Tuesday, April 20, 2010

The Mistaken Connection Between Natural Gas and Utilities

As a shareholder in Mirant (see: Is There Significant Value Behind this Coal-Burning Utility?) I've come to follow the movements in their share price on a day to day basis.

Because of this, I'm very interested in determining what influences the movement of the stock price and whether the downward move that the company has experienced recently was caused by outside factors (i.e. changes in commodities prices, the weakening economy) or internal factors such as market distaste with the company or other problem areas that have yet to crop up in tangible news.

Blurbs that I've read, such as Bob Pisani's Stock Talk from March 31st, 2010, point to natural gas as being a big mover for utility companies like Mirant. Commenting on the movement in independent power producers, Pisani notes:

"Natural gas happened. Independent power producers usually work in regulated markets, where the price they can charge is often tied to natural gas prices. Nat gas went from $6 to $4…a disastrous impact on profits, since fixed costs did not change."

So I thought I'd take Pisani's hypothesis to the data and see what the data had to say. I performed a linear regression in STATA to try and see what connection daily returns in natural gas had on energy producers such as Mirant (MIR), AES Corporation (AES), Dynegy (DYN), RRI Energy (RRI) and NRG Energy (NRG).

The short answer: except for Mirant, natural gas has no statistically significant explanatory power for the companies' stock prices for the time period considered. Even the explanatory power of natural gas for Mirant becomes statistically insignificant when a proxy for market performance (i.e. the S&P 500) is added in.

What I Did

To begin, I used Yahoo! Finance to collect historical daily stock price data for all of the companies mentioned above and for the S&P 500 index. The West Texas Natural Gas Wellhead price was used for natural gas and this data was obtained from GFD (Global Financial Data). For further testing, I also used the WTI Crude price, GSCI Energy Index, Moody's Commodity Index and Dow Jones U.S. Electricity index, all obtained from GFD.

All data was converted to percent return, and to try and control for changing correlation and dependency in the data I only looked at the time elapsed since the beginning of 2009 through the 9th of April 2010. The cut off at Apirl 9th was done to correct for the fact that Mirant and RRI just entered in to a merger agreement.

For the first step, I simply performed a linear regression of the daily percent change in natural gas prices on the daily percent change in the company stock price. Below please find the adjusted R-squared values, coefficients on the natural gas variable and corresponding t statistics from my regressions.

To put the coefficient in to perspective, for Mirant, if there is a 1% positive change in natural gas prices we would expect the stock price to go up by 0.04%.

As we can see above, in AES, Dynegy and RRI adding in natural gas rendered a negative adjusted R-squared value, meaning that it'd be better to guess randomly than look to natural gas as an explanatory variable. It is very easy, from the results shown above, to see that natural gas clearly does not have an impact on utility stock prices for the time period considered.

From a Longer Time Horizon

When I used data spanning back to 2006, the answer started to change. Natural gas became statistically significant for all companies except for AES, and this was even when market performance (i.e. the S&P 500) was added in. The negative coefficient of natural gas in the Dynegy instance is somewhat strange, but the coefficient is so low one can essentially assume it is zero. In fact, in all of the companies the impact of natural gas on stock price was far dwarfed by the S&P 500 variable, in all cases by at least a degree of magnitude.

The conclusion from this study would be that while over the long term utility stock returns are more generally tied to natural gas movements this effect absolutely does not exist on a shorter time frame (i.e. 1-1.5 years going back). This could be because most utilities today hedge for inputs, so they probably are not sweating the day to day movement. These hedges typically go out a year in advance, which could explain why data periods over longer time periods, which can take in to account longer trends, show more significance.

The extremely low values on the coefficients for natural gas, in both the longer and shorter term analysis, suggest that Pisani is mistaken is his connection between natural gas prices and stock price moves of power producers.


Responses to the Previous Article

My most recent article (Does Software Development Threaten to Dethrone Apple) got published on Seeking Alpha, and typical to what I expected there was a lot of discussion following in the comments section. In spite of the fact that it is exceptionally well covered already, I like writing on Apple because there is a very passionate community bullish on the company. This makes a great audience to write for because it serves as a trial-by-fire for your writing style and attention to detail.

Some of the points were very interesting, and one that was reiterated a few times (the argument that Apple's 30% take from App Sales is just enough to cover expenses) is a topic I'd like to do a follow-up article on in the future.
Along these same lines, I actually received two very well-written personal messages from Seeking Alpha members regarding Apple and the topic discussed in the article. I'm going to post them here, unedited by myself, since I feel that they bring up some interesting points, albeit not in favor of the point I was advocating for. If either of the authors are uncomfortable having their messages posted here, feel free to contact me at thesaneinvestor@yahoo.com and I will take them down immediately.

