Dalrymple Finance's  Instablog

There has been a lot of talk about the declining dollar lately, and for good reason.  However, most Americans do not have experience with worst-case currency scenarios and how devastating a devaluation can be.  The problem is that economic systems always seem to favor debtors over savers.  There is ample evidence of this in the current cycle in the US.  We have seen mis-managed, debt laden, highly levered institutions bailed out across a number of industries, from banking and autos to paper.  In contrast, prudent companies and individuals alike have had to make it through on their own all while the purchasing power of their savings steadily erode.  

As an illustration of what a worst-case can mean on an individual level, I present the following story:  

My wife grew up in an Eastern European country.  During that time her grandmother participated in a savings program where she deducted 10% of her salary per month and deposited it into an account earmarked for when my wife got married.  As socialism drew to a close, the account was worth the dollar equivalent of about $2,000, which was nearly enough to buy an apartment.  By the time my wife turned of average marriage age (23), socialism was gone and so was the savings, which then had a dollar value of approximately $3.50.  

In essence what happened here is that the government stole 10% of my wife's grandmother's salary for 10 years.  

One can certainly make arguments about socialist economies, capital controls, etc. that mitigate the devaluation.  Nevertheless, it is an extreme example of what happens in environments where economic and monetary policies are irresponsibly managed with results benefiting debtors and penalizing savers.

Many US paper companies have had a fantastic run-up this year, particularly smaller, highly levered companies.  Cursory review of industry financial statements show weak top-lines, but incredible growth in operating results.  Despite the apparent attractiveness of TTM financials, the paper industry is not experiences a miraculous recovery, rather fundamental improvements have been driven by a stealth industry bailout funded by the increasingly generous US taxpayer.

To illustrate how well the papers have done in this environment, the table below shows recent stock performance of a number of companies in the industry.


Source:  Company filings and DF.

EBITDA growth is shown for the 9-month and 3Q09 periods, both including and excluding the Alternative Fuel Mix subsidy.  The extent of the importance of the subsidy to financial results is apparent.  Growth dwindles dramatically or evaporates completely, as is the case of VRS and KPPC. Multiples, especially those based on operating income due to high debt burdens skyrocket as well.  Viewed another way, the Alternative Fuel credits form a significant percentage of operating income.  As illustrated below, on a 9-month basis, the lowest figure is 43% of operating income; in the cases of KPPC and VRS, operating income was negative without the credits.

Source:  Company filings and DF.

The Alternative Fuel Mixture Tax Credit is set to expire in December of this year.  Unless there is a dramatic turnaround in industry fundamentals, weaker companies with excessive debt burdens will experience rapidly deteriorating financial performance and quarterly comparisons will be incredibly ugly.  Indeed, the financial results that now appear to be miraculous will be revealed as a mirage. 

There are several ways for investors to capitalize on this theme.  Most obviously, is to short the financially weak, such as VRS and KPPC, and buy the stronger, such as low-debt CLW or perhaps even one of the majors to create a domestic relative value structure. 

The addition of Canadian paper companies could make it a more interesting theme.  Canadian companies in the sector have been badly hurt by the subsidy to their US counterparts.  Because the credit funding is based on how much fuel is burned, it encourages US companies to produce product below economic levels and dump it on the market.  This, combined with weakening US Dollar has devastated financial performance of the industry.  With the US subsidy ending, competition should normalize; and as a tit-for-tat, the Canadian government has initiated its own subsidy just as the US subsidy ends.  While not as generous as the US subsidy, it should help the industry.  Additionally, if the US Dollar strengthens, the Canadians would gain substantial advantage. 

There are a range of Canadian companies along the risk curve, including Canfor Pulp Income Fund (CFX-UN.TO), which is currently profitable.  Further, if the company and industry become more profitable, the current monthly dividend of CAD 0.01 could be increased significantly. 

Disclosure:  The author is long CFX-UN.TO and a few other Canadian and US Papers; short KPPC, BZ, and GPK. 

Yesterday, Zerohedge published Golman Sach’s (GS) daily trading record for 3Q09, noting the statistical improbability of not only the firm’s success ratio, but the magnitude of the success.  (Posting here:  http://www.zerohedge.com/article/another-view-goldmans-trading-perfection-and-statistical-improbabilities.)  As ZH notes the firm made over $100M on 116 days in 2009, which equates to 60% of all days in the year.  

When reviewing the article with wide eyed astonishment, it occurred to me that while the record is unbelievable by any Street standard that I am aware of, is it different than Goldman’s recent historical past?  The short answer is that it is different, quite different.

To somewhat reinvent the wheel, the chart below replicates the chart supplied Zerohedge and Goldman in their 10Qs.  The difference is that I add the 9-month figures from 2007-2009 to see how the distribution has changed over time.

Source:  Goldman Sachs and DF.

The chart clearly shows a dramatic improvement between 2007 and 2009 in highly profitable days. It also gives visual clues to a shift from the left to the right, but the magnitude of the shift isn’t particularly clear.  I created a table to more clearly show the magnitude of the shift to the right.  

The table shows each profit/loss category as a percentage of total days in the quarter. I then calculate the average number of days for each segment in 2007-2009 and to generate the percentage change between 2009 performance and the average for the prior two years.  The results are even more stunning than looking at either stand-alone quarters or yearly comparisons.




Source: Goldman Sachs and DF.
The difference demonstrates that 2009 had negative deltas to the prior two year average in 8 out of 10 profit/loss categories, six of which were loss categories. 
The only categories to have positive deltas were the two most profitable buckets, most notably the greater than $100MM days which grew to 68 days or 60% of the total, which represents 72% growth over prior years.  Also notable is that loss days greater than $100M declined 100% to zero from an average of 7% in prior years.  Good risk management there.

One can reach a myriad of conclusions from this data, including but not limited to:

1. The anomaly of all anomalies – Goldman had a lucky streak for the record books.
2. Smart dudes theory – Goldman is simply so much smarter and better than all others in the industry that their cumulative brainpower is a money printing machine.
3. Work hard and prosper – Free market economies are meritocracies.  Work hard every day to manage risk and maximize profits and you will succeed.
4. VaR Shm-aR – Goldman has discovered the holy grail of investing:  increasingly abnormal returns with simultaneous evaporation of tail risk.
5.  Information asymmetry – Relationships with the government can be profitable.  A lack of competition also helps as does liberal TOS with trading clients for just a little looksy into order flow.
6. Borrowing power – Zero to below zero interest rates combined with accommodative definitions of “good collateral” provide tangible benefits to the economy at large (and Goldman in particular).

(This list is by no means exhaustive, feel free to amend with your own conclusions.)

Nassim Taleb frequently points out that wealth aggregation tends to be a winner take all game, but the velocity and magnitude of the shift may even surprise him

 

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