Quarterly review and preview

When the first calendar quarter of 2011 draws to the end, it is time to take a look at what has been on play and what will be on play. Hot terms like inflation, housing prices, recovery, jobs, and geopolitics are inevitably the essentials for upcoming quarters in 2011.

So far, the US economy has recovered strongly from the 2008 crisis with GDP at 3.2%. Concrete recoveries from jobs report and corporation earnings boosted investing community confidence. We see merge and acquisition activities come back to a before-crisis level and keep counting. Mega deals such as AT&T/T-Mobile are the latest but certainly not the last. Another sign is companies are paying more dividends and buying back stocks. The most recent example is banks' announcement. Cheap debts are a factor that fuels these activities, thanks to QE2, besides overall economical recovery.

That is the part we can optimistic about 2011. But the story is yet concluding.

Because of job recovery, consumer spending is up, according to JP Morgan. Not as the same as before, savings are also up. What do people do with savings? One big ticket is housing, which has not kept lockstep as broad economy recovery. From continue sliding housing activities, the worst is yet to come. There are reasons to be conservative about savings.

First of all, the requirements for a down payment and the lending guidelines are much tighter today. So mortgage is still a terrible story. Banks resume foreclosure process after a halt in the end of 2010. So more properties are coming to market for a few months. House stabilization doesn't necessarily mean turn around. It is very likely prices will stay or skid further to some extent.

Secondly, inflation, leading by energy and caused by unstable geopolitics, is interfering into economy recovery. Because of that, food prices are immediate victim. Not only the US but seen internationally. However inflation could be an equalizer for diversified US economy. Agricultural states are riding rising prices very well. Exports are strong and eliminated national deficit.

So we are near to a preview of the rest of 2011: there will not be a lot of bad news through May and June. After that, as QE2 phases out, then some real challenges coming as monetary support shrinks. Investors who are looking for a strong second half may need to be well aware of uncertainties and cautious. And inflation will be in full throttle during summer season. It will be the right time to sit at sideline for a while. But energy is still the hot spot.

RIMM needs to have an upper hand

Research in Motion reported a dim future profit projection in coming quarters. Stock price plummeted 11% on the day. On surface, earning isn't that bad. Profit up 37% in the past quarter. The widely expected Playbook is a lethal weapon that could be a turning point of the game. That is the only buying point for RIMM.

If there is only one hope, that is going to be problematic.

RIMM lost its upper hand since other smart phone vendors started filling their product lines, especially Apple's iPhone. Since then RIMM slowly lost market shares. Even worse, unaware of (or not soon enough) threaten from tablets, RIMM now is in an awkward position: smart phone market is under fierce competition so even a recent announcement of developing country marketing didn't generate any fanfare. Developing countries mean low profit margin and lower prices. Investors don't buy it. Outspoken analysts said they don't believe RIMM's management had a viable plan at all.

On the tablet side, RIMM is already behind Apple and others. Playbook seems a fire fighter to rescue but not well prepared. Features are not as rich as iPad such as wireless functions. Due to development and marketing cycle, there may be a few more quarters to mature the product. Can it wait that long?

RIMM needs something to turn around to regain upper hand. One problem for iPhone and iPad is security. RIMM still has large market because of their security. However, if they don't open application base, they are going to repeat smart phone's loss again over Playbook. Another way to regain upper hand, which is a harder and more desperate, is mimic Nokia's path to ally with Microsoft. Microsoft didn't plan to have any tablet from Steve Ballmore. But if price is correct, it would be possible.

Short term speaking, RIMM is in trouble and it is ordeal to the management.

The reasons of trading Wells Fargo

Twenty years ago, Buffet purchased $290M for 10% Wells' common stock. His reasons were 1) strong management on huge assets, $56B back then 2) good performance, 20% return on equity and 1.25% on assets 3)low risk of having troubled real estate loan losses.

He did increase Wells position along the path, even after 2008 crisis even all three reasons have altered to paths. See the latest BKA's position. Buffet's wisdom is invaluable asset for many. But he also said, "What's required is thinking rather than polling". So what can we think of Wells now?

Wells assets rose to a few hundred billions after acquisitions and acquisition and growth. The current CEO was planning to retire but delay after Wachovia's acquisition. The integration of Wachovia is a daunting task in addition to mortgage loan problem. The bank is just getting too big. John Stumpf indicated that Wells will sell its brokerage division if price is right. This division was a big profit contributor in 2008/2009. Shrugging off this then cash cow could smell something is going on.

