Meeting the “Bond King”

Photo Credit: ~Sage~ || King of the Beasts, eh?

Photo Credit: ~Sage~ || King of the Beasts, eh?

It was winter in early 1995, and I was wondering if I still had a business selling Guaranteed Investment Contracts [GICs].  Confederation Life had gone insolvent the August prior, and I noticed that fewer and fewer stable value funds wanted to purchase my GICs, because our firm was small, and as such, did not get a good credit rating, despite excellent credit metrics.  The lack of a good rating kept buyers away.

Still, I felt I needed to try my best for one more year or so, despite my feelings that the business was dying soon.  With that attitude, I headed off in January to sunny Southern California, to attend GICs ’95, something my opposite number at AIG referred to as a Schmoozathon.

Schmoozathon?  Well, you took your opportunities to ingratiate yourself with current and potential clients, across four days and three nights of meetings, with a variety of parties going on.  I was not the best salesman, so I just tried to play it as straight as I could.

In the middle of the whole affair was a special lunch where Bill Gross was to be the Keynote Speaker.  Because I was talking with a client, I got to the lunch a little late, and ended up at a table near the back of the room.

Things were running a little behind, but Bill Gross got up and gave a talk that borrowed heavily from a recent Pimco Investment Outlook that he had written, comparing the current market opportunities to Butler Creek (see paragraph 6), a creek that he grew up near as a kid, which gently meandered, went kinda straight, kinda not, but didn’t vary all that much when you looked at it as a whole, rather than from a nearby point on the ground.

The point? Sell volatility.  Buy mortgage bonds.  Take convexity risk.  Clip yield.  Take a few chances, the environment should be gentle, and you can’t go too wrong.

After the horrible investment environment for bonds of 1994, this was a notable shift.  So he came to the end of his talk, and it was time for Q&A.  Suddenly, the moderator stormed up to the front of the room and said, “I’m really sorry, but we’re out of time.  We’ve got a panel waiting in the main meeting room to talk about the Confederation insolvency.  Please head over there now.”

Everyone got up, and dutifully headed over to the Confederation panel.  I was disappointed that I wouldn’t get a chance to ask Bill Gross a question, so as I started to leave, I looked to the front of the room, and I saw Bill Gross standing there alone.  It struck me. “Wait.  What don’t I know about Confederation? The best bond manager in the US is standing up front.”

So I walked up to the front, introduced myself, told him that I was an investment actuary, and asked if I could talk with him about mortgage bonds.  He told me that he could until his driver showed up.  As a result, for the next 15 minutes, I had Bill Gross to myself, asking him how they analyzed the risks and returns of complex mortgage securities.  His driver then showed up; I thanked him, and he left.

Feeling pretty good, I wandered over to the Confederation panel.  As I listened, I realized that I hadn’t missed anything significant.  Then I realized that the rest of the audience had missed a significant opportunity.  Oh, well.

As it turned out, I made many efforts in 1995 to resuscitate my GIC business.  It survived for one more year, and collapsed in 1996, with little help from senior management.  It was for the best, anyway.  It was a low margin, capital intensive business, and closing it enabled me to focus on bigger things that improved corporate profitability.  I never went to another Schmoozathon as a result, but the last one had a highlight that I would not forget: meeting Bill Gross.

Mantra: Interest Rates Have to Rise, Interest Rates Have to…

Photo Credit: Beto Vilaboim || No, you are not crazy -- it *is* hopeless

Photo Credit: Beto Vilaboim || No, you are not crazy — it *is* hopeless

I thought of structuring this post like a fictional story, but I couldn’t figure out how to make it good enough for publication.  Well, truth is often stranger than fiction, so have a look at this Bloomberg article pointing at a 37% loss in the ProShares UltraShort 20+ Year Treasury (TBT).

A few points to start with: shorting is hard.  Leveraged shorting is harder.  I think I have reasonable expertise in much though not all of investing, and I put most shorts in the “too hard pile.”

That said, I have taken issue with the “interest rates can only go up” trade for 8-9 years now.  It is not a major theme of mine, but I remember a disagreement that I had with Cramer over it back when I was writing for RealMoney.  (I would point to it now, but almost all content at RealMoney prior to 2008 is lost.)

Many bright investors (usually not professional bond investors) have taken up the “interest rates can only go up” view because of the loose monetary policy that we have experienced, and thanks to Milton Friedman, we know that “Inflation is always and everywhere a monetary phenomenon,” or something like that.

Friedman may or may not be right, but when banks do not turn the proceeds of deposits into loans, inflation doesn’t do much.  As it is, monetary velocity is low, with no signs of imminent pickup.

