One thing about China that people do not talk about

It seems that any respectable publication cannot put out an issue without mentioning China in some way or form. Most of the references relate to Chinese influence on manufacturing industries in developed world. Every industry is worrying about Chinese influence and figuring out how to beat the "Chinese Price." But have a lot of people gave thought to what is behind the "Chinese price?"

The simple answer is the cheap cost of labor, however another very important factor is unbelievably cheap access to capital for Chinese companies. In its October 27th issue Economist ran a wonderful piece on Chinese Banking System (See article here) which mentioned the fact that China has to spend $5 of capital to create $1 of output. Same article states that independent estimate of bad loans in Chinese Banking system are around 20-25%. The latest statistic represents that a significant portion of manufacturing in China is only supported by inefficient loans and not market economics. How much of countries influence is sustainable in the long term?

We have had examples in the past of countries achieving world prominence through short term of destruction of capital. Most recent example is obviously Japan which dominated conversation in the 80's the same way China does now. As an end result of the boom, the country was left with banking system flushed with non-performing loans that took 15 years to clean up, deflation, and a long term recession at the time when the rest of the world was surging ahead.
The other example is USSR up until the 1950's. A lot of people forget that Stalin, through huge infusions of capital and use of cheap labor force put USSR on pace to overtake United States as the world's dominant economy. The five year plans made the nation seem unstoppable until the country ran out of capital and growth turned into long term stagnation.

Its tought to say when China would have to face the consequences of misuse of capital, but as history shows everyone has to.

Is Google really going to take over the world?

Over the last 10 years Google (GOOG) accomplished things that seem unreal. They became a household name, spawned a verb "googled" and in general look to be on track to take over the world. After an IPO at 80, the stock defied all limits and recently closed over $400 per share representing a 125 billion market cap. A lot of people thought it was expensive at its IPO but if you take into account a $6 last year EPS at its opening the stock was trading at less than 13x P/E. While the stock is trading now at $420 and a stratospheric multiple given their potential for growth it could all be justified. I am not writing to figure out whether the stock is worth $400, I do want to point to a couple of facts that I have seen in the recent press that point to a possible change in the principles that guide the company.

We know of a few CEOs like Tyco's Dennis Kozlowski that have been leading flashy lifestyles that lead to the public scandals. Sergey Brin and Larry Page started the company and stuck to simple principles. Their website has always been simple and being super billionaires never were the ones to flash their money. However on November 4th a story in WSJ pointed out the fact that Google owner's decided to buy a Boeing 767-200 to use as a private jet. I am not the one to tell them how to spend their money or question their integrity, but this may point to the fact that they may start enjoying their money a little more going forward.
Than on November 23rd in the same publication a story ran talked about Google hiring practices and tendency to engage into price wars over talent.
Can Google continue to keep its edge? Do they still have the attitude to maximize shareholder's value? Can they continue to grow at an impressive pace? May be this events is beginning of the maturity stage for Google. To justify their current stock price the company will need to earn $25 per share within next few years. Google continues to find new ways to utilize their technology, most recently in digitizing book libraries. However I think their costs will grow faster than most analysts anticipate. For a stock to be a good short candidate, it needs to have a catalyst. May be these recent events point to an existence of one.

Investment Philosophy

In the first post, i touched on some principles by which i chose my investments. I figured it would make sense to formally outline some of the things i look for. Here it goes:

In the search for potential investments I look for companies with intrinsic value significantly higher than their current price. While intrinsic value is often in the eyes of the beholder, I try to look for companies where I can justify higher value with rather conservative operational assumptions. Companies that are going through tough period that depresses earnings and sales are usually perfect candidates if the issues bugging the stock can be comfortably described as temporary. I try not to assume any significant growth in revenues as part of calculating intrinsic value. Growth is often far from certain and the weight given to it in valuation is one of the main reasons value stocks have historically outperformed their growth counterparts. However if significant growth in revenues does occur in the underlying company, it represents a nice “icing on the cake” for the investment.

Some of the companies that I have invested in on the basis described above are: Lazare Kaplan International (AMEX: LKI), Corinthian Colleges (NasdaqNM: COCO), and Bradley Pharmaceuticals (NYSE: BDY).
Lazare Kaplan is an example of stock where downside is sufficiently protected by its assets. Its net working capital, if you include the usual mark-up on the inventory (a safe assumption given their commodity product), is about equal to its market value. Given that company’s margins have been squeezed due to increasing diamond rough prices, any improvement in their ability to pass on those prices to the customer would reflect very favorably in the price of a stock.
Corinthian, for profit educational company, has been hit by various bad news over the last couple of years. They have been under SEC investigation for bad debt accounting, sued by students for inability to transfer credits, and tried to expand to quickly which resulted in depressed margins. As all of the legal issues to date have been defeated and company stopped expanding and started concentrating on improving operations its stock should see significant upside in the next couple of years.
Bradley Pharmaceuticals is a company under investigation by the SEC for its revenue recognition practices. I performed the sensitivity analysis and realized at the time of investment (May 2005) that the market price assumes that quarter of firm’s revenues is doubtful. Based on the news it looked like that no more than 5-10% of firm’s revenues may be in question. Being comfortable that the discrepancy between two figures provides a significant margin of safety, I invested into the company and has been able to realize a 50% gain before a recent sale.

When possible, I also try to look at the companies that would be indirectly impacted by the events that are likely to happen. An example of such company is Maverick Tube Corp (NYSE: MVK). My investment in this company assumes that U.S. would have to start building refineries in a near future. Many articles mention lack of refining capacity as one of the drivers behind high oil prices. Maverick supplies pipers to the oil industry and is likely to benefit from increase in refining capacity. As it trades at less than 7x its last year’s earnings, I thought this would be a cheap way to capitalize on the likely upcoming events.

Why am i doing this?

I decided to open this blog to share my views of the markets through a broader audience. Efficient market theory states that company's market price includes all publicly available information. However, market's often take a short term view of the company's prospects which results in significant fluctuations in market prices. Even the biggest companies with stable operations can see swings of over 50% within six month periods. Just look at the chart of Disney (NYSE: DIS) over the last two years. The price fluctuated significantly between $20 and $30 dollars. Do we truly believe that Disney's long term ability to exploit Mickey and his friends change by 50% within last two years? I cannot take credit for this view. It has been popularized by many Value Investors starting from Ben Graham. As a student of Value Investing i can only subscribe to the the view, share it with you, and profit from it.

At work and in school i have an opportunity to talk about specific securities in very narrow markets. I want use this blog to express my views on broader issues. I have to warn that most of my ideas are long term and would take two to three years to play out. Experimenting with options in an attempt to predict a short term move in the stock price has been a complete disaster for me. I know that i cannot add any value through this kind of analysis which at the end amounts to another form of gambling.

I will post specific ideas, macro thoughts, and general observations. I invest a small amount of money into each one of my ideas. Why would i recommend something to you that i would not buy myself?

All questions and comments are welcome and I will try to follow up within a short period of time.