Force Majeure

FALLS CHURCH, Va.–During economic slowdowns, owning cyclical stocks isn’t the best bet. Furthermore, the coal trade has been crowded of late, and many of the companies are trading at high multiples. But given coal prices and the infrastructure problems, things can improve for coal companies before they get worse.

Heavy rains are taking a toll on Australia’s coal production, causing insurmountable damage. Some of the largest producers in the world have been affected, and they’ve suspended work because of the damage.

Many of the small producers have also been hit hard. Some have even declared force majeure–a legal clause allowing a company to cancel contractual obligations because of circumstances beyond its control.

At the same time, many of the transportation routes have been affected, and rain has also halted loading at the same ports. Because the transportation network has been working at full capacity–causing infrastructure bottlenecks–it will be difficult to make up the lost tonnage, at least in a timely fashion.

Similar problems are cropping up in South Africa, where electricity shortages are forcing producers to cut back on operations.

At the same time, coal prices in China are breaking to new highs as demand remains strong and supply is being curtailed. Although such strong prices can’t be sustained, the tight supply shouldn’t allow prices to fall dramatically. The Chinese, after all, consume more coal per year than the US and Europe combined.

The situation is so alarming that a few days ago US-based railroad company Union Pacific said that it’s been asked to move coal from Utah to the Long Beach, Calif., port to be shipped to China in containers. There are no bulk ships in Long Beach.

This has never happened before. The US domestic market is not only quite sizeable, but the rest of the world has been able to obtain coal from countries such as Australia, South Africa and Indonesia. Now that problems are disrupting supplies, US companies are exploring the opportunity. And it just may work.

Coal usually moves east in the US because the majority of the plants are on the East Coast and in the South. The biggest coal dock is in Baltimore, Md. But even that facility had its problems recently and was forced to close down. The main point, however, is that there are no routes that have been used to transfer coal to the West Coast.

As an aside, the next time someone tells you that the US exports technology and know-how to the rest of the world, ask him to think twice. The money is elsewhere, and the US still has the biggest coal reserves in the world.

The Silk Portfolio has exposure to the coal market though Yanzhou Coal (Hong Kong: 1171, NYSE: YZC). The company was incorporated in 1997 and is one of the four largest coal producers in China. It derives two-thirds of its sales from the domestic market, and it sells mostly to Japan and South Korea in the export market.

This is still the best way to participate in the coal upside, given the company’s pure coal exposure, and because about 55 percent of its sales are on the spot market. The company also sells higher-margin, semi-soft coking coal, which is also in high demand. Buy Yanzhou Coal.

Source: Bloomberg

It may be that the rally I mentioned last week (see Silk, 23 January 2008, The Fed is Your Friend) is already underway. We need a few more positive trading days for it to become a reality.

But given the uncertainty on the economic front—especially regarding how deep the US recession will be—should it materialize we should view it as a rally only, not the beginning of a new bull market.

Nevertheless, valuations are fairly attractive. And there’s plenty of pessimism out there, although not as much as I’d like. Then again, nothing is perfect in this world. If the US recession is mild, get ready to break out to new highs. Only time will tell.

To participate, follow the Fresh Money Buys, which give a balanced exposure to high-beta, more defensive (mainly telecom) ideas. Be nimble and ready to change course. Keep the hedges on.

Stock Thoughts

Melco PBL (NSDQ: MPEL) is up around 25 percent since last week and looks quite strong. Following last week’s discussion on the stock, new information reveals good things for Macau.

Macau’s gaming revenues in the first three weeks of January rose between 70 and 80 percent on a yearly basis and could surpass USD1.25 billion this month alone. During the same time last year, Macau’s revenues rose USD750 million. But if the strong January numbers carry on, revenue growth will easily reach the 30-percent level.

The VIP market–where Melco’s property is focused–has been responsible for these strong numbers. And although the long-term goal is for Macau to become a strong mass-market hub, there will always be room for the high rollers. After all, they’re the ones who can support the market during times of economic uncertainty.

All the statistics point to strong demand. And the fact that no meaningful table capacity will be added this year only makes the case stronger. (No major casinos are due to open this year.) Macau’s table capacity increased by 58 percent last year, the bulk of that boost coming at the end of the year after the opening of the Venetian and the MGM Grand. And it seems now that the market needed some time to absorb the increase.

Once again, investing in Macau is quite risky. But given the long-term potential and the beating the stocks have taken, now’s the time to add to positions. Melco PBL is a buy.

Dr. Reddy’s Labs (NYSE: RDY) reported disappointing earnings; sales were down 20 percent and profits sank 45 percent.

Operations in Germany were the biggest disappointment, and it will take some time for management to turn around its newly acquired business there. The problem in Germany is pricing weakness; Dr. Reddy’s is trying to offset that weakness through higher production at its Indian facilities.

Dr. Reddy’s manufactures and markets pharmaceutical products. The company has three bulk-drug manufacturing plants and one formulation manufacturing plant. It exports to the US, UK, Switzerland, Germany, Spain, Russia and the Netherlands.

The stock has been a Silk Portfolio holding for some time because of its cheap valuation and its potential as an acquisition target. Although the stock price will remain weak short term, it continues to offer long-term value and should be picked up at current prices. Buy Dr. Reddy’s Labs.

As shown in the Fresh Money Buys, I’m still fond of Hong Kong. Bank of China Hong Kong (Hong Kong: 2388, OTC: BHKLY, BoCHK) is my favorite bank there, and I expected it to continue benefiting from the real estate strength in the Special Administrative Region (SAR). See Silk, 9 January 2008, Difficult Times for Longs for more.

Mortgages account for 26 percent of total loans, and the company surpassed HSBC last year to become the largest mortgage originator with a market share of 17.5 percent. At the same time, the bank has limited exposure to subprime (it’s AAA-rated and has no collateralized debt obligations), small enterprise loans (12 percent of loans), and China (7.3 percent).

BoCHK does own US corporate paper, and 50 percent of its bond holdings are denominated in US dollars. The majority of its holdings are in banks and other financial institution paper (57 percent) and corporate bonds (27 percent). I do like the latter exposure, but I’m worried about the financial side. I view this as the main risk to the company, aside from a total collapse in the Hong Kong mortgage market and economy. Buy Bank of China Hong Kong.

As always, it’s better to purchase Hong Kong stocks locally. Most serious brokers now offer this option for US-based investors. Liquidity is a plus in both up and down markets. Alternatively, you can buy the stock on the US over-the-counter market.

Fresh Money Buys

The investment process is constant. So if you’d like to add to your positions in portfolio recommendations or allocate new funds in a diversified way, focus on the following markets, in order (for both countries and sectors). Consult the portfolios on the left-hand side of your screen for details.

  • Russia (energy, telecommunications)
  • Hong Kong (real estate, banking, infrastructure)
  • South Korea (banking, electric power)
  • Philippines (telecommunications, real estate)
  • India (pharmaceuticals)
  • China (consumer, telecommunications, coal, e-commerce, oil)
  • Singapore (banking, telecommunications, industrial, water)
  • Taiwan (telecommunications, ETF)
  • Malaysia (ETF)
  • Macau (gaming)
  • Europe (industrials, communications equipment)
  • Japan (banking, industrials)