Finance Theory

Unfathomable Miscellany

By, 05/04/2007

We like unfathomable things—they're the stuff good investments are made of. Fathoming what others cannot is the best way to get excess returns others cannot. Today's news features a number of unfathomable developments.

1. A Bunch of Yahoos

Many have touted the M&A boom of the last several years, but few can fathom a giant like Yahoo! being bought. And if it were to happen, it must be a perilous thing. The big market rumor of the day hinged upon Microsoft and Yahoo! in renewed talks to merge.

First, Yahoo! isn't even that big. With a market cap of about $38 billion, it's actually a lot smaller than the weighted average market capitalization of the MSCI World Index. A +$38 billion merger may feel big, but specifically within the context of Microsoft's tremendous financial might it's not something to be completely nonplussed about.

This brings up a larger point: high M&A activity doesn't just bring big premiums to companies expressly being acquired. We're fond of saying "If CEOs don't get their share prices up, someone will do it for them." Here's a great example. If a company's share price is too low they become takeover targets. In an environment where a cash hoarding giant like Microsoft could conceivably purchase Yahoo! (and with mostly cash mind you), Yahoo! executives either need to figure out a way to bolster share prices to make a merger uneconomic, or they will eventually get bought. Either way, the share price is facing a lot of pressure to rise.

The market knows this. Whole industries can get bid up on merger speculation. Savvy investors realize, one way or another, share prices have to rise in aggregate because acquiring companies can borrow cheaply at today's long rates and purchase companies with higher earnings yields.

But fathom this: Yahoo! is pretty richly valued (a trailing earnings yield of a little over a percent) and yet it's still susceptible to Mergermaina. Many corporations around the world have earnings yields (the inverse of the P/E ratio) that are actually higher than long term borrowing costs…making them even more attractive.

One way or another, stocks are facing a big force trying to push them up. That's a great thing.

2. China hits a Gusher

There's pervasive pessimism about so-called "peak oil" and the long term supply of fossil fuels. PetroChina (China's top oil producer) announced the biggest Chinese oil discovery in half a century. The find makes PetroChina the world's No. 3 oil company after Exxon and Royal Dutch. The new deposit was found in Bohai Bay, and has around 7.5 billion barrels of oil equivalent. This due in part because of China's increased oil exploration efforts. In fact, PetroChina will likely outspend Exxon and Shell in new technologies to explore, drill deeper, and go further offshore to find new oil.

The point is very simple: there's now an economic incentive to embrace new technology to tap the world's oil reserves in places that heretofore were too dear. The era of "easy oil" might be indeed over, but that doesn't mean it's all over for fossil fuels.

More importantly, this isn't a signal oil prices will plummet anytime soon. It will take years before PetroChina, or any untapped oilfields owned by any company, can actually begin producing the extra black gold.

The main reasons for record gasoline prices don't have much to do with oil supply. It's about the refineries and demand. Many refiners have been down for maintenance, driving inventories lower. Plus, very high gasoline demand, both in the US and abroad, are pushing up prices. In fact, Europe is demanding so much gas, the US is having trouble importing it in the same quantities as last year! These are signs of a world economy chugging along, and that energy prices will remain high.

3. They're Buying What!!!???

Those crazy hedge funds are at it again. Ellington Management Group has bid $58 million for home-mortgage loans from New Century Financial. Who would want all those nasty, defunct, high risk, subprime loans!? And that's not all! The sale of New Century's loan-servicing operation is set to happen soon, for as much as $130 million.

Ellington Wins New Century's Loans With a $58 Million Bid in Auction
By Peg Brickley, The Wall Street Journal (*site requires registration)
http://online.wsj.com/article/SB117823696592891559.html?mod=home_whats_news_us

We say: fantastic! This is the financial market telling us the credit market is in good shape. The so-called "vulture funds," looking to buy up these loan assets on the cheap, aren't doing it out of the kindness of their hearts—they see intrinsic value in holding the subprime loans. This is a sign of overall market stability, not increased risk.

More importantly, have a closer look at the numbers: $58 million and $130 million. This is a mere pittance in comparison to the multi-trillion dollar residential real estate market, and even smaller held next to the gargantuan US and world economies. Today's subprime loan woes are a small thing, not a big thing, and won't sink stocks or the economy.

This is truly a Friday for the unfathomable.

Have great weekend.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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