FROM: GregZw

This is the second article I have read predicting the downfall of Apple because they won't allow third parties unfettered access to their technical environment.

I took my first computer programming class in 1966. I evaluated the original Macintosh computer for Atlantic Richfield Co. before it was originally released in 1984. I worked with one of the original software developers for the TRS80 from Radio Shack that was the first product to use MS-DOS from Microsoft.

I was involved in many debates about the pros and cons of open verses closed technical environments in computing technology. Apple made a decision In the early 80's to keep control over their environment. Microsoft took the open approach.

Apple new they would lose market share in the sort term as most 3rd parties jumped on the Microsoft bandwagon. Apple knew they could provide a richer environment with greater innovation in the long run.

I believe Apples strategy has overtaken Microsofts and will continue to dominate in the future. The battle has begun with Google and will be very interesting to watch over the next several years as google search is replaced by Apple Apps. Google's "open" approach to phones is similar to microsofts approach to computers in the 80's.

Pandora's box is open for Google and it will be interesting to see how they support early adapters to their approach as new technology comes available.

FROM: doncarp

Within the larger context of open markets, your opinion on Apple's control of software on the iPhone and iPad seem to make some sense. But you ignore the role of technology standards has played across the entire spectrum of digital technology. One of Apple's strengths is its control of all hardware integral to its products. This might be, along with Steve Jobs's understanding that Apple is now a media company as much as a technology firm, one of the most important reasons that Apple is now matching Microsoft CPU products in new unit sales. The Windows brand has been damaged by the immense diversity of device interfaces it must accommodate.

Third party software is, I suppose, your exception to this rule. But for what reason? Certainly mainframe computers, automobiles, medical devices have controlled their software and hardware. In most cases, it was not only desired, it was necessary for the product to function safely and be service supported by the manufacturer. Why should the success of Apple products cause them to be excluded from such proprietary control? I'm sure Apple has thought about what margin they can justify within the context of market demand and growth. You make it sound as though they do not deserve the fruits of their success. A rather socialist opinion I might add.

Apple's proprietary marketing system has allowed single programmers to become wealthy in just a few months. It is an exciting and valuable means for tapping the immense diversity of talent and vision that exists all across the far reaches of Internet tethered individuals.

Perhaps you don't recall when Microsoft strong-armed retailers to muscle out Apple from their best display space. In the years that followed, Apple almost was sold out as a near death business. Do you recall the way the Bell system dominated communications here and in the process were able to influence government and their regulators in such a way that Bell became a pure money machine and in the process became an impediment to our national telecom policies. Now many smaller nations such as Korea have more advanced broadband available at cheaper prices than the US will have for many years. Business always tries to optimize its market advantage. If at some time in the future Apple's dominance hinders viable competition, as did Microsoft and Bell, then they should be the target of government anti-trust action. But at the moment, Apple is not keeping software vendors from doing business with competing hand held devices. They are simply doing what they do better than anyone else is doing it. They deserve to be where they are and they are rewarded by their customers with their present market dominance.

What young analysts here sometimes forget is that the country's technical rise to world dominance would not have happened if there were no laws protecting trade secrets and other intellectual property. There is a mistaken sense of entitlement in some consumers which suggests that there should be no reward for a company's technological excellence, that all innovative new products should be subject to immediate generic product cloning. If that were the case, who in their right mind would make the investment to even create an iPhone, iPad or iMac.

Friday, April 16, 2010

Does Software Development Threaten to Dethrone Apple?

A couple of months ago I wrote an article speaking to how Apple (AAPL) was the fourth largest company in the United States by market cap according to the S&P 500 (it is currently the 3rd largest), and began speculating as to whether or not the company deserved this highly coveted position. While being a tech company with no debt obligations is going to bias Apple's position upward in the S&P 500, I do think investors should re-evaluate whether Apple deserves this position in the market.

Yesterday there was a very interesting article posted in Slate (Apple Wants to Own You), and while I feel that the title is far too fear-mongering, I do think that a few of the issues raised are pertinent to Apple's ongoing success.

The biggest point raised in the article is the fact that the locking-out of third-party software that originally only pertained to the iPhone is now being included in the iPad, something at the very least controversial given that the iPad is being hailed as a tablet computer. This is to say that except by ways of the Apple marketplace for apps, you are unable to install any non-Apple endorsed piece of software on the iPad without manually unlocking the device and voiding your warranty. While this may not be a short-term concern for Apple, the Slate article identifies that one of the key draws to Apple products is the rich environment of downloadable apps.

