Trojan Investing Newsletter Volume 2 Issue 2

Trojan Investing Newsletter November 13, 2008 Issue 2 - Volume 2

Welcome Trojan Investors! We would like to thank our contributors and those who have invested their time and effort to make the Trojan Investing Newsletter all that it can be. If you are interested in contributing or editing, please contact us at [email protected]. For those of you who are new to the TIN, read on to find out how you can benefit from joining our readership. Through issues distributed at the beginning of each month, the Trojan Investing Newsletter hopes to bring ideas together that stimulate new ways of thinking to benefit you as an investor. Through critically analyzing economic and sector/industry trends as well as individual securities, we hope to provide you with new insight into how to view the world as a place to invest. We are affiliated with the Trojan Investing Society, the premier finance and investing club at USC. The weekly TIS meetings are a great place to come to express your opinions on the articles written; and where the contributors of those articles will have a chance to answer any questions you have. Being allowed access to a variety of investing ideas through this forum provides our issues depth and breadth that we would otherwise be unable to afford our readership. We sincerely hope that you find our newsletter to be interesting, informative and most of all, enjoyable.

Inside This Issue Trend Analysis Aerospace and Defense, Defensive Play?...p.2

Investment Analysis GS - An Uncertain Future....................... p.4

Learning Center Naked Puts As Limit Orders.................... p.6

Market Performance Snapshot 1-Oct Dow Jones 10,831 S&P 500 1,161 NASDAQ 2,069 Russell 2000 671 10-Year T-Bill 3.768

31-Oct 9,336 968 1,720 537 3.97

Return -13.8% -16.6% -16.9% -19.9% 5.36%

“When you’re in a pit, the first thing to do is stop digContributors: ging.” Joshua Inouye, Richard Graham, Alexander Muhr -James Ellman -Trojan Investing Newsletter Staff

Co-Editor-In-Chiefs: Alexander Muhr Jordan Ohama

Disclaimer: Views expressed in this newsletter are not those of the University of Southern California or any of TIN’s affiliated groups, but the author’s own. Recommendations are made by students, not financial professionals. Readers should not rely on information from the following articles or the recommendations therein for trading or investing. The purpose of this newsletter is to facilitate discussion and broaden students’ awareness of current market issues. This newsletter may contain references or links to websites that are created and maintained by other organizations. TIN does not necessarily endorse the views expressed on these websites, nor does it guarantee the accuracy or completeness of any information presented therein.

A “Defensive” Play? By Alexander Muhr

Price volatility has also been a major factor in decision-making at aerospace and defense firms – where we have only seen Written on: Oct. 20, 2008 3-month historical volatility like now since early 2003 (~65%) In general, aerospace companies – especially the largest ones – and right now we are seeing the same measure spiking to new need immense amounts of capital in order to develop, design highs above 60%. and manufacture their systems or vehicles. Beyond the need for capital, they are also vulnerable to the governments they service, commodity prices, their manufacturing employees, and subcontractors. These dependancies force companies in the aerospace industry to have a diverse set of customers as well as scale in production. There has been a lot of consolidation over the years due to these dilemmas, and many of the remaining players in the industry are large and diverse Products from this industry segment include: • Commercial and passenger aircraft • Military aircraft • Weapons and intelligence systems • Satellites Light Sweet Crude Contiunous Contracts, Nov. ‘05-Current Aerospace is a highly cyclical industry. In a strong economy, more people travel and exchange goods; requiring the transportation services provided by this industry to get business done. During these periods, governments reap the benefits of increased tax revenues and are able to spend more on defense products or other capital-intensive projects contracted to these companies.