At least take time to read the views of those who are long a lot of long Treasuries, and have been that way for a long time — Gary Shilling and Hoisington Management.  Current economic policies are not encouraging growth, and that is true over most of the world.  We have too much debt, and the necessary deleveraging inhibits growth.

Think of this a different way: we have a lot of people thinking that they will retire over the next 10-30 years.  To the extent that you can live with the long-run volatility, I accept the idea that you can earn 6-8%/year in stocks over that period, so long as there isn’t war on your home soil, or a massive increase in socialism.

But what if you are running a defined-benefit plan, investing to back long-dated insurance products, or just saying that you need some degree of nominal certainty for some of your assets.  The answer would be debt claims against institutions that you know will be around to pay 10-30 years from now.

In an era of change, how many institutions are you almost certain will be here 10-30 years from now?  Personally, I would be comfortable with most government, industrial and utility bonds rated single-A or better.  I would also be comfortable with some municipal and financial company bonds with similar ratings.

If followed, and this has been followed by many institutional bond investors, this would result in falling long-term yields, particularly now when economic growth is weak globally.

Now, rates have fallen a great deal over 2014.  Can they fall further from here?  Yes, they can.  Is it likely?  I don’t know; they have fallen a lot faster than I would have expected.

I would encourage that you watch bank lending, and to a lesser extent, inflation reports.  The time will come to end the high quality long bond trade, but at present, who knows?  Honor the momentum for now.

Full Disclosure: Long TLT for my fixed income clients and me (it’s a moderate part of a diversified portfolio with a market-like duration)

Even with Good Managers, Volatility Matters

Photo Credit: sea turtle

Photo Credit: sea turtle

This is another episode in my continuing saga on dollar-weighted returns. We eat dollar-weighted returns.  Dollar-weighted returns are the returns investors actually receive in a open-end mutual fund or an ETF, which includes their timing decisions, as opposed to the way that performance statistics are ordinarily stated, which assumes that investors buy-and-hold.

In order for active managers to have a reasonable chance of beating the market, they have to have portfolios that are significantly different than the market.  As a result, their portfolios will not behave like the market, and if they are good stockpickers, they will beat the market.

Now, many of the active managers that have beaten the market run concentrated portfolios, with relatively few stocks comprising a large proportion of the portfolio.  Alternatively, they may concentrate their portfolio in relatively few industries at a time, as I do.  Before I begin my criticism, let me simply say that I believe in concentrated portfolios — I do that myself, but with a greater eye for risk control than some managers do.

My first article on this topic was Bill Miller, who is a really bright guy with a talented staff.  This is the “money shot” from that piece:

Legg Mason Value Trust enthused investors as they racked up significant returns in the late 90s, and the adulation persisted through 2006.  As Legg Mason Value Trust grew larger it concentrated its positions.  It also did not care much about margin of safety in financial companies.  It bought cheap, and suffered as earnings quality proved to be poor.

Eventually, holding a large portfolio of concentrated, lower-quality companies as the crisis hit, the performance fell apart, and many shareholders of the fund liquidated, exacerbating the losses of the fund, and their selling pushed the prices of their stocks down, leading to more shareholder selling.  I’m not sure the situation has stabilized, but it is probably close to doing being there.

Investors in the Legg Mason Value Trust trailed the returns of a buy-and-hold investor by 6%/year over the time my article covered.  Investors bought late, and sold late.  They bought after success, and sold after failure.  That is not a recipe for success.

FAIRX_15651_image002Tonight’s well-known fund with a great track record is the Fairholme Fund. Now, I am not here to criticize the recent performance of the fund, which due to its largest positions not doing well, has suffered of late. Rather, I want to point out how badly investors have done in their purchases and sales of this fund.

As the fame of Bruce Berkowitz (a genuinely bright guy) and his fund grew, money poured in.  During and after relatively poor performance in 2011, people pulled money from the fund.  Even with relatively good performance in 2012 and 2013, the withdrawals have continued.  The adding of money late, and the disproportionate selling after the problems of 2011 led the dollar weighted returns, which is what the average investors get, to lag those of the buy-and-hold investors by 5.57%/year over the period that I studied.

(Note: in my graph, the initial value on 11/30/2003 and the final value on 5/31/2014 are the amounts in the fund at those times, as if it had been bought and sold then — that was the time period I studied, and it was all of the data that I had.  Also, shareholder money flows were assumed to occur mid-period.)