This of course raises the question of whether software begets users, or users beget software. As it stands now, Apple gets 30% of the sales from all apps. That's a pretty lucrative business for being referee and market maker on your own devices. With Apple additionally trying to take 30% out of magazine subscriptions on the iPad as well as growing rumblings over the subjectivity and increasing conservatism of iPhone and iPad app acceptances, there is concern that Apple is starting to take more advantage of the moat of user base it has built up with the lights-out success of past products.

While the iPad currently has no side-by-side competitor, other phones such as those using the Android operating system produced by Google potentially offer users a more unfettered access to third-party software than those using the iPhone.

The story of the iPad has been a huge success thus far, with Apple reporting over 500,000 units sold. Apple's stock momentum appears to be one of maintained margins and continually growing revenue, with revenue expected to jump 47-80% from last year's second quarter. While Apple has been a very strong performer in the past, it might be worthwhile to current investors to re-weight the risks and evaluate whether the price that Apple is currently trading at is pricing in a significant amount of optimism regarding future success.

My Take on the Goldman Sachs Allegations

BACKGROUND: here is Felix Salmon going in to really great depth on the Goldman Sachs S.E.C. allegations for those of you unfamiliar with the story.

I'm personally long Goldman Sachs (GS) after they lost almost $13 billion in market cap today. The settlement is expected to be in the hundreds of millions of dollars, and GS as a whole only made $4 billion off of subprime bets in general.

Obviously the market is expecting this to have residual effects on their other lines of business, however when I look at the landscape for the business they're involved in I think they've got a pretty good lock down. I would expect GS to distance themselves from the ABACUS events, and potentially blame it on the actions of a few individuals rather than GS internal protocol.

They may end up being liable, however if the trial of the former Bear Stearns hedge fund managers is any indication, some times it's hard to get these charges to stick. Especially since Goldman is going to throw A LOT of money at this to try and make it go away.

This may be my own personal bias, but Goldman Sachs has the ability to snap up the best and brightest minds. If you get a job offer from them, you think long and hard about dropping everything to give it a shot. I'm not going to say I necessarily morally agree with the sorts of things they do, but in terms of having the capacity to make money, they certainly have it. When you have the best minds and a corporate culture that rewards you very well for making contributions to the P/L, you're going to continue to have success in the financial services industry.

Tuesday, April 6, 2010

Is Volatility Getting Cheap Again?

One of the indicators that I like to watch, if for nothing else than for entertainment value, is Barron's Investor Sentiment readings. Last week, depending on which indicator you look at, Bullish consensus ranged from 41.3% to 70%.

One of the questions I constantly want to be asking myself is whether the market is getting complacent, which I would argue is the primary cause of bubbles. I would posit that if the market starts to get too single minded, market efficiency starts to weaken and you start seeing opportunities to take advantage of the follies of other market participants.

Just looking at the way the Dow Industrial Average has been moving (i.e. in terms of scale of the movements), things seem to be quieting down in the market. The standard deviation of daily returns for the Dow Industrial Average has dropped from 2.38 percentage points (from the beginning of 2008 to the end of 2009) to 0.82 percentage points (YTD).

Even when you look at the Dow during a more "pleasant" period of time (mid 2003 to end of 2007), standard deviation of daily returns is 0.74 percentage points, not that much lower than where we are now.

But the key test for whether the market is getting complacent or not is to look at implied volatility. The most common metric for this, the VIX, does so by backing out volatility expectations from S&P 500 put and call options expiring in 30 days (CBOE methodology). When you look at historical VIX levels, the answer to this question is debatable.

Will the Future Be More like 2004 to July 2007 or 1992 to 1999?

These are the two times periods for which there is VIX data that I would call "good" for shareholders. What I was curious about was what the VIX level looked like during these periods.

For 1992 to 1999, you have a geometric mean of 17.03, arithmetic mean of 17.90, and standard deviation of 6.02. For 2004 to July 2007, you have geometric mean of 13.52, arithmetic mean of 13.71 and standard deviation of 2.35 for the VIX.

These are obviously very dramatically different numbers, and the most reasonable explanation for the higher values for the 1992 to 1999 period was the tech boom, and the volatility that that presented. That was a bull market the likes of which was unseen previously, so perhaps an expectation that that will happen again in the near future is foolish. So if you're looking at 2004 to July 2007 as the most likely market climate for the upcoming future, the VIX, which closed at 16.23 today, is still a little bit high.

That being said, 16.23 is the lowest level the VIX has closed at since December 10th, 2007. Depending on how you're feeling about the economy, now might be an interesting time to try and profit off of volatility underpricing.

Trading Strategies

The simplest option would be to buy futures on the VIX, or check out the VXX or VXZ, two ETNs managed by iPath (Barclays).

