Notes on Archer-Daniels-Midland (ADM)

ADM is one of the largest grain processors in the world. The 4 major segments are 1) Agricultural Services - which store/transport/trade commodities, 2) Corn Processing – this turns corn into sweetners and starches. Importantly this segment also includes ADM’s ethanol operation. 3) Oilseeds Processing – where ADM does crushing & origination. Soybean related products are key here. 4) Wild Flavors – a new segment that does specialty food ingredients.

Why am I looking at this in the first place? My bull hypothesis is as follows: 1) As a processor that takes soybean and corn as inputs, weakening commodity prices should help ADM’s margins. 2) Despite the cyclicality, over the long run demand for ADM’s products should be very stable. 3) As the world consumes more proteins, ADM’s volume should grow at higher than GDP.

I also think ADM is a good company to track due to availability of related data. I can monitor data from commodity futures and USDA to constantly update, prove, or disprove the above hypothesis. Things like soybean crush spread, ethanol prices, currencies are available in real time and inform one’s view on ADM.

Segment Contribution and Drivers

Here is a quick rundown of each segment’s contribution to operating income (last twelve months), as well as their drivers:

Oilseeds processing (42% of operating income)

• The key grain here is soybeans so I compared current soybean crush spread against historical levels. Current industry crush spreads (see appendix at the end of the article) are near all-time high but declining, which points to downside for ADM. My first bull hypothesis – that declining commodity prices should help ADM’s margins –thus appears already played out and in fact fading. 
• However, ADM’s oilseeds margins (in terms of $ per ton processed) were stable the past few years even as industry crush spreads fluctuated. My guess is ADM will be relatively stable when industry spreads decline as well. But I certainly would not count on much upside from margin expansion. 

Corn processing (24% of operating income)

• Operating profit from ethanol was down ~$220mm in 1H2015. Some of that will be recoverable as ethanol margins recover, creating upside in the segment.
• However, it seems that analysts are already building in ethanol price recovery (perhaps due to expectations of oil price recovery). Consensus has EPS of 3.08 and 3.40 for 2015E and 2016E. This 10% growth will be hard to come by without ethanol at least stabilizing. Besides, the days of $100 oil are over and ethanol margins are unlikely to fully recover to past levels.

Agricultural services (27% of operating income)

• This is storage/transportation/trading…etc. Historically profit here relies on level of US exports, which is a function of how competitive US is versus say, Brazil. With USD strong and the Brazilian real weak, this segment is unlikely to see much advantage. The near upside here is 1) El Nino somehow destroys Brazilian crops, and 2) US has a great crop. 

Wild Flavors (6% of operating income). This could be a growth area for years to come but not enough to offset the importance of the other segments.

Upside Assessment and Current Action Plan

Looking through the main segments, I just don’t see much earning upside beyond those already factored into the consensus. Thus returns will have to come from multiple expansion, which will likely happen if ethanol stabilizes and exports don’t fall apart. In terms of valuation, right now it trades at 11.9x TTM vs 10yr median of 13.3x. That’s a 12% upside from recovery in multiples. In terms of downside, soybean crush margin can weaken, ethanol stabilization can come later than expected, and Brazil and China can enact policies that hurt US competitiveness and export levels.

This is not enough for me to get in. For now I will sit on the sidelines and wait for fundamentals to get better.

Appendix: Historical soybean margins

I calculated these from front month futures data and the formula Soybean crush = soybean oil (in cents/lb) * 0.11 + soybean meal (in $/short ton) * 0.022 - soybean prices (in $/bushel).  The crush spread is still higher than historical because soybean meal is a larger contributor than soybean oil, and soybean meal prices has not came down as much as the others.

Australia’s Trade with China: Export Iron Ore, Import Women

Australia’s latest balance of payment data included a special case study on trade with China. Scroll to the bottom of that link and you’ll see some interesting stats. 

These male to female ratio looked a little skewed? Especially we’re talking about China here - a country known for too many men.

And Australia gets them young too.

I knew Australia has a trade surplus with China, but I didn’t know it was this good!

Miscellaneous Thoughts about the Market

Here are some thoughts I had about the market in recent weeks. The first 2 sections explain why I think the S&P 500 is still overvalued eve after the recent drawdown.

