This continues on the theme of the last post about long-term commodity valuation. Many people believe that commodity prices are inversely related to real (excluding inflation) interest rates. The argument seems appealing - if the opportunity cost of keeping your money in a commodity is low, its price should be higher than if the opportunity cost is higher. This is particularly true for commodities like gold, where the cost of actually storing the metal is minimal. It would be less for commodities that are hard to store. Here's a graph of gold. The absicca is the yield on ten-year TIPS, and the ordinate is (as before) spot gold / the US CPI, 1983 = 100. Unfortunately, the TIPS series started in June of 2003, so the time frame is not long enough for a complete cycle. In fact, it pretty much only covers the run-up to the GFC, the crisis itself, and the aftermath.

So the fit is pretty good, and it appears that gold is about fairly valued at current levels of real rates. However, I wouldn't put too much stock in the graph. As I said, it's based on a short series. Also, this analysis doesn't forecast where gold is going, only where it is (Funny how much easier that is!). To make a gold forecast you have to forecast where real rates are headed. My personal view is that real rates will very slowly move up over the next few years. This would lead to a flat to very slightly down market for gold. It's clearly not strong enough to make a directional bet.

Here is some work I have been doing on very long-term commodity prices. The first batch concerns the real price of a commodity vs. returns of holding that commodity over the next ten years. This was suggested by Schiller's work on long-term returns in US equities. The theory is that if the real price of a commodity gets too high (vs. overall price levels), new production will come in and slowly drive it down. This should lead to a mean reverting pattern.

Here are the graphs for gold and oil (WTI), but all commodities are quite similar. The gold scatter chart goes back to 1968. The oil chart goes back to 1947. I have a corn chart (not shown) that goes back to 1850! The reversion to the mean is quite strong, as shown by the negative slope of the scatter. What surprised me is how tight the relationship is: the gold log/log R-squared is 82%! Price forecasting models rarely get anywhere near that.

By this measure, virtually all commodities are expected to see negative real returns over the next decade.

More on Dean Foods and WhiteWave

Several  of my friends have commented that stock borrow is in fact available for WWAV. So if you want, you can go long DF and short WWAV. As noted in the previous post, this is a great fundamental play. I hope the shorts don't get too heavy. A thin stock like WWAV can be squeezed unmercifully.

DF also announced its third quarter earnings. Here are the operating income numbers, adjusted for last year's goodwill writeoff and a few smaller things.

                                             Q3/12          Q3/11      %Chng
Dean Foods Total                    $145           $107          35%
Whitewave                                 64               51          25
Legacy Dean Foods                   81               56          44

My takeaway is that the traditional milk divisions of DF are turning around nicely. Given the price at which you can buy these, this is a great deal.

commodityequity blogspot

Dean Foods

DEAN FOODS (DF)

Dean Foods is one of the leading milk companies in the US. Its product portfolio spans the most of the milk spectrum, including fresh milk, ice cream and yogurt. It is not strongly represented in cheese. Its market cap is about $3 billion.

Stockholders have had an unusual time investing in DF. In 2005 DF spun off its higher growth food products business as TreeHouse Foods (THS). Since then DF’s stock has fallen by almost half. THS however has more than made up the difference (assuming the stockholder kept both stocks). Milk is a mature market, and DF has attempted to consolidate the industry. Some acquisitions were ill considered, and forced subsequent write downs. In 2011 a huge goodwill write-down led to a loss of about $1.5 billion. Stockholders’ equity is now slightly negative.

DF is also heavily indebted. Total debt is now about equal to total assets. The interest rate on DF’s bonds ranges up to 9.75%. These are trading above par, so the company would like to call what it can.

Dean does have one big ace in the hole, its White Wave division. WW produces “healthy” milk products such as organic milk and plant-based milk substitutes. It is the US market leader in this category. This is a high growth and higher margin business. To better extract the value from this sector, DF has IPOed about 13% of the division under the symbol WWAV. The IPO was well received, and the stock is trading with a PE of about 27. DF will use the proceeds for debt reduction. It also intends to spin off the rest of WWAV next year. I expect that this will in fact take place since many of the top executives of DF are planning to go to WWAV. DF also intends to sell its Morningstar division for further debt reduction.