Another option would be to literally buy options on the S&P 500 to perform a straddle. This would be done by buying a put and call at the same strike price, presumably with the strike price at the current market price. Your hope would be (presuming strike price is market value on day of purchase) that the closing price on the day your option expires would be the strike price plus or minus the sum of the premiums paid for the put and call options.

I've also written another article on volatility: Getting Exposure to the VIX as a Hedge: Is it Conditionally Correlated to S&P 500 Returns? if you're interested in reading it.

Saturday, April 3, 2010

The Dangers of Anecdotal Evidence

Perhaps it's something that has been embedded in us by the process of evolution, but humans seem to really enjoy articles, snippets, and stories from real human beings rather than data.

Consider every instance you've ever heard of someone doing something that objective reason and presumably some sort of data would suggest is wrong. This could include driving very infrequently yet choosing to lease, or buying a can of Coke every day from the local corner store when one could save 50-75% of this cost by buying a twelve pack and bringing the soda from home.

Now think of when those instances match up with a story or personal experience that seems to fly in the face of data or statistics. "Well my friend blah-blah bought her car and then the engine went out and she had to pay (large sum of money), so I just lease now". Or "my sister so-and-so used to bring her sodas from home, but then one day some of the cans exploded and ruined everything in her pantry, so now I just buy my soda from the corner store on the way to work".

These stories are extremely appealing, because we can identify with them. You imagine yourself in that situation, and since it happened to your friend/family member, it seems to suggest the probability is high that it can happen to you. If you look at this person's experience as a foretelling of what will happen to you (i.e. probability of negative event = 100%), then making a choice that goes in the face of objective data makes sense. However, it could just be that the probability of the effect is fixed, and your friend or family member just happened to be on the wrong end of the probability distribution.

While citing personal experiences to show how personal anecdotes are oftentimes blatantly false is a logical absurdity in and of itself, consider the following article that was on the front page of Yahoo! Finance this Saturday. Entitled: "How My $499 iPad Purchase Became a $1,170 Credit Card Bill", by Jeff Fox from ConsumerReports.org, the article instantly grabs your attention because of the large change, as if to suggest Apple is tricking you.

The article itself is a misnomer because one of the first things Jeff says is that he decided to get the $829 64GB 3G model (because you can use it with more than just Wi-Fi) that evidently releases later in April. Right there, the article should have simply become "How a $829 purchase became $1,170", but Jeff seems to suggest that he was "lured in" with the $499 version.

The other $341 comes from a greater insurance and tech support plan and accessories, all of which Jeff had the choice to purchase. I personally resent the fact that he seems to be suggesting that Apple made him buy these additions. To make his point even more ridiculous, if you go to the Apple website and begin trying to purchase an iPad, all of the accessories are defaulted as "no", which is counter-intuitive if Jeff is right and Apple is trying to pull a fast one.

Outside of the error in trying to make Apple sound like a baddie is the justification for his splurging on additional memory. Jeff states: "As for stepping up to the 64GB iPad, my philosophy is that you can never have too much memory. I have no doubt that I will fill much of that 64GB within the next year or two. Speaking only for myself, the breathing space was worth the extra couple of hundred dollars."

I find this comment particularly hilarious, because if Jeff was most concerned about memory, why not have simply bought a net book, which for around $360 dollars can give you 290% of the memory and 60% more processing power than the 64 GB iPad? (the iPad only has a 1 GHz processor whereas most net books baseline at 1.6 GHz. The iPad beats net books in weight however by being roughly a pound lighter).

Jeff had essentially narrowed down the known universe of purchasable products to between the the higher and lower memory iPad 3G models because of prior selections he had made. When you consider the additional price he paid for the memory in the spectrum of the computing world, the extra cost/amount of memory added seems like highway robbery.

I think that Jeff speaks for a lot of Apple consumers in that his purchasing decision seems to have been driven by the presentation of the product and its ease of use. I'm personally too practical to buy a product who aside from it's touch screen and lower weight is already obsolete from a processing and memory standpoint, yet costs more than double that of competing net books. (granted tablets and net books are by definition not the same, but do accomplish similar tasks by being "mini-PCs")

This isn't the first time I've written about Apple products (see: Is Apple Really the Fourth Most Valuable Company in the United States? ), partly because I find the cult of product so fascinating with this company. If you were to ask a robot which he/she would be willing to pay more for, my guess would be the one that was the cheapest in terms of computing power/dollar (presuming the two products were made with the same quality of components). This doesn't play out the same way in the real world, and I think it's a perfect example of the impact of the "human factor": how presentation and ease of use can put value multipliers on products that are inferior from a hardware perspective.