Earning growth expectations for 2016E still unrealistic

Below are revenue and earnings performance of S&P500 for past 10 years, 2016E data are based on analyst estimates. (I got the data from here)

Notice that in 2016E S&P revenues are supposed to grow 6.3% and earnings 10.5%. Digging deeper into the Factset file referenced above, you can see this is because the analysts are assuming 1) energy sector rebounding sharply, 2) all time high margins.

These assumptions strike me as unrealistic. Regarding the former, the energy sector is expected to grow 19% in 2016 – and this is after being revised downward from 34% a few months ago. The risk is if oil stays lower for longer that 19% earnings growth may not pan out. Regarding the latter point, how we’re supposed to see all time high margins is beyond me, especially when margins have been trending down in recent quarters.

Even if energy sector rebounds sharply, forward P/E multiples should not be high because that’s a one-off rebound, not a recurring growth pattern.

The idea of “low rates justify higher forward P/E” is double counting

Two most often heard reasons for high valuation multiples the past year are 1) low rates, 2) growth. The theory is that the “justified” P/E ratio is calculated as dividend payout divide by (required return on equity – growth). Where required return on equity is defined as risk free rate + “equity risk premium”. Leave aside the equity risk premium which is not directly observable, low rates and strong growth should lead to higher valuation multiples.

This all seem very sensible but does not jive with the data – at least not the rates part. If you run a regression where y = earning yield, X1= 10yr US Treasury rates, X2 = earnings growth, the result (which surprised me) would show that interest rate is NOT a significant factor at all!

I find that counterintuitive – obviously low rates should force up equity prices, no? I think it’s because much of the impacts of low rates are already reflected in growth. If you think about it, low rates are supposed to drive more investment and consumption, which lead to higher earnings growth. So the idea that lower rates justify higher forward P/E ratios is double counting – because the impact of low rates is already reflected in higher forward earnings.

Random Thoughts

How can stock prices be random? When people say stock prices are random, what does that even mean? S&P500 is around 1920 today. So you mean to tell me SPX is as likely to be at 20,000 tomorrow as it’d be at 1940? That’s nonsense. Or are they saying returns are random? So SPX could return 5% next year, or it could return 1030%? That’s clearly absurd also.

I think what they meant is that returns follow a normal distribution or some other probability distribution. But you don’t know what that distribution is. Now that seems likely. But still, “random” would imply stock prices have 0 correlations with fundamentals such as earnings movements. That’s clearly false.

So what do people really mean by “random”? Most likely, it’s just code for saying “it’s so complicated that I can’t figure it out”. I’m not sure they tried.



You don’t believe government can pick winners and losers. So why do you think you can?  Lots of reasons here. Somebody has to win. Besides, investing is not just picking winners and losers, valuation counts too. You buy a “winner” company at 100x free cash flow and you’re going to be a loser.



Day trading is a sad way to live. With the market turbulence, I found myself looking at charts of S&P futures all day. I drew lines of support and resistance and gaps. I looked for breakouts, failure to breakout, and “fake outs”. At one point I found myself checking the charts every hour, staring at minute by minute candle charts of ES Sep’15 oscillating between 1930 and 1950. This is all quite miserable, so I stopped. No day trading for me.

Learning Some Commodities

I spent the past few weeks learning about the futures market, as well as various commodity classes. The reason is I am having a tough time taking directional views of stocks given the generally high multiples, so I prefer relative value ideas instead. But relative value comes much more naturally in fixed income, currencies and commodities. I also hope what I learn here help in my equities investments when the time is right. Some notes here.

Waiting for Back Ended Oil Contango to Normalize

Exploration and Production (E&P) stocks seem to be still pricing in $60-70 oil in the longer term. However December 17 and Dec 18 futures are trading around $54 and $57 respectively. So I’m still waiting for E&P stocks to fall further. But we’re getting there.

Term structure of futures is supposed to tell you market’s future view of storage capacity, cost, and inventory. These things are in turn dependent on the market’s forward view of production and consumption.

Crude oil is currently in an oversupply position so I’m not surprised that the front end of WTI futures (CL) is showing some contango. But this condition extends to the back-end too. Below shows how the spread between Dec 2018 and Dec 2016 evolved over the past year. (This is Dec 2018 minus Dec 2016, so higher = contango).

I read this as the market saying oil will be way oversupplied even in December 2016, thus demand for storage will still be high (implying the market still expects a turnaround in oil by December 2018). That seems inconsistent. By 2H16, if we still have an oil glut I would think the market would be convinced that cheap oil is here to stay (perhaps due to technological advances lowering marginal cost of a barrel), then the back ended futures should come down as well. Term structure should normalize.