Source: Stockcharts.com

One of the biggest impacts of the oil price spike is the pwnage of the airlines industry. The recent price spike has caused many airlines to second-guess expansion plans and cancel orders for planes from stalwarts such as Boeing (Ticker: BA) or EADS. Boeing reported that past quarter plane deliveries are down 23% (25 planes) and over the same period Here are a few themes that investors should focus on in this from last year they are down 33% (42 planes) in its recetly released quarterly (SEC 10-Q) report. industry segment: Government Clientele In 2008 and for the past decade, the US stands out as the unchallenged global leader in terms of the dollar amount. spent on aerospace defense. According to GlobalSecurity. org, which has updated the defense budgets of many differFuel Prices Crude oil prices are obviously one of the main factors that ent countries, the world spending in aerospace defense totals influence how airlines and commercial shipping compa- at least $1.2 trillion dollars. nies operate and expand. Without a stable price or a price at which the firms are profitable, investments in new air- According to the CIA World Factbook, the United States planes or related services decrease. In recent months, is ranked 28th in the world in terms of military spending both extremely high fuel prices and volatility have caused as a percent of GDP – 4.06% (2005 estimate). This is only many companies and governments to decrease spending. including the base budget for the Department of Defense, while other spending may happen under other departments, Currently, crude oil prices stand at $63 per barrel, and for depending on the purpose. From the 2005 budget if the US December 2009 that markets are forecasting $69 oil, while Government we can see that in reality, the comparison to for December 2016 the market expects $85 per barrel of oil. GDP is quite small, even though the amounts might seem

1. Fuel prices – recent and anticipated 2. Government – US and international defense spending 3. Air Traffic – this includes for commerce and travel

huge, but that doesn’t preclude the funds from being taken.

and efficiently transfer them.

For 2009 the Department of Defense has requested $515 billion for its base budget (74% over the 2001 level) and $70 billion in emergency allowances to fight the Global War on Terror.

According to the Bureau of Transportation Statistics, since 1981 (to 2007) “Over-all available ton-miles” for air transportation grew from 61.24 billion to 204.33 billion, an annualized growth rate of 4.55% (BTS). Although the growth rate has slowed to 3.03% per year since 2001, the ability for airplane sales growth still exists due to the aging fleet of airplanes.

DoD Funding that affects the industry: • $17.3B to modernize aircraft fleets • $7.5B for tactical vehicles/armor • $12.7B to build warships • $1.8B for unmanned aerial vehicles • $10.7B to “maintain leadership in space” • $10.4B to enhance “missile defense” systems

Another factor in airplane sales growth comes from developing nations, which have much less capital assets and infrastructure than countries like the US. In the United States and Europe there are 65% of the passenger jets in the whole world, while the population is only 17%. India and China have 37% of the population but only 20% of the passenger jet fleet (Page 7, S&P Industry Survey). As the populations of developing countries grow wealthier, there will be an increased propensity to consume and travel – in turn that will mean buying planes to feed the appetite of the country’s citizens. Regions such as Asia, the Middle East, Africa and Latin America will all grow faster than mature markets like the US and Europe because of the convergence of the world economy and the marginal ability for developed economies to expand rapidly – although that is not out of the question.

These are just some of the major parts of the budget for the DoD, and does show that firms doing business in Aerospace and Defense have a strong tailwind. The one caveat is that military spending in dollar terms is very high, and with a regime change we could see these number decline. The likelihood of that though, looks to be small due to the potential political backlash – fear of terrorist attacks are still widespread and was found to be among the top fears of Americans ac- Near-Term Troubles cording to the exit polls during the recent election. In the near future, due to the major contraction in credit, business will not be good for many aerospace and defense firms. Budgets will need to be trimmed by both the consumer and the government. Some interesting points come out of the shipping and trucking industry to illustrate the amount of business contraction.

US Drone Unmanned Aircraft Source: News.bbc.co.uk

On October 24th, the Wall Street Journal ran an article describing the ordeal that many trucking companies are going through currently. According to the WSJ, 1,908 trucking concerns have gone bankrupt already through the first half of 2008 and are expecting over 2,000 more will go belly-up by the end of the year – that’s out of 200,000 companies. UPS also said they have seen “precipitous declines” in their nextday delivery options, which are where they make most of their money. And this is all happening at a time when normally shipping volumes would be up in anticipation of the holiday season. These kinds of anecdotes reveal what is really going on in the economy, and it’s not pretty.

