May 24, 2009 Volume I, Issue I
In this issue:
Chips and the Dipshits Who Cover Them by The Fly On the Important Matter of Equity Recapitalizations by JakeGint Using World Stock Market Indices by ChartAddict Vix You Up (The Fear/Greed Report) by Gio Distance by Woodshedder This Week by Ragin' Cajun
Chips and the Dipshits Who Cover Them
A recent Credit Suisse survey of 80 Taiwanese companies (semiconductor capital of the world) put inventory levels at an astonishing 48 days, which matched the bottom of 2003 and levels not seen since 1999. Without a doubt, back in early ‘08, executives at the big foundries (TSM, UMC, SMI) were readying for some sort of Armageddon, which resulted in absurdly low capacity utilization levels, as factories were shuttered. Fast forward four months and the factories are racing to meet end user demand, especially for LCD’s, LED’s and anything that goes inside of a smart phone (RIMM, AAPL, PALM). For the most part, the PC market has not enjoyed a sharp revival, as evidenced by the lackluster stock prices of both NVDA and DELL.
Here is my play:
I believe analysts covering the semis are going to try to time an intermediate top. For the love of undercooked chicken, those assholes cannot help themselves, but to muck up their timing and muddy up their research. Look for analysts to come out with negative research notes on the chips, until further evidence of a real turn around. They will base their downgrades on price objectives being met, but ignore the possibility that things are really starting to improve. Into weakness, I want to buy or add to names that benefit from increasing capacity utilization at the foundries. I believe "normalized recessionary levels" fall anywhere between 75-80% capacity. As of now, most foundries are still in
the low 60’s. Here are my names: AMKR, SPIL, ASX, CDNS, TER, KLIC and ATML. In short, whether we are in the midst of a true turn around or mere inventory correction is immaterial to my investment thesis. I do not intend to vote at any of the aforementioned companies annual meetings. Like always, I am interested in grabbing an inflection point, running with it, then tossing it into the dinner platters of the likes of Cramerica-- for proper disposal. Bottom line: Executives at the foundries got it wrong four months ago, via pricing in total collapse. Now, those same idiots are racing to re-supply their factories with chips and electronic parts (AVT is your play for shipping parts to foundries). My sense, the easy trade is to get long the chips, after a dip, going into Q3 earnings. Inventories are simply too low and need to be restocked. As for this week: I am hoping to initiate a position in ATML, into weakness. Aside from playing the name for capacity utilization normalization, ATML is also in the business of supplying the touchscreen market (smartphones) with microcontrollers. Already, they have a design win from NOK and mentioned both MOT and Samsung in their conference call. In addition to the stock being a solid value play for its core business, ATML offers an extraordinary risk/reward, providing their microncontroller business takes off-- landing more design wins.
On the Important Matter of Equity Recapitalizations
I figured I’d take an excursion outside the normal realm of stock advice to discuss a subject in a less liquid arena -- that of private, closely held company mergers and acquisitions. While publicly traded company M&A is certainly a key component in our every day trading analysis, many of you may not realize that the vast bulk of M&A transactions take place every day in what is generically called “the middle market” of smaller, private companies that comprise the backbone of our economy. Increasingly, middle market entrepreneurs are discovering that the equity recapitalization is a great way to achieve liquidity without completely stepping away from the business they love. Demographics are driving much of the M&A market today, with many baby boomers entering what we in the business call “the gray
zone” of their careers, typically beginning in their early fifties. Most successful entrepreneurs have put their very lives into their businesses – working sometimes seven days a week and very long hours for a period of twenty five to thirty years to build them. By their early fifties many owners come to the realization that a) they are vesting the majority of their net worth in a single, illiquid concentrated asset and b) they are not going to live forever. Therefore, a combination of conservatism and a desire for estate planning will drive even the most dedicated of entrepreneurs to contemplate liquidity through sale of his/her company. In the past, when an owner chose to sell his company, the universe of buyers was largely restricted to “strategic acquirors” -- a euphemism for his direct or indirect competitors. Today, thanks to the success of pioneers in the world of financial purchasers like Henry Kravis of KKR and Ted Forstmann of Forstmann Little, “the financial buyer” alternative has become a driving force in the world of private M&A. My colleagues and I have estimated there are now as many as 5,000 private equity vehicles extant, in the form of specific venture and private equity funds, family offices, special purpose pools, and even “one off” executives-for-hire. Thanks to this well developed private capital market, equity recapitalizations have replaced 100% buyouts as the most attractive alternative to the liquidity seeking entrepreneur. The equity recapitalization is attractive because it allows the entrepreneur to take a large amount of his equity risk off the table, while retaining a material part of his company as an investment going forward. This alternative is naturally most attractive to those owners who seek to stay with their company for some period after a liquidity transaction. Because private equity capital usually requires that an acquisition’s management team be retained (as they do not, as a rule, like to operate their portfolio companies), this form of transaction is among their most desired as well. Not only do they retain the management that has created the company and made it so attractive to purchase, but they keep management incented via the shared risk of a continuing equity investment. Let me lay it out in a simple example (see below). An entrepreneur seeks to sell his company, and through a negotiated auction process (JakeGint assisted, one hopes) arrives at an agreed upon purchase price with a private equity firm of his choosing. On the day of close, the assets of the company are sold to a “Newco” structure established by the private equity firm for $100 million. Newco will then be “recapitalized” with a new balance sheet that will be leveraged according to the agreed upon comfort of both parties. In my example, I use a 40% equity and 60% debt structure (this ratio will vary according to the riskiness of the company, it’s history, prospects, and the state of the debt markets). As the debt will be funded by the private equity providers’ partners (usually a combination of bank and/or mezzanine funds), only the 40% -- or $40 million—in equity is required to complete this financing. In my example I posit that the selling owners will wish to retain 30% of the company going forward. They must therefore take from their selling proceeds ($100mm after tax) 30% of $40 mm, or $12 million to fund their retained equity in the company. Even after taxes, they have reduced their net worth exposure to around 20% of the ongoing company, while retaining 30% and a partner who will most likely seek to maximize that asset through additional acquisitions, growth, etc. This method not only allows our entrepreneur to continue with his company, along with an equity (and board) interest in the enterprise, but it also allows the selling owner to take what is in effect “a second bite at the apple.” This is because within three to seven years (typically) that private equity firm will be seeking to either “recap” company again (via debt incursion and dividend to equity holders), or to sell out to a strategic or financial buyer completely. Keep in mind that if all the company does is pay down the debt incurred before selling itself again and sells at the same price as “the first bite,” the owners will have nearly tripled their original investment ($12mm becomes $30mm). If the company manages to grow organically in that period, more is the better (again see the examples given of exit prices and IRR’s).
You can see, therefore, why a hard driving boomer who is perhaps not quite ready to lay down his hammer, but who is seeking the risk modification a certain amount of liquidity brings to one’s later years, might see the equity recapitalization as the perfect solution to his portfolio concerns. From both an emotional and financial standpoint, it’s an excellent fit.
Using World Stock Market Indices
Why is it important to look at the rest of the world? Several reasons: 1. They may foreshadow impending breakouts or reversals in the US indices. 2. Extraordinary strength or weakness in a certain part of the world (e.g. Asia, Europe, etc.) may be cause to go long or short equities that are affected by that particular geographic region. 3. They provide confirmation for the US indices since the world moves together. For example, it is impossible for the US to rise if the rest of the world is in decline. I have outlined major trends, channels, and support/resistance areas in the following world markets ($ + ticker = for Stockcharts.com users):
$NIKK - Tokyo Nikkei Average $HSI - Hong Kong Hang Seng $BSE - India Bombay Sensex 30 $STI - Singapore Straits Times $IDDOW - Jakarta Indonesia $KOSPI - Seoul Korea Composite
$AORD - ASX All Ords Composite
$DAX - German Composite $CAC - French 40 $FTSE - London Financial Times $MIBTEL - Milan Italy $SMSI - Madrid Spain General
$TSE - Toronto Canada TSX Composite $BVSP - Brazilian Bovespa There are certainly more world indices, but these 14 should be diverse enough to give you a picture of what‘s happening in various stock exchanges around the world. It’s important to note that every index is in consolidation which means that none of them are breaking out or breaking down (as of 5/24). The vast majority of the world is showing a further technical move to the upside. The following are exhibiting bullish patterns:
Neutral Range: $HSI, $FTSE, $STI, $MIBTEL, $TSE
Continued Uptrend: $DAX
Ascending Triangle: $CAC, $BVSP, $SMSI
Continuation Gap Up: $BSE
Small Flag: $IDDOW
The below two indices are showing bearish formations: Rising Wedge: $KOSPI
Broadening Ascending Wedge: $AORD
These, and other world indices, should be studied at least once per week.
Vix You Up (The Fear/Greed Report)
Status: Market in confirmed nirvana. Dumb money outnumbering smart money. Bulls still in control of market. Vix Projects: Volatility in VIX signaling third attempt for a longer-term reversal in market in past few months.
Bulls: “I will crush another bear this week!” Bears: “When will this ever end?” This is the dangerous part for bulls. It’s when it seems like the coast is clear that things start to get interesting. It’s when the bears seem to lose all hope, to hear one more demoralizing “I told you so” to shake out the last weak hand, before the market starts correcting itself.
Events Affecting Market Sentiment
As a trader, you should always keep in mind certain events that can shake the market. For starters, write down a list of events that you think can cause the market to spike up or down, and see in the next few weeks if your anticipations are realized. Generally, whenever you notice a market index moving +/-2% and the VIX moving greater than +/- 7% on a certain news event, then you know what is on the minds of traders. So far I only have a few items on my list: US Military action/ Global military action Banks’ financial reports Obama, FED reports Swine Flu (rapidly dropping, but pinned to certain sectors)
The VIX Chart
The VIX is making it hard for a follow-through rally every time it gets in the 20s. I am picking up a significant increase in volatility within the VIX on the daily chart. You may notice how the VIX is jumping up and down all over the place which means there is some hesitation. Bulls are looking for any reason to take profits, and so far the proper move has been to buy every dip… the only thing that concerns me at this point is the increased volatility in the VIX. This is the third time this has happened this year, with the first occurrence happening mid-March, and the second time in mid-April.
I filtered all the ETFs that are above their 200 day moving average, as that average has often been used to mark a bull vs. bear market. Examining which ETFs are above the 200 day might give some clues as to what type of environment we find ourselves in. As seen below, "distance" is the distance in percentage terms the ETF is above its 200 day moving average.
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