I would prefer betting on term structure to normalize than taking a pure directional view. Maybe short Dec 2018 futures and buy Dec 2016 and just keep them there. This would be better than trying to pick a bottom by going long front end futures (and risk sell low / buy high on each rollover)

Additional Notes

The mathematical definition of contango is “convenience yield” < (interest + storage cost). Where “Convenience Yield” is a plug, a calculated number you back into. As such, “convenience yield” reflects a mishmash of miscellaneous factors including not just the value of having it now (“convenience”), but also sellers’ desire for insurance, arbitrageurs expectations, speculator sentiments…etc. So a contango could be due to a few possibilities, the main ones are:

• Trade buyers: well stocked already so no one wants more oil now. Value of convenience is low.
• Trade sellers: low need for insurance (else they would have sold futures and push back-end future prices down)
• Storage providers. Inventory level is high and storage capacity could be running out. So storage cost is bid up.
• Speculators and arbitrageurs. Their actions could just be trend following or be based on nuanced view of future balance.

Some people (like Gartman here) argue that futures term structure have NOTHING to do with future expectations of prices, but just a function of supply/demand and storage cost. That sounds like a smart thing to say but they are really just playing on semantics. All supply and demand have some element of participants’ future expectation - if oil trades at $10 and you expect spot prices to be $100 a year from now, you would buy now, store some oil and sell in the future. You would not only impact the supply and demand of oil, but also bid up storage cost in the process.

The Great British Pound Appreciation of 1996-1997

Above is the historical trade weighted exchange rate for British Pound. Since the latest 80’s there are 3 episodes of big moves. First a gap down around 1992, then a big spike up from second half of 1996 to early 1998, and finally the collapse from 2H07 to end of 2008. The last one is straightforward– the Great Financial Crisis really started in 2007 after the subprime bubble popped. The first one I know also. That was Soros and Druckenmiller breaking the Bank of England.

But what about that big run up in 1996-1997? What happened there?


The Bank of England does a great job of archiving their old reports, and one can quickly figure this out by searching through their Inflation Reports from 1996-1997. What happened was a rare combination of 1) monetary divergence, 2) fiscal divergence, and 3) political uncertainty in the rest of Europe.

The monetary policy part is fairly similar to what’s happening today. Back in 1996 the market expected other European countries to lower their rates while Bank of England was expected to tighten money.

But that was only part of the story. The real driver there was countries gearing up to join the Euro system. Keep in mind this is 1996 and the Euro did not exist yet. Other European countries were preparing to join the EMU and they had to meet the “Maastricht convergence criteria” – which would require them to reduce budget deficits. Here’s how the old BOE report explained it:

“A reduction in planned fiscal deficits abroad—such as that taking place on the Continent to meet the Maastricht convergence criteria—would tend to reduce interest rates there, both because lower deficits raise national saving and because fiscal consolidation may reduce aggregate demand in the short run. The exchange rates of the countries undertaking fiscal consolidation would depreciate as financial capital sought higher returns elsewhere”

And this: 

“the portfolio shift away from currencies of countries most likely to participate in EMU may also have reflected higher risk premia because of the uncertainties involved”

To prove the importance of the EMU and Maastricht convergence, BOE’s November 1997 report even had an interesting study showing that the Italian Lira and Deutsche Mark were getting increasingly correlated, while Sterling/Mark significantly less so. 

So there, a combination of monetary divergence and expected fiscal divergence (due to the advent of Euro) caused the GBP to revaluate upward in 1996-1997.

Here’s what I couldn’t help wonder though: how much of U.K. not joining the Euro could be attributed to its humiliating experience in 1992 trying to tie a currency? Is it possible that Soros, Druckenmiller, and the currency speculation world “taught” U.K. the importance of having an independent monetary policy? Without Black Wednesday, could U.K. have ditched the GBP for the EUR?

If so, Soros and gang might have "broke" the Bank of England, but they saved the GBP.

