Residential vs Commercial Real Estate

I often maintain that investments in residential real estate is much safer than commercial real estates as long as the leveraging is manageable, and that the yield from the property can cover the mortgage payment.  In a slow or contracting economy, people must still have a place to need so residential real estate’s rents, as long as they are priced attractively, will be able to find a renter.  Of course, that assumes the residential area has sufficient population and that the area is not vastly overbuilt.   However, for commercial real estate, the renter must turn a profit in order to support the rent.  Therefore, the landlord must price the rent low enough for the renter of the commercial space to turn a profit.  But rent is just one of the  cost factors of a business, among many other things such as labor costs, inventory costs, promotion costs, etc.  There is no gurantee that a business can turn a profit even if rent is free.  Thus, the margin of safety for commercial space is much lower.

In the past year, most of the focus on real estate problems has been primarily residential real estate.  However, in 2009, I believe much of the focus will be turned to commercial real estates.  The folllowing blog entry describes the situation very well.

The CRE Bust: Quick Overview

When commercial real estates busts, other than all the big banks, a lot of smaller community banks will be hurt as well, as they are popular lenders for developers.  We shall see how this unfolds in the following year.

Where to tax? E-commerce!

Tax revenues, whether it is federal, states, or cities, are declining, and yet government is going to pump tremendous amount of money into the economy in infrastructure building, job creation, etc. in trying to counter the great financial tsunami.  Of course, the government will need to get the money first before it can pump.

There are mainly two ways to get the money:  Borrowing and taxing.

No doubt the US government will be borrowing a lot of money, and that’s why I am very bearish on the future trend of the US dollar despite the current ramp against other currencies.  I am also particularly bearish on the future borrowing cost for the US, and I am shorting 20+ treasuries to reflect that view.

For the taxing part, president-elect Obama also stated that there would be higher taxes for the people who make for than $250,000 and there would be higher corporate taxes as well.  For states, there will likely be high income taxes as well, and for cities, there would be higher public utility costs.

However, one thing I have not heard yet, and I am quite certain that it will happen is to tax e-commerce.  Currently, for non-Washington State residents, people who bought from Amazon.com do not have to pay sales tax through Amazon.com, and instead they are supposed to report these purchases to the State governments and pay the sales taxes directly.  In another word, this is not happening on a grand scale.

E-commerce has now been around for a decade, and yet taxing is exempt.  I don’t think it can hide under the pretense of ‘fostering an infant industry’ much longer.  Once the new government is in place, and State governments begging for more and more money from the federal government, I am quite certain that you’d hear this coming up.  This is very bearish for the largest consumer e-commerce company, Amazon.com.  Spotting a high P/E even after much decline, I expect its stock to tank further when e-commerce taxing chatter grows louder and louder.

How long does a bear market last

This is a great graph illustrating how long previous bear markets lasted compared with the current one:

United States vs Japan

In the past, when I told my friend that the US’s real estate bubble will someday burst just like Japan did, my friend always told me that the US was different from Japan, and that there would only be corrections, but not decades long recessions that Japan had.  In fact, that has been the views of many many Americans.

So now that US is going through a real estate bubble bursting simultaneously with an equity market bursting, we shall see the similarities and differences between the US and Japan.

Similarities:

• Both countries take their interest rate down to almost zero.
• Both countries try to save their financial institutions from going bankrupt, by either nationalizing the institutions or inject vast sums of money into them.
• Both countries are run by elected politicians who must please their voters.

Differences:

• US companies have substantially reduced employment while Japan maintained stable employment.
• US is highly indebted while Japan had lots of savings when bubble burst.
• US is a domestic consumption economy while Japan had an export oriented economy.

Japan had lost 20 years of growth since its bubble burst and still not recovered.  Given the similarities and differences of their situation and policies, how will United States come out of its bubble?

Under $10 market leaders

It has been amazinig to me how many market leaders in their own sectors are now under $10/share.  A brief list as follow:

• Starbucks ($8.61): Undoubtedly the king of coffee.
• Las Vegas Sands ($6.11): Its owner once the 3rd richest man in the US.
• Citigroup ($9.53): Once the largest bank on earth.
• Corning ($8.91): Still the largest glass manufacturer of LCD panels in the world.
• Macy’s ($7.52): The department store in every mall.

These are only a few, not evening mentioning companies in high tech industry, home building, insurance, etc.  Of course, there are those that are already bankrupted or nationalized such as Lehman brothers, AIG, Fannie Mae, Freddie Mac, etc.

Stocks as long term call options

These days, a lot of stocks have fallen more than 70-80% and their share prices have breached below $5 or even much lower.  With this kind of price, it’s much better to treat them as call options as long term investments.  However, there are subtle differences on why some of these stocks fell to this price range.

1) Heavy debt wrecking havoc

Las Vegas Sands, once the crown jewel of all casino stocks, is the typical example of this.  Traded as high as $120/share, touched below $5/share on Oct 28 and Oct 29.  This is an incredible story, since as we all know, the house always win, but apparently not in the case when the house is built on debt and bad times hit it hard.  Given time and lower debt structure, there is no doubt that LVS would regain its glory, but now the whole franchise is in question.   However, if you believe that the company can cross this chasm, this is a great call option, already illustrated by a subsequent short squeeze which took it to over $15/share  after it traded below $5, although now it had backed down to close at 7.03 on Nov 7th.

2) Deteriorating or simply lack of fundamentals compounded with debt structure

Once the largest EDA companies, Cadence Design Systems, falls into this category.  Traded as high as $24/share in 2007, its share price is now $4.  Cadence has almost all the problems a company can have: questionable accounting, bloated structure, declining market share, just to name a few.  Normally balance sheet analysis does not come into question, but in this credit environment, it comes under great scrutiny.  While the company has sufficient cash, $250 million convertible note is due in 2011, and another $250 million convertible note is due in 2013.  The combination of declining revenue, questionable accouting, and having <5 yrs convertible notes on the book, will likely keep the share prices in the single digits for some time even if credit market improves.

3) Disappearing earnings and cash flow

Trident Microsystems, with ~$200 million liqudation value but only $96 million in market capitalization, falls into this category.  The main problem with companies like Trident is the disappearance of its revenue, along with earnings and cash flow.  Nonetheless, the balance sheet is intact, and it can still survive quite a long time even under this credit environment.  If one has faith in the company’s direction and its future, I believe this kind of company is suitable enough as long term call options.

However, remember, while these < $5 stocks can have great potential, the nature of call options is that you can lose all your money on it.

How Bill Miller lost his way

Bill Miller of Legg Mason was regularly touted as an investment genius because of his beating of S&P 15 years in a row.  His biggest story was his investment in Amazon.com.  However, if you read the story right, he basically bought Amazon.com at its high, and kept doubling down when the share prices crashed.  When Amazon.com rose back from its low, this behavior earned him great profits.  This kind of story can only happen to mutual fund managers, as they keep getting continuous flow of new money from 401K to keep doubling down.  For any normal investor or hedge fund manager, it would have been a road to disastrous results if they bought at the very high.

Nonetheless, the latest news for Bill Miller that raised great questions about his genius was his continual investments in Countrywide, Fannie Mae, Freddie Mac, AIG, and the like, in the last two years.  A quick google on ‘bailout’, and you can tell how those investments had worked out for him.

However, while it’s difficult for most people to imagaine that those wonderful financial companies would have ended up with value of almost nothing, what prompted me to really notice Bill Miller was Yahoo.  When Microsoft made a bid for Yahoo, and Carl Icahn moved in to try to shake up the board to make ways for the Microsoft/Yahoo deal, it was Bill Miller, a large shareholder of Yahoo, sided with management and blew the deal off.  I don’t know what kind of return he was expecting, but to most investors, a $31/share bid over previous closing of $19/share was pretty good when the financial market was starting to crumble at the time.   I just did not see how his action helped shareholders, or for his fund.  Fast forward 9 months, now it seems like Yahoo is once again throwing Microsoft’s name in public as its share price dropped to ~$13/share, while its deal with Google is off.  I don’t know how Bill Miller feels about this, but to me, what he did to Yahoo’s shareholders sums up how I think of Bill Miller as an investment professional.

World hoping China’s ramping up internal consumption to offset global consumer contraction

Almost every one is hoping that China’s citizens will ramp up their consumptions to at least offset part of the global consumer contraction.  However, most westerns highly under-estimate the ability of Chinese to live frugally and to hoard cash.  In fact, almost all people in emerging markets do much better than Americans or Europeans to adapt to a more frugal environment.

While China’s government will certainly try to relax credit and increase spending to stimulate the Chinese economy, but if Chinese perceive that hard time is coming, which many already do, it will take a lot more efforts than most people think to pry cash from their hands to spend on unnecessary items.

In the recent few days, global stock markets have rebounced quite a bit from its low, but the Shanghai Composite has not participated much in it.  This should be very troubling to those hopeful souls who are counting on China to save the world economy.

Greed has no ends

Ken Fisher, a so-called guru in money management, is really a piece of work.  Not only did he tell people to keep buying stocks even after the market starting to crack last year, his latest column in Forbes urges 60-65 yrs old folks to keep putting money in the stock market because they could have another ‘25-35 years to go’.

While the market may rebound and produce great return, I don’t suppose he would pay for his clients’ medical bills if they need the money during a market downturn.

You can also read another article he wrote in April 08 how he took Goldman Sachs demoting Abbie Cohen for being bullish too long as a contrarian indicator, and determine yourself whether he is a joke or not.

