NYSE:DSL), and Maguire Properties (NYSE:MPG) you are sitting on a some real profits now. Betting on inflation volatility is a good place to put a portion of that money.

Lorillard: A Menthol Cigarette Ban Could Pay Off Big For LO Shorts

Lorillard (NYSE:LO) derives about 95% of its revenue from the sale of a single brand of menthol-flavored cigarettes, namely Newport. The tobacco bill last year came very close to banning all flavored cigarettes. Menthol flavor makes cigarettes taste like peppermint candy and feel like soothing cough drops. Kids are more likely to start smoking menthol-flavored cigarettes because of the peppermint taste. They are also more dangerous because the menthol masks the harsh feeling of hot smoke, leading smokers to inhale more deeply. Civil rights groups strongly favor a menthol ban because a large majority of black smokers smoke menthol-flavored cigarettes. You can read more about this topic here.

So will civil rights and anti-tobacco groups succeed in getting Congress to ban menthol cigarettes next year? Maybe. I’d handicap it at around 50/50. Tobacco state Dems will oppose this law, but moderate Republicans in suburban districts will offset them. The risk of a menthol ban was big enough that the Loews family that controlled the Newport brand via its Loews Corporation for decades decided to fully divest this potentially toxic investment by spinning it off completely. Loews Corporation’s main line of business besides tobacco was insurance. And the good actuaries that they are, the company saw the huge risk in owning a pure-play menthol flavor cigarette brand.

LO puts with very low strike prices only started trading about three weeks ago. I believe the market has not yet correctly priced them. These June 2009 and Jan 2010 puts on Lorillard are a small part of my speculative portfolio, but could produce profits of 500% to 1500% in a worst case scenario for Lorillard. Even if this doesn’t happen next year, I expect cigarette sales to continue if not accelerate their secular decline, cash-strapped state governments to continue to raise tobacco excise taxes, and the weak economy to push dedicated smokers further into generic brands.

Disclosure: Long YGE, SOLF, TSL, CSIQ, STP, XGM. Long ABK calls. Long puts on CRZ, FED, LO, GLD, GS. Short DSL calls.