Simple Stuff: On Bid-Ask Spreads

Photo Credit: Eddy Van 3000

Photo Credit: Eddy Van 3000

This piece is an experiment.  A few readers have asked me to do explanations of simple things in the markets, and this piece is an attempt to do so.  Comments are appreciated.  This comes from a letter from a friend of mine:

I hope I don’t bother you with my questions.  I thought I understood bid/ask but now I’m not sure.

For example FCAU has a spread of 2 cents.  That I understand – 15.48 (bid) – that’s the offer to buy and 15.50 (ask) – that’s the offer to sell.

Here’s where I’m confused.  How is it possible that those numbers could more than $1 apart? EGAS 9.95 and 11.13.  I don’t understand.  Is the volume just so low?  And last price is 10.10 which is neither the ask nor bid price.  Can you please explain?

You have the basic idea of the bid and ask right.  There is almost always a spread between the bid and the ask.  There can be occasional exceptions where a special order is placed, such as an “all or none” order, where the other side of the trade would not want to transact the full amount, even though the bid and ask price are the same.  The prices might match, but the conditions/quantities don’t match.

You ask why bid/ask spreads can be wide.  I assume that when you say wide, you mean in percentage terms.  Here the main reason: many of the shares are held by investors with a long time horizon, who have little inclination to trade.  Here is a secondary reason: the value of the investment is more uncertain than many alternative investments.  I believe these reasons sum up why bid/ask spreads are wide or narrow.  Let me describe each one.

1) Few shares or bonds are available to trade

Many stocks have a group of dominant investors that own the stock for the longish haul.  The fewer the shares/bonds that are available to trade, the more uncertainty exists in where the assets should trade, because of the illiquidity.

Because few shares are available to trade, price moves can be violent, because it only takes a small order to move the price.  Woe betide the person who foolishly places a large market order, looking to buy or sell at the best price possible.  I did that once on a microcap stock (the stock of a very small company), and ended up doubling the price of the stock as my order was fully filled, only to see the price fall right back to where it was.  Painful lesson!

As a result, those that make markets, or  buy and sell stocks tend to be more cautious in setting prices to buy and sell illiquid securities because of the difficulty of trading, and the problem of moving the market away from you with a large order.

I’ve had that problem as well, both with small cap stocks, and institutionally trading illiquid bonds.  You can’t go in boldly, demanding more liquidity than the market typically offers.  If you are buying, you will scare the sellers, and the ask will rise.  If you are selling, you will scare the buyers, and the bid will fall.  There is a logical reason for this: why would someone come into a market like a madman trying to fit 10 pounds into a 5-pound bag?  Perhaps they know something that everyone else does not.  And thus the market runs away, whether they really do know something or not.

In some ways, my rookie errors with small cap stocks helped me become a very good illiquid bond trader.  For most bonds, there is no bid or ask.  Some bonds trade once a week, month, or year… indicative levels are given, maybe, but you navigate in a fog, and so you begin sounding out the likely market to get some concept of where a trade might be done.  Then negotiation starts… and you can read about more this in my “Education of a Corporate Bond Manager” series… I know most here want to read about stocks, so…

2) Uncertainty of the value of an asset

Imagine a stock that may go into default, or it may not.  Or, think of a promoted penny stock, because most of them are in danger of default or a dilutive stock offering.  Someone looking to buy or sell has little to guide them from a fundamental standpoint — it is only a betting game, with volatile prices in the short run.  Market makers, if any, and buyers and sellers will be cautious, because they have little idea of what may be coming around the corner, whether it is a big news event, or a crazy trader driving the stock price a lot higher or lower.

For ordinary stocks, large enough, with legitimate earnings and somewhat predictable prospects, the size of the bid-ask spread reflects the short-run volatility of price.  In general, lower volatility stocks have low bid-ask spreads.  Even with market makers, they set their bid-ask spreads to a level that facilitates trade, but not so tight that if the stock gets moving, they start taking significant losses.  And, as I experienced as a bond trader, if news hits in the middle of a trade, the trade is dead.  You will have to negotiate afresh when the news is digested.

As for the “Last Price”

The last price reflects the last trade, and in this era where so much trading occurs off of the exchanges, the bid and ask that you may see may not reflect the true state of the market.  Even if it does reflect the true state of the market, there are some order types that are flexible with respect to price (discretionary orders) or quantity (reserve orders).  Trades should not occur outside of the bid-ask spread, but many trades happen without a market order hitting the posted bid or lifting the posted ask.

And though this is supposed to be simple, the simple truth is that much trading is far more complex today than when I started in this business.  I disguise my trades to avoid alarming buyers or sellers, and most institutional investors do the same, breaking big trades into many small ones, and hiding the true size of what they are doing.

Thus, I encourage all to be careful in trading.  Until you know how much capacity for trading a given asset has, start small, and adjust.

All for now, until the next time when I do more “simple stuff” at Aleph Blog.

Advice on Organizing Asset Allocations and Managers

Photo Credit: Roscoe Ellis

Photo Credit: Roscoe Ellis

I was reading an occasional blast email from my friend Tom Brakke, when he mentioned a free publication from Redington, a UK asset management firm that employs actuaries, among others. I was very impressed with what I read in the 32-page publication, and highly recommend it to those who select investment managers or create asset allocations, subject to some caveats that I will list later in this article.

In the UK, actuaries are trained to a higher degree to deal with investments than they are in the US. The Society of Actuaries could learn a lot from the Institute of Actuaries in that regard. As a former Fellow in the Society of Actuaries, I was in the vanguard of those trying to apply actuarial principles to risk management, both when I managed risks for insurance companies, worked for non-insurance organizations, and manage money for upper middle class individuals and small institutions. Redington’s thoughts are very much like mine in most ways. As I see it, the best things about their investment reasoning are:

  • Risk management must be both quantitative and qualitative.
  • Risk is measured relative to client needs and thus the risk of an investment is different for clients with different needs.  Universal measures of risk like Sharpe ratios, beta and standard deviation of asset returns are generally inferior measures of risk.  (DM: But they allow the academics to publish!  That’s why they exist!  Please fire consultants that use them.)
  • Risk control methods must be implemented by clients, and not countermanded if they want the risk control to work.
  • Shorting requires greater certainty than going long (DM: or going levered long).
  • Margin of safety is paramount in investing.
  • Risk control is more important when things are going well.
  • It is better to think of alternatives in terms of the specific risks that they pose, and likely future compensation, rather than look at track records.
  • Illiquidity should be taken on with caution, and with more than enough compensation for the loss of flexibility in future asset allocation decisions and cash flow needs.
  • Don’t merely avoid risk, but take risks where there is more than fair compensation for the risks undertaken.
  • And more… read the 32-page publication from Redington if you are interested.  You will have to register for emails if you do so, but they seem to be a classy firm that would honor a future unsubscribe request.  Me?  I’m looking forward to the next missive.

Now, here are a few places where I differ with them:

Caveats

  • Aside from pacifying clients with lower volatility, selling puts and setting stop-losses will probably lower returns for investors with long liabilities to fund, who can bear the added volatility.  Better to try to educate the client that they are likely leaving money on the table.  (An aside: selling short-duration at-the-money puts makes money on average, and the opposite for buying them.  Investors with long funding needs could dedicate 1% of their assets to that when the payment to do so is high — it’s another way of profiting from offering insurance in of for a crisis.)
  • Risk parity strategies are overrated (my arguments against it here: one, two).
  • I think that reducing allocations to risky assets when volatility gets high is the wrong way to do it.  Once volatility is high, most of the time the disaster has already happened.  If risky asset valuations show that the market is offering you significant deals, take the deals, even if volatility is high.  If volatility is high and valuations indicate that your opportunities are average to poor at best, yeah, get out if you can.  But focus on valuations relative to the risk of significant loss.
  • In general, many of their asset class articles give you a good taste of the issues at hand, but I would have preferred more depth at the cost of a longer publication.

But aside from those caveats, the publication is highly recommended.  Enjoy!

A New Exercise in Industry Rotation

At Abnormal Returns, over the weekend, Tadas Viskanta featured a free article from Credit Suisse called the Credit Suisse Global Investment Returns Yearbook 2015.  It featured articles on whether the returns on industries as a whole mean-revert or have momentum, whether there is a valuation effect on industry returns, “social responsibility” in investing, and the existence of equity discount rate for the market as a whole.

There are no surprises in the articles — it is all “dog bites man.”  They find that:

  • Industry returns exhibit momentum
  • There is a valuation component in industry returns
  • Socially responsible investing doesn’t necessarily produce or miss excess returns
  • There is an overall equity discount rate, which is levered about 20-25 times, i.e., a 1% increase in the rate lowers valuations by 20-25%.

The first two are well-known for individual stocks, so it isn’t surprising that it happens at the industry level.  The third one has been written about ad nauseam, with many conflicting opinions, so that there is little effect is no big surprise.  The last one resembles research I saw in the mid-90s, where the effect of changes in real interest rates has about that impact on stocks.  Again, nothing new — which is as it should be.

But now some more on industry returns.  They found that industry return momentum was significant.  Industries that did well one year were likely to do well in the next year.  The second finding was that industries with cheap valuations also tended to do well, but it was a smaller effect.

So, using one-year price returns as my momentum variable and book-to-market as a valuation variable (both suggested in the article), I divided industries for companies trading in the US into quintiles (also suggested in the article) for momentum and valuation.  (Each quintile has roughly 20% of the total market cap.)  Here is the result:

IMVC

 

Low valuations are at the right, high at the left.  Low momentum at the top, high momentum at the bottom.  Ideally by this method, you would look for industries in the southeast corner.

To me, Agriculture, Information Technology, Security, Waste, Some Retail, and Some Transportation look interesting.  One in the far southeast that is not so interesting for me is P&C Insurance.  Yes, it has done well, and compared to other industries, it is cheap.  But industry surplus has grown significantly, leading to more competition, and sagging premium rates.  Probably not a great time to make new commitments there.

Anyway, the above table should print out nicely on two sheets of letter-sized paper.  Not that it would be a substitute for your own due diligence, but perhaps it could start a few ideas going.  All for now.

One Dozen Reasons Why the Average Person Underperforms In Investing, Part 1

Photo Credit: NoHoDamon

Photo Credit: NoHoDamon

Brian Lund recently put up a post called 5 Reasons You Deserve to Lose Every Penny in the Stock Market.  Though I don’t endorse everything in his article, I think it is worth a read.  I’m going to tackle the same question from a broader perspective, and write a different article.  As we often say, “It takes two to make a market,” so feel free to compare our views.

I have one dozen reasons, many of which are related.  I do them separately, because I think it reveals more than grouping them into fewer categories.  Here we go:

1) Arrive at the wrong time

When does the average person show up to invest?  Is it when assets are cheap or expensive?

The average person shows up when there has been a lot of news about how well an asset class has been doing.  It could be stocks, housing, or any well-known asset.  Typically the media trumpets the wisdom of those that previously invested, and suggests that there is more money to be made.

It can get as ridiculous as articles that suggest that everyone could be rich if they just bought the favored asset.  Think for a moment.  If holding the favored asset conferred wealth, why should anyone sell it to you?  Homebuilders would hang onto their inventories. Companies would not go public — they would hang onto their own stock and not sell it to you.

I am reminded of some of my cousins who decided to plow money into dot-com stocks in late 1999.  Did they get to the party early?  No, late.  Very late.  And so it is with most people who think there is easy money to be made in markets — they get to the party after stock prices have been bid up.  They put in the top.

2) Leave at the wrong time

This is the flip side of point 1.  If I had a dollar for every time someone said to me in 1987, 2002 or 2009 “I am never touching stocks ever again,” I could buy a very nice dinner for my wife and me.  Average people sell in disappointment thinking that they are protecting the value of their assets.  In reality, they lock in a large loss.

There’s a saying that the right trade is the one that hurts the most.  Giving into greed or fear is emotionally satisfying.  Resisting trends and losing some money in the short run is more difficult to do, even if the trade ultimately ends up being profitable.  Maintaining exposure to stocks at all times means you ride a roller coaster, but it also means that you earn the long-term returns that accrue to stocks, which market timers rarely do.

You can read some of my older pieces on how investors earn less on average than buy-and-hold investors do.  Here’s one on how investors in the S&P 500 ETF [SPY], trail buy-and-hold returns by 7%/year.  Ouch!  That comes from buying and selling at the wrong times.  ETFs may lower expenses, but they also make it easy for people to trade at the wrong times.

3) Chase the hot sector/industry

The lure of easy money brings out the worst in people.  Whether it is tech stocks in 1987, dot-coms in 1999, or housing-related assets in 2007, there will always be people who think that the current industry fad will be a one-way ticket to riches.  There is psychological satisfaction to be had by buying what is popular.  Everyone wants to be one of the “cool kids.”  It’s a pity that that is not a good way to make money.  That brings up point 4:

4) Ignore Valuations

The returns you get are a product of the difference in the entry and exit valuations, and the change in the value of the factor used to measure valuation, whether that is earnings, cash flow from operations, EBITDA, free cash flow, sales, book, etc.  Buying cheap aids overall returns if you have the correct estimate of future value.

This is more than a stock market idea — it applies to private equity, and the purchase of capital assets in a business.  The cheaper you can source an asset, the better the ultimate return.

Ignoring valuations is most common with hot sectors or industries, and with growth stocks.  The more you pay for the future, the harder it is to earn a strong return as the stock hopefully grows into the valuation.

5) Not think like a businessman, or treat it like a business

Investing should involve asking questions about whether the economic decisions are being made largely right by those that manage the company or debts in question.  This is not knowledge that everyone has immediately, but it develops with experience.  Thus you start by analyzing business situations that you do understand, while expanding your knowledge of new areas near your existing knowledge.

There is always more to learn, and a good investor is typically a lifelong learner.  You’d be surprised how concepts in one industry or market get mirrored in other industries, but with different names.  One from my experience: Asset managers, actuaries and bankers often do the same things, or close to the same things, but the terminology differs.  Or, there are different ways of enhancing credit quality in different industries.  Understanding different perspectives enriches your understanding of business.  The end goal is to be able to think like an intelligent business manager who understands investing, so that you can say along with Buffett:

I am a better investor because I am a businessman, and a better businessman because I am an investor.

(Note: this often gets misquoted because Forbes got mixed up at some point, where they think it is: I am a better investor because I am a businessman, and a better businessman because I am no investor.)  Good investment knowledge feeds on itself.  Little of it is difficult, but learn and learn until you can ask competent questions about investing.

After all, you are investing money.  Should that be easy and require no learning?  If so, any fool could do it, but my experience is that those who don’t learn in advance of investing tend to get fleeced.

6) Not diversify enough

The main objective here is that you need to only invest what you can afford to lose.  The main reason for this is that you have to be calm and rational in all the decisions you make.  If you need the money for another purpose aside from investing, you won’t be capable of making those decisions well if in a bear market you find yourself forced to sell in order to protect what you have.

But this applies to risky assets as well.  Diversification is inverse to knowledge.  The more you genuinely know about an investment, the larger your positions can be.  That said I make mistakes, as other people do.  How much of a loss can you take on an individual investment before you feel crippled, and lose confidence in your abilities.

In the 25+ years I have been investing, I have taken significant losses about ten times.  I felt really stupid after each one.  But if you take my ten best investments over that same period, they pay for all of the losses I have ever had, leaving the smaller gains as my total gains.  As a result, my losses never inhibited me from continuing in investing; they were just a part of the price of getting the gains.

Temporary Conclusion

I have six more to go, and since this article is already too long, they will have to go in part 2.  For now, remember the main points are to structure your investing affairs so that you can think rationally and analyze business opportunities without panic or greed interfering.

On Bitcoin

Photo Credit: Zach Copley

Photo Credit: Zach Copley

I’ve generally been quiet about Bitcoin.  Most of that is because it is a “cult” item.  It tends to have defenders and detractors, and not a lot of people with a strong opinion who are in-between.  There’s no reward for taking on something that has significance bordering on religious for some… even if it proves to be a bit of a “false god.”

I view Bitcoin as a method of payment, a collectible item, a commodity that is not fully fungible, and not a store of value.  It is not a currency, and never will be, unless a government takes it over and adopts it.

In order for a tradable item to be a store of value, the amount of variation in value in the short- to intermediate-term versus other items that has to be limited.  If there are other tradable items with greater stability toward the other items, those tradable items would be better stores of value.  Thus Bitcoin is inferior as a store of value versus the US Dollar, the Euro, the Yen, etc.  It is far more volatile versus goods and assets that one might want to buy, and goods and liabilities that one might want to fund.

Now as an aside, the same thing happens in hyperinflationary economies.  Merchants have to change their prices frequently, because the currency is weak.  Often another currency will begin to replace the weak local currency, like the US Dollar or the Euro, even if that is not legal.

Fungibility implies that any Bitcoin is as good as any other Bitcoin.  But with failures like Mt. Gox, a Bitcoin exchange that had Bitcoins under its care stolen from it, a Bitcoin under the care of Mt. Gox was not as valuable as one elsewhere.  (Another aside: that happened in a minor way with the Euro when Euros in Cypriot banks were forced to have a “haircut,” while Euros elsewhere were unaffected.)

Bitcoin is a means of payment, a way of transferring value from one place/person to another.  It seems Bitcoins move well, but they are less good at being safely stored.

The theft of Bitcoins points out the need for there to be a legal system to protect property rights.  Licit participants in Bitcoins as a group have not been adequate to assure that the rightful owners might not lose them as the result of computer hacking.  Contrast that with the protections that credit card holders have when false transactions are applied against credit card accounts.  The credit card companies eat the losses, funded by profits from interest charged an interchange fees.

The libertarian vision of a currency that does not require a court, a government to protect it is misguided.  Where there are thieves, there is a need for courts to try cases of theft, and deal with questions of equity if theft leads to an insolvency.

Now, governments can be less than fair with their own judicial systems.  I think of Dennis Kozlowski, formerly CEO of Tyco, who was barred from using his own money in self-defense when the US Government brought him to trial.  Much as you might like to have value protected from the clutches of the government, that is easier said than done, and there are thieves that will pick away at those who get value away from governments, because ultimately in an interconnected world, you have to trust other people at some points, and trust can be violated as much as the rights of a citizen can be violated.  Repeat after me: THERE IS NO PERFECTLY SAFE PLACE ON EARTH TO STORE VALUE!  That said, though, there are safer places than others, and so you have to live with the risks that you understand, and are prepared to take.

If you think that Bitcoin fits that bill, well, knock your socks off.  Have at it.  I will stick with US Dollars in banks, money market funds, bonds, and public and private stocks.  Maybe I will even buy some gold that does nothing, just for the sake of diversification.  But ultimately my store of value is in the bank of Heaven, as it says in Matthew 6:19-21:

“Do not lay up for yourselves treasures on earth, where moth and rust destroy and where thieves break in and steal; but lay up for yourselves treasures in heaven, where neither moth nor rust destroys and where thieves do not break in and steal. For where your treasure is, there your heart will be also.”

There is no perfect security on Earth, try as hard as you like.  Bitcoins may keep value away from the government under some conditions, but who will protect your property rights in Bitcoins in the event of theft?  You can’t have it both ways, so Bitcoins as property would either be taxed and regulated by governments, or be totally underground, which would diminish utility considerably.

One final note: Bitcoins can’t be used of themselves to produce something else.  They are a fiat currency, and only has value to the degree that users place on it.  I liken it to penny stocks, where traders can bounce the price around, because there is nothing to tether the price to.  At least with gold, you have jewelers demanding it to turn it into jewelry, and a broader pool of people who are somewhat less jumpy about what the proper exchange rate between gold and dollars should be.

But, gold can be stolen… again, no Earthly store of value is perfect.  All for now.

Fade High Price-Sensitivity Assets in Crude Oil

Media Credit: Terence Wright

Media Credit: Terence Wright

This will be a short post. If we get a significant updraft in the price of oil, and Saudi production policy has not changed, you might want to sell crude oil price-sensitive assets. The marginal cost of production for a lot of crude oil that is shale related is around $50/barrel, and that is where I think the market “equilibrium” will bounce around for a few years, until global growth picks up.

I hold my positions for longer periods of time, so I may not do much off of this, but I would expect crude oil prices to be range-bound for a few years, with all of the volatility which a global commodity can have.

That’s all folks.

An Idea Whose Time Should Not Come

Media Credit: Bloomberg

Media Credit: Bloomberg

I get fascinated at how we never learn. Well, “never” is a little too strong because the following article from Bloomberg, Meet the 80-Year-Old Whiz Kid Reinventing the Corporate Bond had its share of skeptics, each of which had it right.

The basic idea is this: issue a corporate bond and then package it with a credit default swap [CDS] for the same corporate bond, with the swap cleared through a clearinghouse, which should have a AAA claims-paying ability.  Voila! You have created a AAA corporate bond.

Or have you?  Remember that bond X guaranteed by Y has many similarities to bond Y guaranteed by X, because both have to fail for there to be a default.  I used to help manage portfolios that had many different types of AAA bonds in them.  Some were natively AAA as governments, quasi-governments (really, Government Sponsored Enterprises) like Fannie and Freddie, or corporations.  Some were created by insurance guarantees from MBIA, Ambac, FGIC, or FSA.  Others were created via subordination, where the AAA portion took the losses only if they were greater than a highly stressed level.  Lesser lenders absorbed lesser losses in exchange for the ability to get a much greater yield if there was no default.

There is a lot of demand for AAA bonds if they have a high enough yield spread over Treasuries.  The amount of spread varies based on the structure, but greater complexity and greater credit risk tend to raise the spread needed.  Here are some simple examples: At one time, you could buy GE parent corporate bonds rated AAA, or GE Capital corporate bonds with an identical rating, but no guarantee from GE parent.  The GE Capital bonds always traded with more yield, even though the rating was identical.  AIG had a AAA credit rating, but its bonds frequently traded cheap to other AAA bonds because of the opacity of the financials of the firm (and among some bond managers, a growing sense that AIG had too much debt).

So how would one get a decent yield spread under this setup?  The CDS will have to require less spread to insure than the spread over Treasuries priced into the corporate bond.

How will that happen? Where does the willingness to accept the credit risk at a lower spread come from?  Note that the article doesn’t answer that question.  I will take a stab at an answer.  You could get a number of hedge funds trying to make money off of leveraging CDS for income, the excess demand forcing the CDS spread below that implied by the corporate bond.  Or, you could get a bid from synthetic Collateralized Debt Obligations [CDOs] demanding a lot of CDS for income.  I can’t think of too many other ways this could happen.

In either case, the CDS clearinghouse is dealing with weak counterparties in an event of default.  Portfolio margining should be capable of dealing with small negative scenarios like isolated defaults.  Where problems arise is when a lot of default and near defaults happen at once.  The article tells us what happens then:

ICE requires sellers of swaps to backstop their contracts with various margin accounts. If the seller fails to pay off, then ICE can tap a “waterfall” of margin funds to make the investor whole. In the event of a market crash, it can call on clearing members such as Citigroup and Goldman Sachs to pool their resources and fulfill swap contracts.

There’s still a danger that the banks themselves may be unable to muster cash in a crisis. But this shared responsibility marks a sea change from the bad old days when investors gambled their counterparties would make good on their contracts.

That shared responsibility is cold comfort.  Investment banks tend to be thinly capitalized, and even more so past the peak of a credit boom, when events like this happen.  Hello again, too big to fail.  Clearinghouses are not magic — they can fail also, and when they do, the negative effects will be huge.

Two more quotes from the article by those that “get it,” to reinforce my points:

The bond is a simple instrument with a debtor and creditor that’s proven its utility for centuries. The eBond inserts a third party into the transaction — the seller of the swap embedded in the security who now bears its credit risk.

Such machinations may be designed with good intentions, but they just further convolute the marketplace, says Turbeville, a former investment banker at Goldman Sachs.

“Why are we doing this? Is our society better off as a result of this innovation?” he asks. “You can’t destroy risk; you just move it around. I would argue that we have to reduce complexity and face the fact that it’s actually good for institutions to experience risks.”

and

“The way we make money for our clients is by assessing risk and generating risk-adjusted returns, and if you have a security that hedges that risk premium away, then why is it compelling? I would just buy Treasuries,” says Bonnie Baha, the head of global developed credit at DoubleLine Capital, a Los Angeles firm that manages about $56 billion in fixed-income assets. “This product sounds like a great idea in theory, but in practice it may be a solution in search of a problem.”

And, of course, fusing a security as straightforward as a bond with the notorious credit-default swap does ring a lot of alarms, says Phil Angelides, former chairman of the Financial Crisis Inquiry Commission, a blue-ribbon panel appointed by President Barack Obama in 2009 to conduct a postmortem on the causes of the subprime mortgage disaster. In September 2008, American International Group Inc. didn’t have the money to back the swaps it had sold guaranteeing billions of dollars’ worth of mortgage-backed securities. To prevent AIG’s failure from cascading through the global financial system, the U.S. Federal Reserve and the U.S. Treasury Department executed a $182 billion bailout of the insurer.

“When you look at this corporate eBond, it’s strikingly similar to what was done with mortgages,” says Angelides, a Democrat who was California state treasurer from 1999 to 2007. “Credit-default swaps were embedded in mortgage-backed securities with the idea that they’d be made safe. But the risk wasn’t insured; it was just shifted somewhere else.”

The article rambles at times, touching on unrelated issues like index funds, capital structure arbitrage, and alternative liquidity structures for bonds.  On its main point the article leave behind more questions than answers, and the two big ones are:

  • Should a sufficient number of these bonds get issued, what will happen in a very large credit crisis?
  • How will these bonds get issued?  When spreads are tight, no one will want to do these because of the cost of complexity.  When spreads are wide, who will have the capital to offer protection on CDS in exchange for income?

I’m not a fan of financial complexity.  Usually something goes wrong that the originators never imagined.  I may not have thought of what will go wrong here, but I’ve given you several avenues where this idea may go, so that you can avoid losing.

Learning from the Past, Part 3

Photo Credit: Thibaut Chéron Photographies

Photo Credit: Thibaut Chéron Photographies

I wish I could tell you that it was easy for me to stop making macroeconomic forecasts, once I set out to become a value investor.  It’s difficult to get rid of convictions, especially if they are simple ones, such as which way will interest rates go?

In the early-to-mid ’90s, many were convinced that interest rates had no way to go but up.  A few mortgage REITs designed themselves around that idea.  Fortunately, I arrived at the party late, after their investments that implicitly required interest rates to rise soon, fell dramatically in price.  I bought a basket of them for less than book value, excluding the value of taxes that could be sheltered in a reverse merger.

For some time, the stocks continued to fall, though not rapidly.  I became familiar with what it was like to go through coercive rights offerings from cash-hungry companies in trouble.  Bankruptcy was not impossible… and I burned a lot of mental bandwidth on these.  The rights offerings weren’t really good things in themselves, but they led me to buy in at a good time.  Fortunately I had slack capital to deploy.  That may have taught me the wrong lesson on averaging down, as we will see later.  As it was, I ended up making money on these, though less than the market, and with a lot of Sturm und Drang.

That leads me to my main topic of the era: Caldor.  Caldor was a discount retailer that was active in the Northeast, but nationally was a poor third to Walmart and KMart.  It came up with the bright idea of expanding the number of stores it had in the mid-90s without raising capital.  It even turned down an opportunity to float junk bonds.  I remember noting that the leverage seemed high.

What I didn’t recognize that the cost of avoiding issuing equity or longer-term debt was greater reliance on short-term debt from factors — short-term lenders that had a priority claim on inventory.  It would eventually prove to be a fatal error, and one that an asset-liability manager should have known well — never finance a long term asset with short-term debt.  It seems like a cost savings, but it raises the likelihood of insolvency significantly.

Still, it seemed very cheap, and one of my favorite value investors, Michael Price, owned a little less than 10% of the common stock.  So I bought some, and averaged down three times before the bankruptcy, and one time afterwards, until I learned Michael Price was selling his stake, and when he did so, he did it without any thought of what it would do to the stock price.

Now for two counterfactuals: Caldor could have perhaps merged with Bradlee’s, closed their worst stores, refinanced their debt, issued equity, and tried to be a northeast regional retail player.  It didn’t do that.

The investor relations guy could have given a more understanding answer when he was asked whether Caldor was having any difficulties with credit lines from their factors.  Instead, he was rude and dismissive to the questioning analyst.  What was the result?  The factors blinked and pulled their lines, and Caldor went into bankruptcy.

What were my lessons from this episode?

  • Don’t average down more than once, and only do so limitedly, without a significant analysis.  This is where my portfolio rule seven came from.
  • Don’t engage in hero worship, and have initial distrust for single large investors until they prove to be fair to all outside passive minority investors.
  • Avoid overly indebted companies.  Avoid asset liability mismatches.  Portfolio rule three would have helped me here.
  • Analyze whether management has a decent strategy, particularly when they are up against stronger competition.  The broader understanding of portfolio rule six would have steered me clear.
  • Impose a diversification limit.  Even though I concentrate positions and industries in my investing, I still have limits.  That’s another part of rule seven, which limits me from getting too certain.

The result was my largest loss, and I would not lose more on any single investment again until 2008 — I’ll get to that one later.  It was my largest loss as a fraction of my net worth ever — after taxes, it was about 4%.  As a fraction of my liquid net worth at the time, more like 10%.  Ouch.

So, what did I do to memorialize this?  Big losses should always be memorialized.  I taught my (then small) kids to say “Caldor” to me when I talked too much about investing.  They thought it was kind of fun, and I would thank them for it, while grimacing.

But that helped.  Remember, value investing is first about safety, and second about cheapness.  Cheapness rarely makes something safe enough on its own, so analyze balance sheets, strategy, use of cash flow, etc.  This is not to say that I did not make any more errors, but this one reduced the size and frequency.

That said, there will be more “fun” chapters to share in this series, because we always learn more from errors than successes.

Talking About Value Investing and Fed Policy

Here is the second part of my interview on RT Boom/Bust. It was recorded while the FOMC was releasing its statement, so I had no idea at that time as to what the announcement had been.

The interview covers my view of Apple (not one of my strong points), Fed Policy, and what should value investors do in this low interest rate environment. Note that not all of my opinions are strong ones, and that in my opinion is a good thing. Often the best opinions are not controversial.

If you are interested in these topics, or listening to me, then please enjoy the above video. My segment is about seven minutes long.