Lessons to Learn

  1. Good managers who have ideas that will work out eventually need to be bought-and-held, if you buy them at all.
  2. Be wary of managers who are so concentrated, that when they receive a lot of new cash after good performance, that the new cash forces the prices of the underlying stocks up.  Why be wary?  Doesn’t that sound like a good thing if new money forces up the price of the mutual fund?  No, because the fund has “become the market” to its stocks.  When the time comes to sell, it will be ugly.  If you are in a fund like this, where the fund’s trading has a major effect on all of the stocks that it holds, the time to sell is now.
  3. There is a cost to raw volatility in large concentrated funds.  The manager may have the guts to see it through, but that doesn’t mean that the fundholders share his courage.  In general, the more volatile the fund, the less well average investors do in buying and selling the fund.  (As an aside, this is a reason for those that oversee 401(k) plans to limit the volatility of the choices offered.
  4. Even for the buy-and-hold investor, there is a risk investing alongside those who get greedy and panic, if the cash flow movements are large enough to influence the behavior of the fund manager at the wrong times.  (I.e., forced buying high, and forced selling low.)
  5. The forced buying high should be avoidable — the manager should come up with new ideas.  But if he doesn’t, and flows are high relative to the size of the fund, and the market caps of investments held, it is probably time to move on.
  6. When you approach adding a new mutual fund to your portfolio, ask the following questions: Am I late to this party?  Does the manager have ample room to expand his positions?  Is this guy so famous now that the underlying investors may affect his performance materially?
  7. Finally, ask yourself if you understand the investment well enough that you will know when to buy and/or sell it, given you investing time horizon.  This applies to all investments, and if you don’t know that, you probably should steer clear of investing in it, and learn more, until you are comfortable with the investments in question.

One final note: I am *not* a fan of AIG at the current price (I think reserves are understated, among other things), so I am not a fan of the Fairholme Fund here, which has 40%+ of its assets in AIG.  But that is a different issue than why average investors have underperformed buy-and-hold investors in the Fairholme Fund.

Factor Glut

Photo Credit: Dan Century

Photo Credit: Dan Century

I use factors in my investing. What *are* factors, you ask?  Factors are quantitative variables that have been associated with potential outperformance.  What are some of these factors?

  1. Valuation (including yield)
  2. Price Momentum (and its opposite in some cases)
  3. Insider Trading
  4. Industry factors
  5. Neglect
  6. Low Volatility
  7. Quality (gross margins as a fraction of assets)
  8. Asset shrinkage
  9. Share count shrinkage
  10. Measures of accounting quality
  11. and more…

This is a large portion of what I use for screening in my eighth portfolio rule.  I’m not throwing this idea out of the window, but I am beginning to call it into question.  Why?

I feel that the use of the most important factors are getting institutionalized, such that many major investors are giving their portfolios a value tilt, sometimes momentum tilts, and other sorts of tilts.  I also see this in ETFs, where many funds embrace value, yield, momentum, accounting, or other tilts.

Now, we have been through this before.  In 2007, momentum with value hedge funds became overinvested in the same names, with many of the funds using leverage to goose returns.  There was quite a washout in August of that year as many investors exited that crowded trade.

I’m not saying we will see something like that immediately, but I am wary to the point that when I do my November reshaping, I’m going to leave out the valuation, yield and momentum factors, and spend more time analyzing the industry and idiosyncratic company risks.  If after that, I find cheap stocks, great, but if not, I will own companies that are hopefully not owned by a lot of people just because of a few quantitative statistics.

I may be a mathematician, but I try to think in broader paradigms — when too many people are looking at raw numbers and making decisions off of them solely, it is time to become more qualitative, and focus on strong business concepts at reasonable prices.

Numerator vs Denominator

Photo Credit: Jimmie

Photo Credit: Jimmie

Every now and then, a piece of good news gets announced, and then something puzzling happens.  Example: the GDP report comes out stronger than expected, and the stock market falls.  People scratch their heads and say, “Huh?”

A friend of mine who I haven’t heard from in a while, Howard Simons, astutely would comment something to the effect of: “The stock market is not a futures contract on GDP.”  This much is true, but why is it true?  How can the market go down on good economic news?

Some of us as investors use a concept called a discounted cash flow model.  The price of a given asset is equal to the expected cash flows it will generate in the future, with each future cash flow discounted to reflect to reflect the time value of money and the riskiness of that cash flow.

Think of it this way: if the GDP report comes out strong, we can likely expect corporate profits to be better, so the expected cash flows from equities in the future should be better.  But if the stock market prices fall, it means the discount rates have risen more than the expected cash flows have risen.

Here’s a conceptual problem, then: We have estimates of the expected cash flows, at least going a few years out but no one anywhere publishes the discount rates for the cash flows — how can this be a useful concept?

Refer back to a piece I wrote earlier this week.  Discount rates reflecting the cost of capital reflect the alternative sources and uses for free cash.  When the GDP report came out, not only did come get optimistic about corporate profits, but perhaps realized:

  • More firms are going to want to raise capital to invest for growth, or
  • The Fed is going to have to tighten policy sooner than we thought.  Look at bond prices falling and yields rising.

Even if things are looking better for profits for existing firms, opportunities away from existing firms may improve even more, and attract capital away from existing firms.  Remember how stock prices slumped for bricks-and-mortar companies during the tech bubble?  Don’t worry, most people don’t.  But as those prices slumped, value was building in those companies.  No one saw it then, because they were dazzled by the short-term performance of the tech and dot-com stocks.

The cost of capital was exceptionally low for the dot-com stocks 1998-early 2000, and relatively high for the fuddy-duddy companies.  The economy was doing well.  Why no lift for all stocks?  Because incremental dollars available for finance were flowing to the dot-com companies until it became obvious that little to no cash would ever flow back from them to investors.

Afterward, even as the market fell hard, many fuddy-duddy stocks didn’t do so badly.  2000-2002 was a good period for value investing as people recognized how well the companies generated profits and cash flow.  The cost of capital normalized, and many dot-coms could no longer get financing at any price.

Another Example

Sometimes people get puzzled or annoyed when in the midst of a recession, the stock market rises.  They might think: “Why should the stock market rise?  Doesn’t everyone know that business conditions are lousy?”

Well, yes, conditions may be lousy, but what’s the alternative for investors for stocks?  Bond yields may be falling, and inflation nonexistent, making money market fund yields microscopic… the relative advantage from a financing standpoint has swung to stocks, and the prices rise.

I can give more examples, and maybe this should be a series:

  • The Fed tightens policy and bonds rally. (Rare, but sometimes…)
  • The Fed loosens policy, and bonds fall. (also…)
  • The rating agencies downgrade the bonds, and they rally.
  • The earnings report comes out lower than last year, and the stock rallies.
  • Etc.

But perhaps the first important practical takeaway is this: there will always be seemingly anomalous behavior in the markets.  Why?  Markets are composed of people, that’s why.  We’re not always predictable, and we don’t predict better when you examine us as groups.

That doesn’t mean there is no reason for anomalies, but sometimes we have to take a step back and say something as simple as “good economic news means lower stock prices at present.”  Behind that is the implied increase in the cost of capital, but since there is nothing to signal that, you’re not going to hear it on the news that evening:

“In today’s financial news, stock prices fell when the GDP report came out stronger than expected, leading investors to pursue investments in newly-issued bonds, stocks, and private equity.”

So be aware of the tone of the market.  Today, bad news still seems to be good, because it means the Fed leaves interest rates low for high-quality short-term debt for a longer period than previously expected.  Good news may imply that there are other places to attract money away from stocks.

Ideas for this topic are welcome.  Please leave them in the comments.

When Will the FOMC Tighten the Fed Funds Rate?

Photo Credit: Moon Lee || When is this train going to arrive?

Photo Credit: Moon Lee || When is this train going to arrive?

There are several ways to gauge the Federal Open Market Committee wrong. I am often guilty of a few of those, though I hope I am getting better.  Don’t assume the FOMC:

  • Shares your view of how economies work.
  • Cares about the politics of the situation.
  • Knows what it really wants, aside from magic.
  • Won’t change its view by the time an event arrives that was previously deemed important for monetary policy.
  • Cares about the reasoning of dissenters on the committee.
  • Understands what is actually happening in the economy, much less what its policy tools will really do.

But you can assume the FOMC:

  • Cares about the health of the banks, at least under extreme conditions
  • Wants to do something good, even if their minds are poisoned by neoclassical economics
  • Will err on the side of saying too much, rather than too little, when it feels that its policies are not having the impact desired on the markets and economy.
  • Will act in the manner that most protects its continued existence and privileges.

So if we want to guess when the FOMC will tighten, we can do three things:

  1. Look at market opinion
  2. Look at the FOMC’s own opinions, or
  3. Something else ;)

Let’s start with market opinion.  At present, Fed funds futures have the Fed funds rate rising to 0.25% in the third quarter of 2015, and 0.50% in the fourth quarter.  Now, market opinion has tended to be ahead of the actual actions of the FOMC on tightening policy, so maybe that will be true in the future as well.  So far, those betting for tightening in the Fed funds futures market have been losing over the last few years along with those shorting the long Treasury bond, because rates have to go up.

Okay, so what does the FOMC think?  Starting back in January of 2012, they started providing forecasts to us, and here is a quick summary of their efforts:

central tendency_10374_image001 GDP

In general, they have been overly optimistic about growth in the US economy.  They probably still are too optimistic.

 

 

Unemp

They have been better at forecasting the unemployment rate, even as it has become less useful as an indicator of how strong labor conditions are because of discouraged workers and more lower wage jobs.

PCE

 

In general, they have expected inflation to perk up in response to their policies a lot faster than it has happened.

FF

 

And as a result, like the market, they have expected to tighten in the past a lot sooner than they are presently projecting, which is not all that much different than the view of the market.  Also like the market, you can’t simply take an average of their views as representative of where Fed Fund will be.  Since the FOMC relies on voting, the median view would be more representative than the average Fed funds rate forecast, and that has remained at a relatively consistent “tightening will happen sometime in 2015″ since September 2012.  The median estimate of where Fed funds would be at the end of 2015 has also been 0.75-1.00% over that same period, which is higher than the current market estimate of 0.60%, but lower than the FOMC’s own estimate of 1.1%.

So, where does this leave us, but with a view that the FOMC will tighten policy next year.  But what if the monetary doves on the FOMC remain dominant?  After all, those that are permanent voting members are more dovish than the average participant tossing out an estimate.  That leaves me with this, which reflects the influence of the doves better:

Tighten

 

This graph is based on the average forecast, which includes a decent number of outlier views from some of the doves, which at present suggests tightening in January of 2016, but if you take into account the time drift of views since September 2012, it augurs for tightening in August of 2016.

The drift has happened because the economy has not strengthened the way the FOMC expected it would.  If we muddle along at the average rate of growth over the last two years, the FOMC may very well sit on its hands and not tighten as quickly as presently expected.  After all, labor conditions are soft, and inflation as they measure it is not roaring ahead.  (Please ignore the asset price inflation that aids the non-existent wealth effect.)

As it is, statements from the FOMC have been noncommittal, only saying that they are ending QE.  They are still waiting for their grand sign to act on Fed funds, and it has not come yet.

Summary

Current expectations from the market and the FOMC suggest that the Fed funds rate will rise in 2015.  Prior expectations of FOMC action have signaled much earlier action than what has actually happened.  From my vantage point, it is more likely that the FOMC moves later than the third quarter of 2015 versus earlier than then.  The FOMC has been slow to remove policy accommodation; it is more likely that they will remain slow given present economic conditions.

 

 

The Future Will Be Like The Past, Only More So

Photo Credit -- Javier || Buffett believes in America

Photo Credit — Javier || Buffett believes in America

Yesterday there was an article where Buffett was quoted on getting mortgages to buy houses. Let me quote the most relevant portion:

“You would think that people would be lining up now to get mortgages to buy a home,” Buffett said today at a conference hosted by Fortune magazine in Laguna Niguel,California. “It’s a good way to go short the dollar, short interest rates. It is a no-brainer. But so far home construction pickup has been slower than I had anticipated.”

Now, when I read the comment stream on the article, I was not surprised at the level of disagreement, but the vitriolic nature of the the disagreement.  Buffett is certainly not made of Teflon anymore, and fame has led to its share of detractors.

Now, I don’t think that Buffett is giving the right advice to everyone here, but I also don’t think that he is talking his book because has has investments in firms that sell:

  • Real estate
  • Manufactured housing
  • Building materials
  • Mortgages
  • Etc.

Indeed, Buffett has enough investments that almost anything he says could be talking his book.  I think his character is such that he does not talk his book — his firm is one that is built on “low hype” attitudes, at least, low hype for a company of its size and complexity.

Should everyone run out and get a mortgage because it is a cheap time to be borrowing money?  That is an individual question, hinging on how secure and high your income is versus the likely payment on the mortgage, and other housing-related expenses.

The interest rate may indeed be low relative to history, but how well will the economy do in the future?  Maybe residential housing is too expensive in some areas to get a lot of people excited about buying.

Buffett also said:

“Household formation falls off dramatically in a recession, at least initially,” he said. “But that doesn’t last long. Hormones kick in and in-laws get tiresome, too.”

Unless something changes in US culture, there have been changes to the demand for homes, driven by the following factors:

  • People are marrying later and less frequently
  • They are having fewer kids
  • Urban areas are more attractive for many people to live in, reducing commute time and costs.  Even car-buying is affected.
  • There are fewer move-up buyers because of the financial crisis.
  • The ability of lower middle class people to afford homes has been reduced, particularly in high cost of living areas.
  • The financial crisis has ruined the illusion that residential real estate is an investment that can’t lose money.

There may be more reasons, but even though the 30-year mortgage is the cheapest long-term financing that an average person can get, there are more people than before who are not interested in buying a home.  Renting suits their goals fine.

As such, I think Buffett is wrong here, and that borrowing to buy residential housing will not be as prominent as it was in the past.  But I don’t think he has any bad intentions in what he said — he believes in America, and thinks that we will return to the consumption patterns of the past, which relied on too much debt in my opinion.

Final note: I’m getting tired of reading comment streams.  The people there are often too cynical, and too loose with the truth.  Their expectations for what they deserve in this life are also inflated beyond what is reasonable.  Some turn to conspiracy theories to keep themselves from blaming their bad fortune on their own actions.

Buffett is generally a good guy, and a good example as far as businessmen go — he does not deserve the abuse.  I don’t agree with Buffett’s politics, but I don’t think that he is not sincere.

Full disclosure: long BRK/B and WFC

Managing Money for Retirement

Photo Credit: eric731 -- People can budget, but can they manage risk?

Photo Credit: eric731 — People can budget, but can they manage risk?

Investing is difficult.  That said, we can make it harder still.  We can encourage people with little to no training to try to do it for themselves.  Sadly, many people get caught in the fear/greed cycle, and show up at the wrong time to buy and/or sell.  We get there late, and then our emotions trick us into action, when the rational investor says, “Okay, I missed that move.  Where are there opportunities now, if there are any at all?”

But investing can be made even more difficult.  Investing reaches its most challenging level when you are relying on your investing to meet an anticipated and repeated need for cash outflows.

Institutional investors will tell you, portfolio decisions are almost always easier when there is more cash flowing in than flowing out.  It means that there is one dominant mode of thought: where to invest new money?  Some attention will be given to managing existing assets — pruning away assets with less potential, but the need won’t be as pressing.  (Note: at really high rates of cash inflow, investing gets really tough as well, but that’s another story, and one that I successfully lived though 1998-2003…)

What’s tough is trying to meet a cash withdrawal rate that is materially higher than what can safely be achieved over time, and earning enough consistently to do so.  Doing so as an amateur managing your own retirement portfolio will be a particularly hard version of this problem.  Let me point out some of the areas where it will be hard:

1) You don’t know how long you, your spouse, and anyone else relying on you will live.  Averages can be calculated, but particularly with two people, the odds are that one will outlive an average life expectancy.  Can you be conservative enough in your withdrawals that you won’t outlive your money?

2) My estimate of what the safe withdrawal rate is on a perpetuity is the yield on the 10-year Treasury Note plus around 1%.  That additional 1% can be higher after the market has gone through a bear market, and valuations are cheap, and as low as zero when you are near the end of a bull market.

Now, most people people with discipline want a simple spending rule, and so those that are moderately conservative choose that they can spend 4%/year of their assets.  At present, if interest rates don’t go lower still, that will likely (60-80% likelihood) work.  But if your income needs are greater than that, your odds of yields over the long haul go down dramatically.

3) Will you be able to maintain an iron discipline, and not overspend your assets?  It’s tempting to do so, and the temptation will get greater when bad events happen that break the budget, whether those are healthcare or other needs.  It is incredibly difficult to avoid paying for an immediate pressing need, when the soft cost is harming your future.  There is every incentive to say, “We’ll figure it out later.”  The odds on that being true will be low.

4) How will you deal with bear markets, particularly ones that occur early in retirement?  Can you and will you reduce your expenses to reflect the losses?  On the other side, during bull markets, will you build up a buffer, and not get incautious during seemingly good times?

This is an easy prediction to make, but after the next bear market, look for a scad of “Our retirement is ruined articles.”  Look for there to be hearings in Congress that don’t amount to much — and if they do amount to much, watch them make things worse by creating R Bonds, or some garbage like that.

5) Avoid investing in too many income vehicles; the easiest temptation to give into is to stretch for yield — it is the oldest scam in the books.  This applies to dividend paying common stocks, and stock-like investments like REITs, MLPs, BDCs, etc.  They have no guaranteed return of principal.  On the plus side, they may give you capital gains if you use them right, buying them when they are out of favor, and reducing exposure when everyone is buying them.

Another easy prediction to make is that junk bonds and non-bond income vehicles will be a large contributor to the shortfall in asset return in the next bear market, because a decent number of people are buying them as if they are magic.  The naive buyers think: all they do is provide a higher income, and there is no increased risk of capital loss.

6) Avoid taking too much or too little risk. It’s psychologically difficult to buy risk assets when things seem horrible, or sell when everyone else is carefree.  If you can do that successfully, you are rare.  What is achievable by many is to maintain a constant risk posture.  Don’t panic; don’t get greedy — just stick to your investment plan through the cycles of the markets.

7) As assets shrink, what will you liquidate?  The best thing would be being forward-looking, and liquidating what has the lowest risk-adjusted future return.  What is achievable is selling assets off from everything proportionally, taking account of tax issues where needed.

8 ) Are you ready for Social Security to take a hit out around 2026?  Once the trust fund gets down to one year’s worth of payments, future payments get reduced to the level sustainable by expected future contributions.  Expect a political firestorm when this becomes a live issue, say for the 2024 Presidential election.  There will be a bloc of voters to oppose leaving benefits unchanged by increasing Social Security taxes.

9) Be wary of inflation, but don’t overdo it.  The retirement of so many people may be deflationary — after all, look at Japan and Europe so far.  Economies also work better when there is net growth in the number of workers.  It will be tempting for policymakers to shrink what liabilities they can shrink through inflation, but there will also be a bloc of voters to oppose that.

10) You need a defender of two against slick guys who will try to cheat you when you are older.  If you have assets, you are a prime target for scams.  Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make your money stretch further.  But there are other scams as well — run everything significant past a smart younger person who is skeptical, and knows how to say no when needed.

Conclusion

If this all seems unduly dour (and I haven’t even talked about defined benefit plan issues), let me tell you that this is realistic.  There are not enough resources to give all of the Baby Boomers a lush retirement, without unduly harming younger age cohorts, and this is true over most of the developed world, not just the US.

Even with skilled advisers helping you, you need to be ready for the hard choices that will come up.  Better you should think through them earlier rather than later.  Who knows?  You might take some actions that will lower your future risks.  More on that in a future post, as well as the other retirement risk issues.

Buying an Inexpensive Car

Photo Credit: FotoSleuth

Photo Credit: FotoSleuth

I bought an inexpensive car a couple of days ago, a 2009 Toyota Corolla with 19,700 miles on it.  It’s in almost perfect condition.  I paid ~$10,300 in cash to get it, inclusive of tax and tags.

Sound like a good deal?  I think so, but let me give you the negatives:

  • Only one key, and no manual.
  • I had to spend some extra time looking for it, and had to travel 50+ miles twice to get it.  (And a third time to get permanent plates…)
  • The vehicle was previously a total loss, as its front end was badly mangled in an accident.  Thus, it only has a salvage title, which limits the ability to finance the vehicle — few banks will lend against it.  That doesn’t affect me, but it might affect others.
  • Also, if it gets wrecked, selling and re-titling a vehicle with a salvage title can be problematic.  (Not that I expect that, but in 2007, I had a car totaled that was parked in front of my house, mostly on my yard.)
  • I had to wait for it to be repaired.

But on the plus side:

  • I traded away an older vehicle to a family that needed a large 15-seat van, at a price that helped them.
  • My auto insurance costs have gone down.
  • Gas mileage has gone up.
  • I’ve bought three vehicles from this niche dealer before, and they have all worked out well.  He selectively buys Toyotas and Hondas at auto auctions that have been deemed total wrecks by insurers, after analyzing them to see what it would take to make them as good as new.  Then he fixes and sells them; that’s all he does.
  • Because I’ve bought from this fellow before, when he heard I was in the market for a car, he mentioned that he had one car he had not listed yet — the one I bought.  All of his deals are good, but this one more so.  I’m flexible about what I drive, and so I’m happy to get a car in good condition for a good price.

Now, most of my readers don’t live in the DC area, so this won’t be so relevant to most of you.  You might not have a niche dealer in your area doing something similar, assuming that you can live with the disadvantages, and get comfortable with the quality of the repaired vehicle.

This does point up the idea of going off the beaten track, and looking non-conventionally for a car, which is a decent-sized expense for most people.  Flexibility helps.  I look for cars that have good repair records on average, and am not wedded to any particular style.  I think that older cars with relatively few miles are at present a niche that few actively target to purchase.  Pricing models break down for them, because they are rare, almost all of them have a story behind them, and many people don’t like driving older cars, even if they are in very good condition.

You may have a better way of finding cars than I do — if you do, feel free to share it below in the comments.  As it is, I’m not really a writer on personal finance, so this is a rare article that may help you practically in buying a car.  A few final points:

  • Befriend someone trustworthy who knows cars well, and is willing to help you.  People who love cars often like helping others find a good deal.
  • When you find someone who offers unusual value, stick with him.
  • Be flexible.  I’ve known a lot of people who have paid a lot more than they needed to for what my father called, “Fancy Rolling Stock.”
  • Consider total costs of ownership.  Older cars don’t need collision insurance.  Some makes and models wear better than others, so repair costs could be lower for those cars.  Analyze likely fuel efficiency.

Finally, if you have a deal that is pretty good, be happy with it.  Don’t overspend time looking for the absolute best deal.  In my opinion, the best is elusive, you can never truly know if you have it, and pretty good is attainable.  And that is true for more than just buying cars — don’t let perfection become the enemy of the pretty good.  (Shall I write about that for investment analysis?  When do we ever get to certainty?…)

What Should the Cost of Equity Be to Value Investors?

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Photo Credit: Sepehr Ehsani — Which project is better, project A or project B?

I can’t remember where I ran into it, but I found this article on a blog that I had not run into before on Calculating [the] Cost of Equity for Value Investors.  I think it gets close to the right answer, and I would like to sharpen it here.

My answer to a lot of economic questions is: what’s the alternative?  Many people look at the shiny formulas in investing but don’t ask what they really mean.  (More people just don’t look at the formulas… which has its pluses and minuses.  The math reveals, but it also conceals hidden assumptions.)

After wisely dismissing how to calculate the cost of equity from Modern Portfolio Theory [beta] and the Gordon model, he considers cost of equity based off of return on equity, and begins to get tied up in problems.  Let me try.

The cost of equity is important for a number of reasons:

  • It helps answer the question, “When should a company issue or buy back stock?”
  • It provides a measure for the alternative use of equity capital on competing unlevered projects/investments of equivalent riskiness.

Note the each of the reasons is structured as a series of comparisons.  I’ll use a discounted cash flow [DCF] analysis as an example.  Imagine a simple project requiring an investment of equity capital.  There is a certain cost, and the risk is enough that you can’t borrow money for financing — it must be funded by equity.  There are expected after-tax cash flows from the project that you think are a best estimate of returns.  When would you invest in the project?

I would compare investments versus other similar investments, and look at as many similar projects from a riskiness perspective, and see which investment yielded the best return.  The second place project as returns go is the alternative project for investment by which the winning project is judged, and surprise, the winning project has a positive net present value evaluated at the rate of the alternative project.

(An aside: it just hit me that I am recreating part of the learning process that I went through back when I was a TA at UC-Davis 31 years ago, helping teach Corporate Financial Management [CFM], while taking quadratic programming [QP] course at the same time — I ended up doing my QP paper on using QP to choose investments to maximize returns without explicitly calculating internal rates of return, thus quietly solving a problem that the undergrad CFM textbook said could not be done.  FWIW, which isn’t much.)

Now, I’m waving my hands at what I mean by risk, but to me it is the best estimate of the probability distribution of outcomes, thus giving you estimates of what the likelihood and severity of adverse outcomes could be.  The thing is, in real life we know these figures poorly at best, but the framework is still useful because the investor making the decision needs to choose the project of a class of projects with roughly the same risk profile.  Though my initial example included only equity-financed projects, this could be expanded to consider all projects, where the amount of debt on projects affects their risk, and the tax-affected debt cash flows are a deduction from returns.

The process would remain the same: look at as many similar projects from a riskiness perspective, and see which investment yielded the best return on the equity.  The second place project as returns on the equity go is the alternative project for investment by which the winning project is judged.

Back to Stocks

Where does that leave us as stock investors?  I subscribe to the “pecking order” theory of the cost of capital, which says that firms use the cheapest form(s) of capital to fund their incremental financing needs, which means they should rarely issue equity. The exception would be if they are undertaking a project so large that it would make the company significantly more risky if they were to issue only debt for financing.

We do see companies engaging in buyback activity when they can’t find better uses for slack capital.  In many cases, there are few large projects begging for the attention of management.  Buying back stock earns the earnings yield for the firm.  Managements buying back stock make the statement that there are no more incremental projects of equivalent risk that would have an unlevered return on equity greater than the earnings yield for the firm.

Now maybe shareholders may have a bigger set of investment choices than the firm does, so perhaps dividends could be a better choice for shareholders, but it will have to be a lot better, because dividends are taxable.

In general, we want to see management teams be careful users of equity capital, taking note of its cost for the benefit of shareholders.  Every good management team should have their schedule of possible projects for investment, but always recognize there is the alternative of buying back stock as a last resort.  In that limited sense, the earnings yield is the cost of equity for the firm, unless big profitable projects beckon.

There’s more to say here, but maybe this is a good start.  Thoughts?