Fraud in Focus

1. Sick of binary

I’ve always found it irritating how much those in finance love to label situations binary.

Example: ‘the Eurozone crisis is a binary situation, either the whole thing blows up, or markets will rocket’.

Er, how about it just muddles through and the world doesn’t end. Really that unlikely? (I ranted about this previously with ‘Chill Out on the Zone’.)

There are, however, some situations that are binary, and there is easy money to be made.

2. A willing buyer for a Chinese scam

Here is the company in question: Focus Media

It sells advertising space in China.

Recently Carlyle, a private equity group, put in a bid to buy the company at $27. While the bid could be raised (unlikely for reasons given below) the best case scenario for the stock is that the deal goes through and shareholders get $27.

It would be the biggest private equity deal ever done in the Middle Kingdom, and the deal junkies of Carlyle would surely love this tombstone next to the rest of their lives work on their desk.

Importantly, now that they have made a bid they have the right that the mums and dads of the stock market don’t have: They can go in do the proper due diligence. They will probably not like what they find.

See below if you want more detail on takeovers.

3. Why it’s almost definitely a fraud

John Hempton of Bronte Capital has a record of exposing frauds by fairly clever but completely reasonable methods (UK and otherwise international readers: Bronte is a sweet little beach around the corner from where I live – great park for bbqs, decent surf, but on all counts not quite as good as Tamarama) . Once a red flag comes up, for example, when a Chinese company claims to be vastly more profitable than its Western counterparts, he gets his hands dirty figuring out fairly ingenious but replicable ways of finding them out – like calling their suppliers and customers to see if they actually exist.

It’s the sort of strategy that lends itself to publicity – once he has a position, the more people who buy or sell the stock the faster it will be pushed where he wants to go – a far cry from the sneaky secretive hedge fund dudes in fixed income.

In this Focus Media’s case there are a number of red flags, chief being:

  1. Focus Media bought suspicious shell companies for significant amounts, then gave them back to the owners for nothing – an excellent way to explain to auditors why a very profitable company has no cash
  2. The business of Focus Media is vastly more profitable than its Western counterparts, and the numbers it provides for its business doesn’t make sense
  3. The company lied a number of times, and has even admitted its more egregious counts, e.g. how it reported posters as digital screens
  4. Other players in the industry don’t list Focus Media amongst their competitors

Jumping on the bandwagon (not sure which was first) is Muddy Waters, a research and investment firm that really kicked the whole Chinese fraud thing off last year with its expose of SinoForest, when it turned out there were no forests.

Anyway if you want the detail read Bronte Capital’s blog.

The main thing I care about is the price is $23, if the private equity firm completes its due diligence (and in doing so, fails its own due diligence test), the stock is going to $27. If it’s a fraud then it will drop dramatically, below $7. Definitely binary, definitely money to be made.

4. A perfect situation for options

This truly binary outcome throws up more ways to play it than you can count.

In this case, you could buy the stock and put options in much greater size.

Another way would be to load up on options both sides.. buy October $25 calls for $0.20. If the deal goes through you make 10x your money that day – more than enough to account for whatever you spend on puts.

5. My Take

There are some cheeky reasons to suggest this deal won’t going through.

Stocks have a habit of playing their hand: too many people know if a deal is likely to go through or not. Before takeover announcements stocks drift up, and before they fall through often they start drifting down. This is the case in the highly regulated West – in China the cheats are far more flagrant, and the recent steep falls in $FMCN suggest the Chinese have tipped their hand.

This whole trade, by the way, doesn’t rely on any properietary financial analysis. The fact that some people have good reasons think it’s a fraud, and others are willing to pay precisely $27 to take the company over, is enough. We can leave the forensic accounting to John Hempton.

6. A demonstration of retardedness in the option market

As a final possible trade, the nature of options means that over long time periods the pricing simply becomes ludicrous.

There are two effects: as you go forward in time the fair value of options increases rapidly for a given implied volatility, while the implied volatility itself also tends to increase (i.e. upwards sloping vol curve). The net effect is that long dated options are very richly priced (expensive).

Just looking at live market prices now, Jan 15 calls struck at $27 are selling for $1.50. Since the best case scenario  is that the stock goes to $27 and is taken off the market, this is pretty damn close to free money. If any economist amongst you wants to try and twist this in to efficient markets you have, as usual, completely missed the plot.

Tempted to put on a trade?


Mapping tech

1. Mapple

The blogosphere has erupted with piquant critiques of Apple’s decision to adopt a highly flawed map system in their new iPhone. Without knowing much at all, I’m about to speculate wildly on why.

As you’re probably aware Google has developed cars that drive driverless, one of those technologies that could be implemented tomorrow with huge benefits to all, but societal inertia – in this case from legal, legislative and technophobic hurdles, will make this take decades.

The positive impacts will be enormous. Far fewer will expire on the roads as all driver-caused accidents cease. Commute times will plummet as vehicles drive more efficiently – that highly irritating caterpillar of movement that kicks off in long queues when the lights change will be no more. In face, there’s every chance that traffic lights will no longer be necessary and at intersections lines of traffic will stream orderly through each other.