Shorting AUD/USD: on FDI and Reflexive Potential

Summary Reasons for Shorting AUD/USD

• Technical downtrend is intact
• Demand of AUD will be weaker in the future due to lower FDI and portfolio flows. Trade balance is negative but that’s a less important factor in my mind.
• Factors that make AUD’s “reflexive” – price movement here can be self-reinforcing, rather than self-correcting 

Shorting AUD/USD is a fairly popular trade. Here are what I gather as the most cited rationales for shorting AUD/USD. Australia's main exports are iron ore and coal but prices for which have fallen and will likely stay low due to weak demand from China. Trade balance will deteriorate. The Reserve Bank of Australia thinks further depreciation is necessary and will keep rates low or even cut rates to stimulate the economy.

I agree with that line of reasoning, but trade balance and lower interest rates are not the only reasons that AUD will continue to depreciate. Going forward, in my opinion, foreign direct investment and potential for “reflexivity” will be bigger drivers of AUD decline.

Importance of Foreign Direct Investment

In the chart below, I used balance of payments (BOP) from 2006 to 2014 as proxy for historical inflows and outflows. Australia has persistently ran trade deficits and even bigger primary income deficits. What propped up demand for AUD in the past few years were foreign direct investments (FDI) and sometimes portfolio flows.

Note how trade balance is a relatively minor contributor versus other flows. Primary income is mostly stable while portfolio investment is fickle (and likely negative going forward). FDI though, has been consistently strong, but will likely deteriorate drastically going forward.

FDI is concentrated in the mining sector (~roughly 40% of foreign investment in Australia), and that is likely to drop off given prevailing weakness in commodity prices. Demand from China will stay weak given its continued shift away from an investment driven economy.

Reflexivity - Quick Background

But how much of that is already priced in? That’s always tough to know. A different question though, is will lower exchange rates hurt economic fundamentals and lead to even lower prices? i.e. is there a reflexive relationship here? I think so, but first a quick summary of George Soros’ reflexivity framework (as it relates to currencies) is as follows:  

• Prices are driven by different factors of supply and demand. Some of these factors are self correcting, and some are self-reinforcing. 
• Self-correcting means weaker prices -> improving demand vs supply -> stabilization in prices. 
• Self-reinforcing means weaker prices -> deteriorating demand vs supply -> further weakening in prices. 
• To see if a trend will continue, an analyst can break down price into different sources of supply/demand, and determine if self-reinforcing flows outweigh the self-correcting ones. 

In the context of foreign exchange:

• Price = nominal exchange rates. Supply and demand are inflows and outflows in the balance of payments items. 
• Trade balance is typically a self-correcting: lower nominal currency -> lower real currency -> better trade competitiveness and trade balance -> stabilization of currency 
• Portfolio investments tend to be self -reinforcing: lower nominal currency -> expectation of even lower FX -> expected currency losses tend to outweigh interest rate differentials for bonds and detract from equities returns). 
• FDI could be either self-correcting or self-reinforcing 

Analysis

With that background, here’s why I think AUD/USD will be a reflexive situation that keeps driving downward.

1. The main self-correcting flow, trade balance, is a relatively minor factor here (as shown in the BOP chart above). Further, Australia’s trade balance will likely see less improvement from currency devaluation due to its unique situation. Lower prices of main exports (iron ore and coal) is not going to help much if the problem is structurally lower demand from your customer in the first place. Australia’s main competitor in iron ore is Brazil and that currency is even weaker. So Australia is not going to get much of a boost in trade balance from weaker AUD.

2. FDI is likely a self-reinforcing flow in this case – weaker AUD will lead to weaker FDI. Remember again, FDI for Australia is big in the mining sector. With commodities, prices are in USD but local production costs are in the local currencies. When Australia and Brazil’s currency weaken versus the USD, local costs are effectively lowered and that will pass through to lower commodity prices. Would you invest in a mining project when 1) commodity prices will likely stay low or get even worse, and 2) the sector already has excess capacity? I don’t think so.

3. Portfolio inflows are self-reinforcing. For Australia, portfolio flows are mostly debt securities as opposed to equity. 10 year government bonds for Australia yield ~2.85% versus ~2.25% in the United States. What little extra yield you get from investing in an Australian bond could easily be overwhelmed by movements in currencies, which is decidedly negative in this case.

My conclusion is that the downward move in AUD/USD will continue, because the self-reinforcing elements (FDI and portfolio outflows) outweighs the self-correcting mechanism of trade balance.

This may take a while to play out though, and you incur negative carry on the trade. So timing and technicals do matter. AUD/USD hovers around 0.74 at the time of this writing. I am short and have a stop loss around 0.77 and my eventual target is as low as 0.65. The risk is if Australia comes out with massive investment project (develop North Australia for example) and attracts money from abroad. But that is unlikely in the current government and in any case unlikely to offset weakness in mining projects.