DF is a case where the first order numbers are terrible, but much better on a closer look. WWAV is priced at $16.75 (Nov 2). DF’s 86.7% of the remaining shares in WWAV are worth about $2.495 billion. Thus the rest of DF is being priced at about $640 million. Let’s see what you get for that value:

Stockholders equity is negative, so nothing there. However, the non-WWAV assets are still producing a substantial free cash flow. I like to look at “sustainable operating cash flow” which excludes transient fluctuations such as year-to-year changes in inventories, payables and income tax credits. I also exclude the non-cash goodwill write down in 2011.Note that WWAV income is pro forma or estimated.

All Data in ‘000s:

	2011	2010	2009
Net Income	(1,592)	83	228
Minus: WWAV income	97	87 est	81 est
Plus: non-Transients	322	312	293
Plus: Goodwill Adj.	2,075
Minus Capital Invst.	325	301	267
Equals Sustainable FCF	384	7	172

So the $640 million of non-WWAV value has produced about $562 million in FCF in the last three years. In fact, the above table may even be conservative, since much of the capital investment likely goes to WWAV and will end after the spin.

This looks like a great value, but there are some major risks. First and foremost, the value of WWAV may be too high. The PE is in line with some other fast growing health food companies, but the whole sector may be expensive. Bear in mind that this is a story stock and will have to grow into its valuation. Like all growth stocks, an earnings miss or a change in the story could ruin things very quickly. Also, the stock is thinly traded. Once the full spinoff is made, the scarcity value will dissipate.

One could hedge this by shorting WWAV, but I doubt that this is reliably possible. The borrow may be available now, but it will probably be sporadic.

DF is also going to sell its Morningstar division to further pay down debt. They claim expect more than$1 billion for it. We will see. Even if this goes through, it is hard to see DF returning much if anything to stockholders for awhile. The company has a major task in rebuilding its balance sheet.

There is some commodity risk to DF since higher grain/oilseed prices would impact milk production costs. Since the current very bad crop is on everyone’s minds, I’m willing to take this risk. Note that if grain supplies get truly tight, the government could change the ethanol mandate.

Finally, DF has a pretty concentrated customer base, including bigwigs such as Sysco, Wal-Mart and Target. They have been selling to them for many years, and presumably have developed an understanding on profitability metrics. However, this kind of concentration is always risky, so keep it in mind.

Even with these risks, this is an interesting play. The company is generating a lot of cash. As they pay down/refinance their debt, this will increase. This cash will stay in the company for a few years, but it still belongs to the stockholders. If this keeps up, there will eventually be a dividend. I’m intending to take a small long position in DF and follow the company closely. After the WWAV spin, I might take a substantial position.

Is The Public Getting Back Into Stocks?

For the last few years bullish commentators have gone on and on about the avalanche of cash on the sidelines. If retail were want to get back into stocks, this could lead to an old-fashioned buy-the-dip bull market. But until recently, it just has not happened. Retail has been more interested in bonds or, at most, low-beta dividend stocks. Reported flows in and out of mutual funds and ETFs confirm this: bond assets are up and stocks are down.

Is this about to change? Mutual fund flows only come with a lag. ETF flows are reported daily. I track these ETF flows; here is a graph of cumulative flows since June.

(click to enlarge)

The big US stock ETFs include SPY, QQQQ, IWM and XLF. This graph includes all such ETFs. Note that cumulative flows into US equity ETFs (the green line) started to take off in early September. As you would expect, the initial advance was correlated with a rise in the overall market (SPX). However, the rise has continued even with the market's stall at around the 1440 level.

Here's another chart.

(click to enlarge)

The brown line is flows into leveraged funds (These are mostly stocks, but also include alternative assets and bonds.). This had been trending down quickly, indicating the fast money was getting out of the market. It may be turning around.

The past three years have seen a major bull market that has been frustratingly difficult to trade. This is because moves happen quickly, sometimes instantaneously. If you are not positioned before the move, you miss it. This is typical of a market without laggy participants. If retail is back, maybe this will change.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

I wouldn't be too quick to sell today's EU-based rally. Something seems a little different here. First, the communications from this meeting seem quite different from previous ones. No one is declaring victory. Second, there does seem to have been some real give on both sides, particularly the German side. Finally, the ECB bank supervision, if it really comes, will be a game changer. Until now, the banks in the Med. countries have been pretty much cash machines for the politicians and politically connected real estate interests. If that changes, it's a big deal.


So I only took a token of my long positions off. In fact because of my long gamma, I am longer than yesterday. We shall see....

Value vs. Growth

Using The Vanguard funds: