The Aleph Blog

On Berkshire Hathaway and Asbestos

Recently, a friend of mine from Canada came to stay with me.  We talked about a wide number of things, but when we talked about investing, I described insurance investing to him, giving my usual explanation on reserving.

Classical life insurance reserves are a science.  Death happens with regularity, it is only a question of when.  Short-tail P&C, health, etc, are almost a science — the claims come quickly, and the reserves get adjusted rapidly.  Long-tail Casualty and Liability is a dark art at best.  Mortgage, financial, and title insurance reserving is not even an art; there is no good theory behind them, as is true of life insurance products with secondary guarantees, particularly those dealing with variable products.

As an example of long-tail P&C, I told my friend about Berkshire Hathaway and asbestos — I mentioned to him how BRK has become the reinsurer of choice for insurers with uncertain asbestos liabilities.  Buffett has reinsured White Mountains, AIG, CNA, Equitas. and many others, the most recent being Liberty Mutual, which happened after the talk with my friend.

This is retroactive reinsurance, where an insurer purchases insurance from a reinsurer to cover business previously written.  This is an uncommon form of insurance, and most commonly used when the amount of claims is very uncertain.

Quoting from the Bloomberg article:

Liberty Mutual Group Inc. issued $750 million of bonds to help finance a payment to a unit of Warren Buffett’s Berkshire Hathaway Inc. (BRK/B) for covering the insurance company’s liabilities tied to asbestos.

The 4.85 percent, 30-year notes were sold to yield 160 basis points more than similar-maturity Treasuries, according to data compiled by Bloomberg. Standard & Poor’s increased Liberty Mutual’s rating one level to BBB from BBB- after Berkshire’s National Indemnity Co. agreed last week to provide as much as $6.5 billion of coverage for the insurance company’s liabilities for asbestos, environmental and workers’ compensation policies.

“This agreement covers Liberty Mutual’s potentially volatile U.S. A&E liabilities and largely mitigates potential risks from future adverse reserve developments,” Tracy Dolin, an S&P analyst, said in a statement.

Berkshire, which has grown over the last five decades by investing insurance premiums in stocks and takeovers, has assumed billions of dollars in asbestos risk from insurers including American International Group Inc. and CNA Financial Corp.

Liberty Mutual paid Omaha, Nebraska-based National Indemnity about $3 billion for the coverage, according to a July 17 company statement.

This is similar to the other deals, where the premium paid is roughly half the amount of what BRK could have ot pay out at maximum.  Note that BRK has capped its exposure to the claims.   If asbestos claims against Liberty Mutual exceed $6.5 Billion, Liberty Mutual will have to pay the excess.

I don’t think there is another American insurance company with more asbestos exposure than BRK.  That’s not necessarily a bad thing, though.  Let me quote from BRK’s recent 10-K:

We are exposed to environmental, asbestos and other latent injury claims arising from insurance and reinsurance contracts. Liability estimates for environmental and asbestos exposures include case basis reserves and also reflect reserves for legal and other loss adjustment expenses and IBNR [DM: Incurred But Not Reported] reserves. IBNR reserves are based upon our historic general liability exposure base and policy language, previous environmental loss experience and the assessment of current trends of environmental law, environmental cleanup costs, asbestos liability law and judgmental settlements of asbestos liabilities.

The liabilities for environmental, asbestos and other latent injury claims and claims expenses net of reinsurance recoverables were approximately $13.7 billion at December 31, 2013 and $14.0 billion at December 31, 2012. These liabilities included approximately $11.9 billion at December 31, 2013 and $12.4 billion at December 31, 2012 of liabilities assumed under retroactive reinsurance contracts. Liabilities arising from retroactive contracts with exposure to claims of this nature are generally subject to aggregate policy limits. Thus, our exposure to environmental and other latent injury claims under these contracts is, likewise, limited. We monitor evolving case law and its effect on environmental and other latent injury claims. Changing government regulations, newly identified toxins, newly reported claims, new theories of liability, new contract interpretations and other factors could result in significant increases in these liabilities. Such development could be material to our results of operations. We are unable to reliably estimate the amount of additional net loss or the range of net loss that is reasonably possible.

Long tail P&C reserves are roughly 20% of the total gross P&C reserves of BRK, and this deal with Liberty Mutual increases it.  Again, that’s not a bad thing, necessarily.  Given the premium paid, even if BRK pays out the maximum on average 10 years from now, the deal is a winner if BRK earns more than 8% per year.  If 15 years 5.3%.  If 20 years, 4%.  Given the long period before the ultimate payment of claims, BRK can make money in most scenarios.

That said, if anything bad ever did happen to BRK, such that its solvency was impaired, there would be a lot of insurance companies hurting as a result.  BRK is critical to the payment of asbestos claims.  There is not a better company to entrust with this task.

Full Disclosure: Long BRK/B for myself and clients — we own the equivalent of one “A” share.

On Learning Compound Interest Math

When I read articles like this where people get scammed borrowing money, I say to myself, “we need to teach children the compound interest math.”

Even my dear wife does not get it, and she sends the children to me when they don’t get it.  But beyond learning the math, a healthy skepticism of borrowing needs to be encouraged, especially for depreciating items like autos.

The compound interest math is really one of the more simple items of Algebra 2.  Everyone should be able to calculate the value of a non-contingent annuity at a given interest rate.