There are more transformative benefits. We’ll be able to get drunk and be driven home by google (changing laws to allow this would be one of the many ways to encourage people to adopt the technology – widely publicising the safety record would be another).

With a bit of luck one day in our lifetimes we’ll be able to summon our cars parked at home to wherever we are.

As ever there will be winners and losers – taxi drivers look likely to lose.

There will be some crazy start up possibilities. Imagine an app that allowed you to rent out your car, so for a fee anyone nearby could get a ride, after which the car would return to where you left it. The car owner gets extra cash, the user gets a ride when, where and where hither he wants it, and the enterprising start-up in the middle gets a tiny slice of the revenue. That would have fairly substantial first mover advantages as well, but I digress.

The layout of vehicles will be based on entertainment and comfort, rather than convenience for the driver, and here lies the goldmine for the company involved.

The technology driving the car will put a prime display in front of all of us where there used to be none. Forget the iPad – the search potential, advertising dollars and drastic lifestyle improvements will be completely framed by a the company that can put this screen in every vehicle – or maybe you would just plug in your smartphone and tell it where to go.

Apple has seriously dropped the ball by giving Google such an enormous head start, firstly by adding google maps to all iPhones previously sold giving an enormous market and allowing the global user base to improve the product, and secondly by allowing such a fierce competitor to steer driverless innovation in directions of its choosing. Perhaps Apple could do more than hoard it’s +$100 billion trove.

2. Market play

Anyone who’s let me bore them with talk about stocks knows I’ve been a big $AAPL fan for quite some time. The company has better products than anyone else, is more profitable than anyone else, has huge entry barriers to its markets, has a closed, completely controlled ecosystem, and more importantly has been far cheaper than the market for quite some time. While it is indeed a ‘tech’ stock, it is the closest thing to a Buffett company I can remember seeing.

You wouldn’t believe the retarded conversations I’ve had with people in the market who should really know better.

Once I had to explain to a hedge fund manager who targeted ‘cheap stocks with strong cash flow generation and defensive margins’ that Apple was the highest rated by not only all of his own arbitrarily chosen metrics, but also by a number of others, the inclusion of which into his decision making would make a lot of sense (for example, its ridiculously high earnings growth).

I sat with a rates trader who questioned the trade after the stock had risen to the then lofty levels of $400, arguing ‘we’ve just had a strong risk rally, the next sell-off I expect it to go to $200, [he gestured on a chart where it was pre-rally]. It might be a good trade then’. The guy hadn’t even bothered to consider the market implications of the fact that the company in question had literally more than doubled in size since then. Sure much of fixed income is by nature mean reverting – bond principal tends not to double – but the concept of equity isn’t that hard to understand.

Most frustratingly I had a kind-of-interview (one of those ones where you just meet someone but the unspoken possibility of employment is undoubtedly present) with another fund manager and, upon being asked for trade ideas provided Apple. I was treated to a two hour lecture on the various details (and I mean technical not financial details) of Apple’s mid 90s strategic blunders, apparently oblivious to the fact that investing at that time would have made an absolute fortune while simultaneously disregarding the fact that the events under discussion occurred 15 years ago. (Actually, I quite like most of this guy’s work – more on one of his other ideas in another post).

Right now the case is a lot more balanced. Apple’s existing products will continue to throw off billions of dollars, almost definitely for the next few years at least – and the company still makes sense as a low risk investment, particularly as it has no debt and is sitting on a mound of cash. But the process by which competitors catch up is quite clearly well underway.

Google on the other hand was always a little less exciting financially. That ruthless financial management exercised by Apple (as seen in their frugal-with-respect-to-revenue research budge) was completely orthogonal to Google’s don’t-be-evil strategy. GoogleX, with its driverless cars and who knows what else, has shown the incredible potential aggressive and imaginative research funding has to both dramatically improve our lives and summon huge revenue streams out of thin air. I’m going to sell some $GOOG puts, and if there’s a sell-off I’m going to take the stock.

Everyone knew the smartphone business was going to make a fortune, particularly once it was well underway. The wrong approach was to pick a winner: Blackberry bears witness to that (as does Nokia, but that was more obvious). The right approach was to pick a number of companies and recognise that a pie growing that fast was going to be hugely profitable for anyone who could nab a decent share. Apple and google were obvious choices then.

If Google’s driverless cars become standard, rather than a speculative possibility next decade, there is a good chance a number of players will harvest enormous profits. Fortunately with public equity markets, it’s possible for all of us to take a share.

Rust II

The Cost Curve

These things kind of speak for themselves. You can see the market apex (RIO, BHP and Vale) is perfectly positioned, and (theoretically) production would have to almost halve to put them in danger of an operational loss. The high cost Chinese production in red was what was supposed to drop out to keep the price above $120 – whoops.

How the Players are going to Play it


This appears to be one of those common examples where the participants in a market seem to be conspiring amongst themselves to completely and unnecessarily wipe out the entire profits of their industry.