Another recently Wells development was the sudden departure of CFO. That was not a planned retirement. Wild imaginations were rampant especially that was at the time a new mortgage disclosure procedure started. That is not a good sign at all. Wells' position on loan has not been changed after 20 years. It is still the most important business for Wells. Given current California trouble, loan losses, in our opinion, will not be a low probability event, like 20 years ago. At least the process is prolonged to a point that performance is as stellar as before. That is the next point.

Wells' return on equity is 10.5% and 1.01% on assets. Of course, their size has been more than double. The good sign is great operation margin at 30% plus. But can we see a slowing down? Even with a special dividend of $7c, it is still a long way to back to normal dividend. Since it just revised dividend a week ago, it won't be soon to do that again.

Anyway, we don't think Wells is as attractive as before, given current price about $32. But Buffet is right when price is right and we will follow: we welcomed the decline because it allowed us to pick up many more share at the new, panic prices.

The new, panic prices are not present.

The Yale Model and University Endowments

Everything has its limits, no matter how well you had planned it. We will look at one of the most successful university endowment model to get some insights.

The Yale model, named after David Swensen at Yale university, invested a wide range of "alternative assets", like private equity fund and hedge fund to diversify asset allocation besides conventional equity and fixed income assets. In addition to these, real estate investment is also an important component in the portfolio, which is relatively less liquid. For universities, this is usually fine because universities do not need high liquidated asset for short term. More importantly, alternative assets reduce volatility from equity markets. So this is by and large a diversified strategy.

This model was widely successful in the years since its inception until the 2008 crisis hit. Yale University endowment, for years under Swensen's leadership, provided double digit return. The model has been duplicated too. For example, the University of California endowment, follows the same pattern: as from the record on December 21, 2009, UC Regents has total securities $5.7B. Assets were allocated in equity ($2.6B), fixed income ($1.1B), and alternative assets ($2.0B) (data is from State Street). In particular, alternative assets include private equity and real estate.

The model hit a wall in 2008. Nationally, the value of college endowments declined by 23 percent in the fiscal year, which ended in June 2009. The Yale endowment lost 25% and Harvard lost $10B or 30%. Among the Golden State's major players, Stanford University saw a 26.7% drop in endowment value in 2009, to $12.6 billion. The UC Regents' endowment assets took a 20.6% dive, to $4.9 billion, and the University of Southern California plunged 25.6%, to $2.7 billion. Given universal equity loss in 2008/2009, illiquid alternative asset did not provide much diversification but worked against overall performance. In other words, when liquidity was much needed, the portfolio did not come to rescue.

That brings up a question: what else could have or can be done? The Yale model is the most diversified allocation that scatters around all available financial tools. Should endowments be more concentrated in equity and fixed income to have high liquidity? Recall that the equity market was hammered by about 30% in 2008/2009, it is interesting to see that the Yale model didn't provide much diversification compared to a simple S&P 500 index fund when such large scale crisis came. In other more plain words, no matter what have been done, the disaster could not be avoided, as long as you were in the market.

This is why "black swan" always has its supporters.

When to Buy Japan

The title here is a bit flashy, for most. The disaster is just unfolding, what do you mean to buy? Yes, we think Japan is a great buy. It is not a question of "whether to buy" but "when to buy". A financial come-back after years of sluggish performance but a sudden hit by a terrible earth quake would not destroy its up rising trajectory. Also, the government shows strong financial controllability dealing with speculation. Once technical issues (such as nuke leak) are resolved, it would be a perfect rebound: strong credit injection, rebuild, inventory restock, etc. So it is a great buy and the question is only "when"?

A excerpt from Fisher's Classical "Common Stock and Uncommon Profits" can not be more convincing. He illustrated a question of "when to buy":

From the standpoint of the investor there are two aspects of all this that have particular significance. One of these is the impossibility of depending on any sure time table in the development cycle of a new product. The other is that even for the most brilliantly-managed enterprises, a percentage of failures is part of the cost of doing business.

Both of these situations would drive stock price to a sensational buy. So he continues:

Once the extra sales effort has produced enough volume to make the first production scale plant pay, normal sales effort is frequently enough to continue the upward movement of the sales curve for many years. Since the same techniques are used, the placing in operation of a second, third, fourth, and fifth plant can nearly always be done without delays and special expenses that occurred during the prolonged shake-down period of the first plant. By the time plant Number Five is running at capacity, the company has grown so big and prosperous that the whole cycle can be repeated on another brand new product without the same drain on earnings percentage-wise or the same downward effect on the price of the company's shares. The investor has acquired at the right time an investment which can grow for him for many years.

In other words, the best buy time is when the two situations struck and stocks become insanely cheap. Stock prices' return is just a matter of time. We think the best buy time is just right in front of us.