In the longer term, there are still many threats in the world and defense spending will be a prime mechanism for protection. Military spending in China is increasing, while Iran continues to clamor for nuclear power (and possibly weapons), and Islamic extremism has not really decreased, so the US and other countries will continue to budget billions of dollars for aerospace and defense firms to compete for. Overall the industry can considered a “defensive” play during a downturn due to the outstanding contracts the firms Air Traffic currently hold and their ties with government. Economic When we talk about “air traffic” there are two segments. First downturns hurt virtually every business, but some are able there is the passenger who is paying to travel. Second, there to maintain their competitive advantage, and Aerospace & are firms such as UPS and FedEx that buy planes in order to Defense industry certainly has that quality. transport goods throughout the world and need to quickly

An Uncertain Future - GS By Richard Graham Recommendation: Sell Snapshot Company Name: Ticker Symbol: Closing Price (Nov 13): Market Cap: P/E (ttm)

Goldman Sachs Group, Inc. GS $67.31 $26 Billion 4.04x

Source: www.finance.yahoo.com

It seems that every week a new wave of financial institutions are hit with cataclysmic losses and either have to accept a government bailout or are forced to merge with a more financially sound company. Until recently, Goldman Sachs Group, Inc. appeared unscathed by the collapsing markets and was one of the last standalone investment banks. By late September, 2008 though, it had succumbed to market pressure and was reorganized as a bank holding company. It further offered $5 billion in preferred stock to Berkshire Hathaway, Inc., held a public offering for $5.75 billion and accepted a $10 billion capital injection from the US Treasury.

activities, and asset management and securities services. Its primary operations occur in the United States, accounting for 71% of its revenues in 2007. In spite of the financial downturn, Goldman posted a profit of $1.89 per share in their most recent quarter, ending August. This number however, is significantly less than the $6.54 per share Goldman posted a year earlier. Its primary source of revenue came from trading and investments, which accounted for almost 50% of overall revenue last year. The other two segments, investment banking and asset management and securities services each made up about 25% of Goldman’s overall revenue.

Challenges Now that Goldman is a CIB, in order to be considered well capitalized it will be required to keep a Tier 1 capital ratio of 6% and a Leverage Ratio of 5%. Its current Tier 1 capital ratio of 4.6% and Leverage Ratio of 3.7% is unsustainable and Goldman will be forced to deleverage itself to meet Leverage Ratio requirements. Goldman’s trading and investments activities, which accounted for 50% of its revenue, will bring in less revenue in the future due to the decrease in investable capital. Collapsing commodity The financial prices and landscape may equity marbe volatile and kets pose unpredictable, further risks but there is still for this opvalue and potenerating divitial to create valsion. These ue within these market conlarge institutions. ditions reBy researching quire GoldGoldman Sach’s man to rely current financial Source: Finance.yahoo.com more heavsituation, its future prospects and the likelihood of those prospects, it is possible to determine whether or ily on investment banking and asset management activities to not this company still has any value and whether the current maintain and grow its profits. Unfortunately for Goldman’s investment banking arm, companies are less willing to go market price clearly reflects this value. public or merge/acquire due to poor market sentiment and lack of availability of credit. According to the Wall Street Most Recent Quarter (MRQ) After being reorganized as a bank holding company, a com- Journal, there has been 25 straight weeks without an Amerimercial investment bank (CIB), Goldman is involved in in- can IPO. This streak represents the longest period without an vestment banking activities, trading and principal investment IPO in the last 28 years. The weak IPO market doesn’t only

mean fewer IPOs, it also means lower willingness to pay high credit crisis. Moreover, Goldman has taken the necessary fees, lowering the margin on any potential future deals. steps to increase its liquidity by participating in the Treasury’s market rescue program by issuing $10 billion in senior unBalance Sheet Trouble secured debt to the Treasury. Furthermore, while there have Goldman Sachs is also currently facing problems related to been rumors of a merger with Citigroup, Goldman has taken its assets. According to its most recent 10-Q filing, Goldman no real steps to merge with other financial institutions, a sign still holds roughly $30 billion dollars in collateralized debt ob- of its strength to remain independant. ligations (CDOs) and mortgage-backed securities. Of these, $18 billion are Level 3 assets. In order to be classified as a Final Analysis Level 3 asset, it “requires inputs that are both significant to Until the current market turmoil passes, it is unclear whether the fair value measurement and unobservable.” This means or not Goldman will suffer more losses from the market colthat Goldman values these assets themselves and does not lapse. Goldman’s inability to more heavily trade as a result of value them at market price. Because Goldman is valuing two- becoming a CIB and decreasing investment-banking fees due thirds of its CDO and MBS portfolio as Level 3 assets, the to current macro-economic uncertainty also could prevent mark down which should accompany the decrease in market future profit growth. However, Goldman’s superior business prices for CDOs and MBS has not occurred. Even though strategy and leadership leave it poised to succeed in the curGoldman posted a $1.5 billion gain on Level 3 Assets in its rent market. While Goldman has a powerful leadership factor most recent quarter, the potential for future write-downs ex- working to grow the company the aforementioned analysis ist. As it unwinds its trades and deleverages itself, Goldman of Goldman’s financial troubles trumps and creates uncermay be forced to revalue its Level 3 Assets, particularly its tainty for future profit growth and the potential for more CDO and MBS portfolio, at a potentially significant loss. losses and a smaller share price. For that reason I am recommending Goldman Sachs Group, Inc. as a SELL.

