Newsletter Q4 2005
October 16, 2005
The Residential Real Estate Boom and Consumer Spending
As the Economist magazine
points out, the housing boom is global in nature. Housing prices relative to
both rents and household income have reached record levels in the U.S. and eight
other countries: Australia, Britain, New Zealand, France, Spain, the
Netherlands, Ireland, and Belgium. Many analysts argue that this is an
indication that houses are more overvalued than at previous peaks.
Some regions of the United
States have experienced more dramatic price appreciation than others. For
example, as of September 2005, the metropolitan Phoenix area had a 47% increase
in the median price of a home over the previous year to a record level of
$263,000. Jim Sexton, owner of John Hall & Associates, said that there are now
about 15,000 houses listed for sale in Maricopa County compared to 6,000 in the
April-May time period. The inventory of houses for sale is rising and it is
taking longer to sell them.
The surge in home prices
has been accompanied by creative financing arrangements. In California, over
60% of all new mortgages this year are either interest only or negative
amortization loans, up from 8% in 2002. Nationwide, the figure is one-third.
The drawback of these types of loans that make housing “more affordable” is that
when the interest only or negative amortization period ends, the subsequent
principal amortization over the remaining term of the loan increases payments
substantially.
The link between home
prices, consumer borrowing and consumption is clear. While the value of U.S.
homes increased by 34.7% over the 10 quarters between January 2003 and June
2005, outstanding mortgage debt expanded by an almost identical rate of 34.5%.
Even though housing prices have surged in recent years, homeowners’ equity as a
percentage of the market value of household real estate has declined to 56.8% in
the second quarter of 2005 from the annual average of 58.6% during the 1990s.
In 2004, borrowing against home equity reached nearly 7% of disposable personal
income. Recent declines in housing prices in Australia and Britain have been
accompanied by abrupt slowdowns in consumer spending. As home prices level off
or decline in the U.S., consumer borrowing and spending will subside.
Accounting problems at
Fannie Mae (FNM) may eventually impact mortgage lending and the economy. Fannie
Mae was sponsored by the U.S. Government in 1938 to provide a secondary market
for home mortgages. The company now has a cost basis of $768 billion for its
mortgage portfolio and has guaranteed another $1,520 billion of mortgage backed
securities sold to investors. Earlier this year, FNM announced that it had
violated accounting principles in recording its derivatives and other
transactions, estimating a possible cumulative after-tax loss for the
restatement period from 2001 through mid-2004 of as much as $10.8 billion. In
addition, the Wall Street Journal reported on September 29, investigators have
found new accounting violations that include overvalued assets, underreported
credit losses, misused tax credits, and the possible use of finite insurance
policies to hide losses after they were incurred. The restatement of earnings
may take until the second half of 2006. Demonstrating a remarkable lack of
objectivity, the credit rating agencies have not lowered FNM’s credit rating
from AAA, in spite of the absence of reliable financial information, a thin
capitalization structure, and the potential delisting from the New York Stock
Exchange.
Additions
Chevron Corp. (CVX) is one
of the world’s largest integrated oil companies with proved reserves of 8.7
billion barrels of oil and 21.2 trillion cubic feet of natural gas. CVX sells
for 8.5X estimated earnings for 2005. According to McDep Associates, the
enterprise value of CVX is at a 25% discount to the present value of its
reserves (based upon $50 oil and $10 natural gas) and refinery operations.
Sinopec Shanghai
Petrochemical Co. Ltd. (SHI) is located in Shanghai and is one of the largest
petrochemical companies in China. SHI processes crude oil into a broad range of
products in synthetic fibers, resins and plastics, intermediate petrochemicals
and other petroleum products. For the six months ended June 30, 2005, SHI
reported earnings of $2.96 per ADR (ADR = 100 shares). In the second half of
2005, the company expects the supply of petrochemicals in China to increase
substantially due to the completion of large ethylene projects in Shanghai and
Nanjing. While Goldman Sachs has a neutral rating on the stock, it expects SHI
to remain a beneficiary of China’s oil product pricing reform.
Sonic Environmental
Solutions Inc. (SNV on Toronto Venture Exchange, SEVSF in the U.S. pink sheets)
is commercializing the use of sonic energy in environmental and industrial
processes. Its initial focus is the remediation of soils contaminated with
polychlorinated biphenyls (PCB). It is estimated that more than 1.4 billion
pounds of PCBs were manufactured worldwide for use in electric transformers and
other industrial uses before production was banned in 1977. The Canadian
Government has budgeted C$3.5 billion to be spent over several years for the
remediation of PCBs on federal lands. Estimates of the worldwide market
potential for PCB remediation exceed $40 billion. Sonic’s process is
recommended by the United Nations due to cost and safety advantages over the two
alternative remediation processes – “dig and dump” and incineration.
Transportable treatment plants that are deployed on-site cost about $2.5M each
and can generate about $5 million of free cash flow per year when operated for
two shifts per day. Sonic deployed its first commercial-size plant in June 2005
and is currently exploring potential joint ventures with several companies.
First Trust/Aberdeen Global
Opportunity Income Fund (FAM) is a closed-end fund that invests in foreign
bonds. Countries that account for more than 5% of the portfolio as of 6/30/05
are Russia, Mexico, Norway, Brazil, and Australia. Most bonds are government
issues denominated in foreign currencies. FAM currently sells at an 8% discount
to net asset value and has a dividend yield of 8.9%.
Deletions
Holly Corp. (HOC) was sold
during the quarter for significant gains. At the time of sale, HOC was selling
for about 14X estimated earnings and profit margins were at historically high
levels.
The Oppenheimer Strategic
Income Fund (OPSIX) was sold. OPSIX is a mutual fund that was received in
exchange for the Oppenheimer Multi-Sector Income Trust (OMS), which was merged
into OPSIX at net asset value.
UT Starcom (UTSI) was sold
at a loss after management announced lower expectations for revenue and earnings
during the second half of 2005. The announcement represented another negative
surprise from the company and upside potential appeared limited.
Aspen Insurance Holdings
Ltd. (AHL) was sold. At the time of sale, Hurricane Rita appeared likely to
result in lower earnings estimates and the remainder of the hurricane season
might result in additional earnings reductions.
The American Century
International Bond Fund (BEGBX) was sold to provide a source of funds for
closed-end funds selling at a discount to net asset value and individual foreign
government bonds.
Updates
Sinovac Biotech Ltd. (SVA)
announced that it received a government grant for the development of an avian
flu vaccine for humans. The company also received a $4.9 million commercial
line of credit from a Chinese commercial bank at a preferential rate of 5.31%.
SVA is in the process of raising more capital to expand production. After a
recent presentation at the UBS Global Life Sciences Conference in New York City,
there is additional interest in the company from institutional investors.
Methanex Corp. (MEOH)
announced that it would cease production of methanol and ammonia at its Kitimat
(British Columbia, Canada) site on November 1 and convert the facility to a
terminal operation. MEOH also will be ceasing production at its 500,000 ton per
year Waitara Valley plant in New Zealand. At both facilities, the higher cost
of natural gas made the economics unfavorable. Methanol can be produced at a
lower cost at its facilities in Chile and Trinidad, which have long-term
take-or-pay contracts for natural gas at favorable prices.
If you have any questions
regarding your accounts, please do not hesitate to call me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.