As the lowest cost producers, BHP and RIo will assume they can afford to keep mining, and have indicated they will do so (to put it mildly). While they will shelve some projects in the pipeline, and have already started, they will make up for lower prices by pumping out greater volumes as they continue to expand production.

The self heralded New Force (Fortescue) has no choice but to produce. Their debt is 10x EBITDA and must be repaid. They certainly have no flexibility to halt production.

The smaller players will have to act according to their capital structure. Those that have debt to pay will have to produce, and if all the profits go to their bond holders and (somewhat foolish) bank lenders and the equity is worthless, then so be it.

Who knows what China is doing, but my best guess would be that they will operate at a loss. Low iron ore prices are undoubtedly in the broader nation’s interest, and combined with the social benefits of keeping employment high the central commanders are quite likely to err on the side of excess productions

So what are we left with? A situation where the entire industry will out produce itself into oblivion. (Actually, this isn’t even close to the worst I’ve seen … for collective stupidity you can’t beat the shipping industry, but that’s a post for another day).

What they should be doing


Those that can stop producing should absolutely stop, but to do that they will need to have little or no debt (a rare situation). The long term benefits are huge – their competitors will be producing in a low price environment, while in 10 years time, when the worlds GDP and population growth is substantially higher, all that ore will still be sitting in the ground, ready for a decade of production at costs way below those of the rest of the industry, which by and large would have already mined and shipped off their best assets. How many people have 20 years to wait, however?

To some extent, this is going to get a lot worse when the Apex decides to make up for lower prices with higher volumes of low cost ore.

It also comes down to capital structure. Miners, which know better than anyone else the extremely well publicised increase in production, which will really only hit full stride in 2014, should have raised equity last year. Would that have left them with too much cash? They shouldn’t have cared, as they’d now be able to buy their own shares back at much lower prices, providing windfall profits for their buy-and-hold investors, or been best positioned to pounce on distressed assets. But who bothers to think like that?

A five year view


Personally I think this will be a slow motion train wreck. We’re in the ‘plunge’ part of the cycle. Invariably to some extent the cost curve will work as it should and the higher cost guys should reduce their exposure somewhat. Those who have disconnected the long term thesis (iron ore prices going down over the next five years) with their trading limits, and who bet against the industry only recently will probably have to buy back their shorts at a loss in the short to mid-term. Noones going bankrupt tomorrow. The combination of these two factors will certainly lead to some kind of rally.

But in 2014 the reality of the increased production profiles will hit, and those that left themselves exposed to the spot price with weak capital structures will be at the mercy of their various bank but (mostly non-bank) lenders, and the industry will be up the creek, so to speak.

Where could the upside come from?


In a nutshell, there needs to be a demand surprise. Africa gets its act together and plays the role of China in the noughts, in the teens (these decade names suck). Or perhaps even low price itself is enough to boost steel demand. It’s quite hard to see that happening however, as their is just so much spare capacity in the industry (by one estimate, China’s steel capacity is 850m tonnes a year, but last year only used 630.

Furthermore, if the price goes up, the miners will just put those shelved expansion plans back on the table, and push down the price and wipe out the value of their equity once again (hence five year view). The size of the demand shock would have to be enormous.

And remember, it wasn’t so long ago that the iron ore price was in the $20-30 range.

How to make a dime and a buck


What do you think?

This is how I would play it. There is no point in playing around with the equities.. I mean, you can. There is a good chance you will do quite well in the short term, as it looks like one of the most powerful forces in markets, that of the short squeeze, has just been put into action, and these things tend to be quite dramatic. But looking ahead more than six months, it is almost impossible to see where the bumper profits will go to.

Instead, I’d suggest looking in the debt markets, particularly for eg. the New Force. What you want to find are great, low cost assets, with high financial costs. (Eg $50-60 operational break-even on the cost curve, but $80-90 once financing costs are taken into account). This would be trading below par, and would provide a handy coupon while you wait.

If the predicted collapse in the industry actually occurs, you are the one holding the cards. As a debt holder (and this will completely vary case by case according to the various instruments that have been used and their particular features) you might be able to force an equity raising. So the miner would have to sell more shares and completely smack it’s already whacked share price. management would then be forced to use the proceeds to pay you back at par. And that, say around 2015/6/7, would be the perfect time to consider buying the shares, and participate in whatever upside the industry has over the next 10 years. I’m guessing the Roaring Twenties will be a great time to be holding enormous amounts of low cost mining assets.

If this plays out as expected, I will probably be doing this somewhere, so get in touch then if you want to get involved.

One final thought


Something that seems to be missing from the commentary is the effect that low iron ore and steel prices have on all of us. Steel (and other base metals) are one of the key inputs into the global economy, and reducing that cost is undoubtedly a great thing for most people. It might be deflationary, but it’s the good kind of deflation, like high oil prices, which just concentrate wealth in the handful of lucky misogynistic medieval desert dwellers, is the bad kind of inflation.