What Drives NZD/USD

In my last post I mentioned shorting the NZD/USD. At the time of that trade, I only had a rough sketch of the thesis: 1) the chart already showed a breakout to the downside, and I was waiting for a retouch to confirm the resistance level around 0.71, 2) I happened to be looking into Fonterra and had developed a negative view, but I thought NZD/USD might be a better way to implement that short. 3) a quick calculation of fair value based on BIS Narrow REER showed me that NZD could go as low as 0.60, thus a highly favorable risk and reward.

Then Reserve Bank of New Zealand announced a (surprise) rate cut on 6/11/2015 and NZD collapsed below 0.71. New Zealand is now lowering rates while US is raising rates. I also got my technical confirms and went ahead with the short. During the past 2 weeks that trade works really well - the NZD has went down so fast that I’m now reassessing the situation and bracing for a pullback (but staying short).

It was a bit of an “invest first, investigate later” type of situation, and I wanted to catchup in terms of understanding what drives NZD/USD over the long run. So I plotted the chart below with 1) NZD/USD, 2) the Dollar Index (DXY), and 3) NZD real effective exchange rate.

The cool thing about currencies is that they do move in long, multi-year trends. In the next section, I listed out the major up and downs over the past 2 decades and did some research to explain the drivers. The short-one sentence summary would be this: the drivers of NZD/USD are USD strength, NZ’s growth differential vs rest of the world, interest rate differentials, and commodity prices/terms of trade. I'd put inflation differentials up there too but that has a more indirect effect as it really drives the market through interest rate policies.

Summary of various NZD/USD trends

• 1988 (not shown on chart) 
• NZD collapsed from ~0.7 to ~0.55. NZ had stagnant growth and bursting of a commercial property bubble.

• Late 1996 – late 2000 – Big downtrend from 0.7 to 0.4
• USD was on a strong uptrend. US went through an investment boom and productivity spike which drove up USD’s real equilibrium exchange rate (think of a 2 dimensional plane with a) upward sloping savings – investment and  b) a downward sloping current account balance on the X-axis and real exchange rate on the Y-axis. The S-I curve is upward sloping while the current account balance curve is downward sloping. Here the USA have more investment, so the Savings - Investment curve would shift to the left, leading to higher real exchange rate)
• On the NZ side, in 1997 the economy fell into recession with after 2 summers of drought. NZ was also hit by the Asian financial Crisis.

•  2002-2005 – big uptrend. From ~.40 to .~74
• General weakness in USD. USD was overvalued at its previous peak, but the structural factors that boosted USD were now reversing. The downward move coincided with bursting of the dot com bubble, and the subsequent low US interest rates. 
• NZ has positive growth differential versus rest of world. NZ had a positive output gap and positive short term interest rate differential. Commodity prices were strong.

• 2005-2006- dip from ~.74 to ~.60 then a rebound
• The market believed that New Zealand was falling into recession, and GDP contracted slightly in December 2015. But this turns out to be a false alarm and GDP reaccelerated in 2006, and NZD/USD went on a strong rebound from 2006 to mid-2008 (~0.6 to >0.8)

• 2008/2009 - a massive dip during the Great Financial Crisis. There was another dip in 2011 when NZD fell from 0.88 to 0.74 due to prospect of Eurozone breakup.

• June 2011 – 1H2014: NZD/USD traded with general uptrend rising toward 0.89 
• Context for 1H14. NZD benefited from diverging monetary policy versus the rest of the world. The market had gotten used to QE with US, Eurozone, Japan all in monetary easing mode. But in 1H14 the RBNZ actually hiked rates. NZD benefited from strong interest rate differentials (both spot and expectations). Meanwhile Fonterra and the dairy sector enjoyed historically high prices, so the country enjoyed strong terms of trade which propped up the NZD.

• 2H14 to current.. big downtrend from 0.89 to 0.67
• US Dollar Index went on a big spike. 
• On NZ side, growth slowed and market had developed expectation of continued rate hikes which was not met. Dairy prices and commodity prices have collapsed. RBNZ came out with aggressive stance saying NZD is over-valued and actually intervenes to depreciate NZD. 
• By June 2015 RBNZ cut the Official Cash Rate and set expectations for further rate cuts. NZD/USD dropped below a critical support level.