Fed cuts 25 bps, as expected

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent. Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters. Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully. The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

What does this mean for our fund? I think it means that we can continue to work at deploying capital on a consistent basis. The Fed has been successful in creating some sort of “soft-landing” for the housing collapse (i.e. avoiding another Great Depression).

I believe we will see further market turbulence as the final sub-prime write-downs finally come out the tailpipe, but that the worst is over. It may take awhile for the markets to get steady on their feet, but at least they don’t appear KO’d for the count. I think we continue along, prepared to deploy capital at a consistent basis, while taking advantage of market pullbacks.

Further Reading (Bill Gross’ Investment Outlook May 2008):

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+May+2008.htm

Current Asset Allocation

ASSET ALLOCATION	Target	Actual
Growth/Hedge	20.0%	9.4%
Value	75.0%	15.6%
Cash	5.0%	65.0%
M&A Arbitrage Strategy
BCE	10.0%	6.8%
Sub-total	10.0%	6.8%
Long/Short Hedge Strategy
Long Natural Gas Fund ETF	2.0%	0.0%
Short Oil Fund ETF	2.0%	0.5%
Sub-total	4.0%	0.5%
Small Cap Value Strategy
Canadian Hydro Developers	2.0%	1.4%
Other	2.0%	0.0%
Sub-total	4.0%	1.4%
Small Cap Mining/Spec Strategy
Bronco Energy	2.0%	0.7%
Sub-total	2.0%	0.7%
Large Cap Canadian Value
Other	5.0%	0.0%
Astral Media	5.0%	2.7%
PetroBank Energy	2.0%	3.6%
Sub-total	12.0%	6.3%
Large Cap US Value
Nokia (ADR)	5.0%	2.0%
Phillips Van Heusen	5.0%	3.2%
Other	5.0%	0.0%
Dollar Financial	7.0%	4.2%
Sub-total	22.0%	9.3%

Housing Crisis

From today’s FT:

“Flow of funds data put the value of household real estate at the end of 2007 at $20,155bn. Roughly calculated, the Case-Shiller index’s 5 per cent drop since then equates to $1,000bn wiped out in the space of two months – almost 10 times the size of the federal tax rebate. Much of that will be saved rather than spent.”

I’d like to have some conviction on what this information means for global equity markets over the next year. It seems obvious that there will be a steep decline in consumer spending… but the question is will this recessionary impact be offset by recent history-making monetary and fiscal stimulus.

Lex article from FT on the housing crisis:

http://www.ft.com/cms/s/2/38130794-15f2-11dd-880a-0000779fd2ac.html

Phillips Van Heusen on the move

Today we took an initial position in PVH at $39.30 with the aim of investing more should the stock lower in the near term. The company owns Calvin Klein, IZOD, Arrow Van Heusen and Bass and licensed in 18 other brands including Timberland, Kenneth Cole.

I had been interested in investing in Ralph Lauren for sometime because I considered them to be the best overall clothing brand worldwide and the stock valuation had been regressing. An investor/friend I respect suggested that if I liked Ralph Lauren then I should take a look at Phillips Van Heusen as it had similar business fundamentals and was available for much cheaper.

Turns out PVH is similar to Ralph Lauren in that the company makes money through licensing its globally well-known brand. The Calvin Klein brand is number 2 in the US behind Polo and is the number 1 in China. Keeping the brand legitimate, Creative Director Francisco Costa has earned respect among the world’s high-fashion circles after taking over directly from Mr. Klein in 2003 (prior to CK Costa worked at Gucci and Tom Ford).

The Calvin Klein brand is also well-positioned among the price-point spectrum: they have a high-end luxury segment (which loses money, but keeps prestige); a mid-tier segment that markets to younger hipper crowd (this drives the business Asia and Europe) ; and the last tier is the CK ‘white’ label that specializes in t-shirts, underwear, socks, etc. (the basics).

PVH’s licensing model currently accounts for a small portion of sales (12%), but a large portion of operating profit (52%). PVH receives a royalty of ~10% on net sales from licensees while controlling the creative on design and advertising. Management’s aim is to grow the licensing business by 9%/year. PVH is also the biggest private label player in US department stores for both dress shirts and neck-ties.

Today, CEO Emanuel Chirico claimed the Calvin Klein unit of apparel manufacturer Phillips-Van Heusen Corp could grow to $7 billion in global retail sales by 2010. In 2007, PVH posted total revenue of $2.43 billion.

Valuation

I calculate margin of safety to be around 35%. The company is now trading at 12x trailing earnings compared to 18X for the industry and its own long-term average of 19x. Management believes it will achieve 9% organic growth. I think the recent stock price drop was due to the market underestimating the expected international CK trends. PVH is trading at good value (not as cheap as it was two weeks ago) and offers exposure to China/India consumer growth.

BCE M&A Arbitrage

We added to this position today. We think the biggest risk to the deal remains that the U.S. and European banks involved will try to pull out the financing as they have done in the Clear Channel deal. However none of the banks involved have hinted at backing out and OTTP and TD Bank have been consistent in their claims that they believe the deal will go through. We think that American M&A arbitrageurs are the ones keeping the spread wide as American investors were the most spooked by the recent credit crunch. Since the crunch began last summer there has been a tendency to lump all leverage-affected deals together. Remember, BCE is a much different company than Clear Channel in regards to cash flow generation and capex requirements. We view BCE’s balance sheet as strong, with more than C$2 billion in debt reduction and minimal funding requirements. Even with a spike in capital spending at Bell Canada operations to support wireless and wireline broadband access, BCE has had sufficient cash to support its dividend. Pre-takeover, BCE planned to pay out 70% to 75% of its earnings in the form of dividends, including spending on building out its broadband network. This strong financial position, along with private equity’s proposed productivity improvements, should provide enough support for the financing close.

Risks:
1) Approval by the CRTC is dependent on greater Canadian content on the BCE board post-LBO, although Industry Minister Jim Prentice has already given conditional approval to the deal. We don’t think this is significant enough to sink the deal.

2) The bondholders’ appeal starts today in the Appeals Court. Again, the Quebec Superior Court already threw out the bondholders’ case against the deal in March and most people believe Appeals will do the same. There is still a chance they can take there case to the Supreme Court if they lose.

RETURN POTENTIAL: 13.2% over two months, 78% annualized
HEDGE: Long the equity, long Bell 7.65% Dec. 2031

Related Reading:

network.nationalpost.com/np/blogs/tradingdesk/archive/2008/04/24/long-equity-and-long-credit-trade-recommended-for-bce.aspx

FX burn

I made a mistake trading FXP today. Bought it at $64.80 and sold it at $64.30 on a stop loss order.

First mistake: placing a stop loss. The stop loss at $64.30 was a mistake because it was too close to my purchase price. In retrospect, I would have been happier holding the stock lower.

Second mistake: not monitoring the f/x spread. The broker tried to take $0.03 on the transaction. The buy was done at a rate of $1.001 and the sell, 13 minutes later, was done at $1.031. As you can see from the daily USD/CAD chart below, the broker added a shocking bid-ask spread to the transaction.

For a share bought at $64.80 and sold at $64.38 the transaction loss should be ($0.42)/share

However, add the f/x translation from USD to CAD and the math on the transaction becomes:

Buy 64.80/1.001 = $64.7352
Sell 64.38/1.031 = $62.4442
Loss/share = ($2.29)

In the end I was able to negotiate with the broker to cover the f/x loss (I get the feeling they get a few of these compliants). He settled the trade out of the USD money market account rather than the CAD account and the f/x loss was negated.

LESSONS LEARNED: Give a stop loss trade room to breathe and never trust a broker when it comes to f/x spreads. The biggest error here was my judgment on the trade itself, but I also felt like this guy.

Missing the Boat

Phillips Van Heusen – 5 day chart

Issue: Tried to buy at $35, tried to buy at $36, tried to buy at $37, tried to buy at $38 and missed it all the way up by being too fancy with market limits.

Lesson: Trade with conviction.

Company website:

www.pvh.com/

The Outlay

The Current Market Environment

Overall company valuations appear to be relatively cheap, but I still believe market levels will contract before a sustainable rise. According to Goldman Sachs, we are still 15% above historical trough recessionary P/E levels. Furthermore, variable rate mortgage resets in the US only peaked in March so I think we are in for at least one more quarter of bank earnings surprises, write-downs and increased volatility.

In terms of timing, the S&P 500 is up over 7% for the past month and I think it will have to give some of those gains back in the near term. We should begin by investing between 60-70% of capital at these levels so we can take advantage of any market regressions.

I’ve added some plays that I think are timely:

10% in BCE (BCE). The only risk left in the deal is financing and TD and Teachers are both expressing confidence that it will go through. We are looking at ~15% arbitrage upside at these levels. Even if the deal doesn’t go through, we are protected by a P/E of 7x and cash yield of 4%

7% in Dollar Financial (DLLR). This company owns Money Mart in Canada and has growing operations in the US and UK . It is trading at 9.7X 2008 earnings, its the low-cost industry provider, has high-margin fee-based business, competition is waning due to increased gov’t regulation, and they only have 5% of UK market but investing to grow there. Conservative estimates indicate 32% operating growth overall.

1% in Ultrashort 200% Oil & Gas ETF (DUG). We can buy this ETF to short oil without taking on leverage. I think we can make the bet based on $112/barrel being unsustainable — it is up 80% over the past year with consensus estimates pricing it somewhere between $75-$85.

5% in Nokia (NOK). Stock is down on a profit-warning by #4 player Ericsson. However, Nokia is #1 player in global handset market with a strong focus on emerging market growth — i.e. Eastern Europe, Africa, Developing Asia — and a renewed focus on the U.S. Risks to the business include Blackberry competition, but Nokia is a proven technology leader and trades at 11.4x earnings compared to 53x earnings for RIM.

THE OUTLAY

It’s finally time to start investing.

The Current Market Environment

Overall company valuations appear to be relatively cheap, but I still believe market levels will contract before a sustainable rise. According to Goldman Sachs, we are still 15% above historical trough recessionary P/E levels. Furthermore, variable rate mortgage resets in the US only peaked in March so I think we are in for at least one more quarter of bank earnings surprises, write-downs and increased volatility.

In terms of timing, the S&P 500 is up over 7% for the past month and I think it will have to give some of those gains back in the near term. We should begin by investing between 60-70% of capital at these levels so we can take advantage of any market regressions.

Some of the stocks I had outlined in the target portfolio in early March should be removed from our initial outlay. These include:

• 7% in HR Block (stock up 22% since March 11)
• 5% in Sigma-Aldrich (stock up 17% since March 11)
• 5% in Sanofis-Aventis (pharmaceutical company finding too complicated, although recently bought by Buffett and Burgundy )
• 3% in Healthscreen Solutions (too illiquid)

On the other hand, I’ve added some plays that I think are timely:

10% in BCE (BCE). The only risk left in the deal is financing and TD and Teachers are both expressing confidence that it will go through. We are looking at ~15% arbitrage upside at these levels. Even if the deal doesn’t go through, we are protected by a P/E of 7x and cash yield of 4%

7% in Dollar Financial (DLLR). This company owns Money Mart in Canada and has growing operations in the US and UK . It is trading at 9.7X 2008 earnings, its the low-cost industry provider, has high-margin fee-based business, competition is waning due to increased gov’t regulation, and they only have 5% of UK market but investing to grow there. Conservative estimates indicate 32% operating growth overall.

1% in Ultrashort 200% Oil & Gas ETF (DUG). We can buy this ETF to short oil without taking on leverage. I think we can make the bet based on $112/barrel being unsustainable — it is up 80% over the past year with consensus estimates pricing it somewhere between $75-$85.

5% in Nokia (NOK). Stock is down on a profit-warning by #4 player Ericsson. However, Nokia is #1 player in global handset market with a strong focus on emerging market growth — i.e. Eastern Europe, Africa, Developing Asia — and a renewed focus on the U.S. Risks to the business include Blackberry competition, but Nokia is a proven technology leader and trades at 11.4x earnings compared to 53x earnings for RIM.