Revisiting EDA companies

It’s been a long long time since I last updated this blog.  While there are so many things going on in the global market these days, I think it’d be useful to revisit what happened in EDA and talk about each individual company in the sector and what I have done or plan on doing with each.

Cadence

The biggest event that happened in EDA following the last entries no doubt was Cadence’s disastrous quarterly earnings.  The following question asked by Terence Walen of Citigroup illustrated how disgusted and distrustful investors are on the management:

And then lastly, Mike, I know some investors will be asking tomorrow, what the management plan going forward is post acquisition. Can you give us several reasons why you’re the right person to continue to lead Cadence into the acquisition and after?

The fact that it was not answered and the analyst had to ask again on the question illustrated how disoriented Cadence’s management was and how evasive they were on Cadence’s problems.

After the earnings call, investors confidence on the current management were basically shattered, and its stock dropped ~30% from ~10 to ~7.  I sold the Cadence I bought at 10 with a loss, and when I told a friend on that, my friend was quite surpised, as she thought the price was already very low.  I told her I would revisit the stock when it’s ~5.  With the market crashing around the world, Cadence closed at 5.3 on October 14, 2008.

Then on Oct 15, CDNS announced that its CEO, along with his ‘team’, was resigning.  While this was quite good news, as it indicated changes would finally be coming to Cadence, S&P crashed 10% that day, and took CDNS along with it to close at 4.50.

Cadence dropped another bomb on Oct. 23 that it would have to restate its earnings.  This took the stock down to 2.6 that date and closed at 3.22.

The stock is obviously quite low now, with Cadence’s market cap at ~700M.  With many products and being a major EDA company, this may seem like a good deal, but this is actually quite deceiving.  In fact, if it goes back up ~4, I will just sell the remaining amount that I have.  I will say more about this in the next blog entry.

Synopsys

Synopsys, being the strongest EDA company thus far, had escaped any share price deterioration even after Cadence dropped their earnings so much on July 23.  However, as we could see from Mentor, Magma, and Cadence, the slowdown in EDA spending is an industry wide problem.  With that in mind, I shorted SNPS ~24/share, and with the stock market weakened, I covered the stock ~20/share.  However, I obviously covered too early as the stock is ~16 now.  While this may seem low, I am not sure if the stock has priced in disappointment in earnings and guidance yet as this financial crisis is of a much larger magnitude than most people think.  If the stock rises again close to 18, I will consider shorting it again.  But of course, that depends on the market condition and price momentum at that time.

Mentor Graphics

After Cadence withdrew its bid of Mentor, Mentor’s stock dropped from 14 to 10, although it then rose ~20% afterwards in about 2 weeks  This illustrates how market is not efficient, as who would really have believed that Cadence could acquird Mentor, and thus how could the potential acquisition price be maintained after Cadence reported its horrible earnings report.   After Mentor rose to ~12, it’s all downhill from there as the financial crisis unveiled.  It closes at 6.95 Oct. 24.  If there’s a bounce in the market, I will try to short Mentor above 9 depending on the market condition and price momentum at that time.

Magma Design Systems

Magma lowered guidance again on Aug.  7th, and the stock dropped from 6.7 to 5.45.  This is the second time it lowered its guidance this year, and the last time it did that took the stock down from 9.57 to 7 on May 2nd.  With its much lowered stock price and reduced market cap, I picked up the stock at 5.5.  However, after it rose above 6 for a short while, it’s been all the way down.  Now it’s at 1.98 on Oct 24.  The market cap is now below 100M.  With the market cap so low, it could be a takeover target.  However, unless someone treats this as a call option, it’d be difficult to consider its stock as an investment.  It actually shares the same problem as Cadence, as a lot of companies face right now under this ‘credit tsunami’, which I will talk about in the next blog entry.

PDF Solutions

Of all the EDA companies, PDF solutions seems to be holding up pretty well, as it has a good balance sheet as I pointed out in my previous EDA blog entries.  I bought the stock around 6 and averaged down the cost to about 5 over time.  When the general market tanked, PDFS was still holding very well, around 6 most of the time.  With the financial crisis growing, and the stock still performing quite well, I however pulled the plug on Sep. 15 at 5.8 and exited the stock.  It then traded up to as high as 6.7 the following week, but then gradually declined back to the range of 4.5 – 5.5 when the general market declined significantly.  It closed at 4.12 on Oct 24.

While PDFS does not have a balance sheet problem, it’s very illiquid and oftern trades only in hundreds of share on each transaction, and its average volume is only ~40K shares in the past month.  Also, when a sell order of >1000 shares hit the block, it can often takes the stock down dramatically for that trade.

Right now cash constitutes about half of the market cap of PDFS.  However, with the severity of the financial crisis, I expect the stock to trade around its cash level sometime in the future.  If it goes above 5 and is available for shorting, I will consider it.