Source: Lewrockwell.com

Opportunities for Success Before the financial crisis began, Goldman Sachs was considered to be the premier investment bank due to strong leadership from Lloyd Blankfein and David Viniar. Even though the crisis has shaken the books of Goldman Sachs, its leadership and talent has largely remained intact. Goldman’s employees and leadership has so far proven that it has the foresight and financial ability to squeeze a profit even in the midst of the

Goldman Sachs Tower Source: Flikr.com

Naked Puts As Limit Orders By Joshua Inouye Suppose that you want to purchase shares at $50. You could watch the stock every day to see if it drops to around $50 or you could submit a limit order of $50. With the limit order, if it does drop down there, you will have saved yourself 4.39 (the price of WMT at the time of this writing, 11-9-08, was 54.39). However, if the stock never gets to that level, you save nothing and you make nothing. One interesting way to play this is to sell a naked put with a strike price of $50, December expiration (the price of this put on 11-9-08 was $2.31). One of two things will occur at the expiration of this put:

on the downside, so can be wiped out if you’re not careful and you write too many puts. Also, if you don’t wait until expiration and decide to buy the put back because you got nervous about owning the stock, any downside move will have made the put increase in value, and therefore you will be faced with a loss when buying it back if not much time has passed and the implied volatility is approximately the same. Furthermore, if implied volatility goes up, the option price will rise and you will lose if you decide to buy it back. Again, it depends on how much time has passed. The figure below helps explain this graphically.

1. The stock is below $50 at expiration, and you will have the stock put to you at a price of $50 (you will be forced to buy the stock at $50 from the person who bought the option). That’s what you originally wanted, right? Obviously it is now below 50 (maybe much lower) if you were put the stock, but you are confident that WMT is a good stock to own, and are convinced that it will rise in the future. Now, you’ve saved yourself $4.39 plus the premium you brought in from selling the put: $2.31. So you now own the stock at a net cost of $47.69! The put has made your buying price $2.31 less than Profit/Loss Graph of Selling Naked Dec. 50 Puts on WMT the strike price (and your original target price). 2. The stock is above $50 at expiration, and you will not have the stock put to you. Perhaps the stock has rallied, never again to touch the $50 mark. However, you now have made $231 from each contract you sold. That’s a lot better than the nothing you would have made if you didn’t sell the put! As a sidenote to situation 2, the margin requirement for setting up (one) naked call is about $880, so your return on this over the one-and-a-half month period would be 26%, and you didn’t even have to own WMT. This is a nice situation to be in, but will only ideally happen if WMT doesn’t drop much, otherwise you will have to put up more margin to maintain the position (naked option margin requirements are marked to the market), and your percentage return would go down somewhat. But it is still certainly better than 0%. You can even use stocks or bonds you own as collateral for the margin requirements so you don’t have to invest cash for this strategy. There are certainly some strings attached (come on, it’s just simple economics). One is that your risk is leveraged greatly

You originally establish the position at the gold star when the price of the stock is 54.39. Your profit/loss is shown on the vertical axis, and you can see that your initial position has a P/L of $0. That is because you could immediately buy the option back for no profit or loss (less transaction costs, assuming the stock price and implied volatility remain the same). However, if WMT moves up or down, your profit/loss will be determined by movements along the curved black line. If implied volatility rises, the entire black line will shift down, away from the kinked blue line. If implied volatility falls, the entire line will get closer to the kinked blue line. Also, as time passes, the black curved line will get closer and closer to the kinked line until is exactly on top of it at expiration. There are many good things and bad things that can happen when you sell a put, and you should be aware of all of them before you go trying to make 26% returns every month-and-a-half. Note also that since implied volatility is high (it is very high for the market as a whole right now, and it is about 59% for the December 50 WMT put right now), the price of the option is very high and hence the returns from successfully selling options are much higher.