Once people learn that, they might have more skepticism regarding the long-dated pension-like promises that the government makes, because they can look at the future payment stream, and say, “I can’t see how we fund that.”

All for now.

A Letter from a Young Investor

Before I get to the letter, I recommend reading, You’re Ready for Retirement, but Your Savings Aren’t by Jonathan Clement, if you have access to the Wall Street Journal.  Main point: if you can work until age 70, do that, and then retire.

Here’s the letter:

Hi David,

A little background about myself.  I am a 24-year male, and have been working for a little over a year.  The only knowledge I have on investing is passive index fund investing through the book Bogleheads.  I don’t really look at my holdings other than to re-balance every year.

I am currently investing for retirement by maxing out a RothIRA, maxing out a 401k  (that allows a Brokerage account) and some in a taxable Vanguard index fund.  My holdings consist of the total stock and total bond market index funds (90/10). From my current positions my portfolio return has been 20.6%. I calculated the return by return = (market_change + dividends) / total_money. I don’t know if this is a correct formula. The time frame of my holdings is from Jan2012 – June2014. 

I went to a finance workshop that my church was hosting and there was a panel of finance experts (CPA, lawyer, financial advisor) that were indirectly encouraging active investing over passive investing through personal anecdotes. 

Looking at my current portfolio performance, I have a hard time seeing the value in spending time in learning how to actively invest and about finance in general. Currently, I do not follow up on business and market news nor am I reading any economic/investing blogs or magazines. Again, my only investing knowledge is from the Bogleheads book, and so I feel that active investing would be a daunting task. 

Do you have a comparison of an active investment portfolio’s returns (that uses your 8 portfolio rules) against an index fund (such as the Vanguard total stock market) during a bull and bear market?  Also, do you have any advice on where to begin learning about active investing in general? How should one invest for different goals, say investing for retirement in 40 years vs. investing for a home purchase in the Bay Area in 5-10 years? I’m having a hard time seeing how I would balance time in regards to learning about investing, advancing my career through outside studying, serving in my local church, spending time to witness to family, friends and co-workers, and communion with God.  It seems like passive investing is a simpler solution with a decent average long-term return of 7%. I know I am young, have a lot to learn about life and sometimes stubborn in my thinking, so any thoughts and/or advice would be greatly appreciated.

These are the questions I will try to answer:

  1. Should you move to active investing, and are there some alternatives that would allow you gain some of the benefits of active investing, without costing you a lot of time?
  2. Do I have a track record that is publicly available?
  3. Where to learn about active investing?
  4. How should I invest if I want to buy a house in the Bay Area in 5-10 years, and how does that differ from investing for retirement?
  5. Is the time put into learning about investing really worth it when I have so many other social and spiritual commitments?

But  I will answer them in a different order.

Is the time put into learning about investing really worth it when I have so many other social and spiritual commitments?

You can’t be good at active investing without putting time in at least at the level of a hobby, say, one hour per day, six days a week.  When I launched into studying investments at age 27, I already had two advantages — A mother who was self-taught in investing (and beat most mutual fund managers handily), and an academic background in economics and finance (which had its pluses and minuses).

But my commitment to learning about investing was one hour per day, six days a week.  After 5 years, I was an investment actuary, which was pretty rare at that time.  After 11 years, I was hired into the investment department of a medium-sized life insurer.  17 years later, I worked for a notable hedge fund.  23 years later, I started my own firm.

Now, there were some spillover benefits for serving the church.  I have served on various boards of my denomination, chairing some of them, but my knowledge of finance has been a benefit to many of them, and I have been able to prevent a wide variety of errors.  Even this week, a Christian group in western Pennsylvania reached out to me regarding a “too good to be true investment,” and I told them it was likely a fraud.  There are ways that we can serve the church with such knowledge.  Brothers and sisters that I know come asking for advice, and I do not turn them down.

Now, all that said — no, it is probably not worth your time to learn about active investing.  I wrote two articles a while ago taking both sides of the argument:

Decide what you want to emphasize in your life and service to God.  The church benefits from a few “numbers guys” (as some refer to me in my denomination), but it doesn’t need a lot of them, if the group trusts them, and they are wise and upright.

Should you move to active investing, and are there some alternatives that would allow you gain some of the benefits of active investing, without costing you a lot of time?

I don’t think you have to move to active management — you might move to some sort of tilt on you passive management, though.  Over the long run, tilting to value stocks and smaller stocks has been a smart idea.  Cap-weighted indexes have most of their assets invested in behemoths that like Alexander the Great, have “no more worlds left to conquer.”  Investing a disproportionate amount passively in mid- and small-cap stocks can be a wise idea, as can passive investing with a value bias.  Two sides of the issue:

But, maybe wait a while before you add some mid- and small-cap value index funds… valuations are relatively high for small and mid-cap stocks at present.  I have a hard time finding truly cheap stocks at present.

Where to learn about active investing?

As for books, you could look through my book reviews, and scan for the word “value.”  You could visit the website Valuewalk.com; I have to admit I am impressed with what Jacob Wolinsky has done — it is the “go to” site for value investing.

You can also read the letters of notable value investors — Buffett, Klarman, Marks, and more…

How should I invest if I want to buy a house in the Bay Area in 5-10 years, and how does that differ from investing for retirement?

Let me tell you a story.  My congregation is near DC.  My congregation asked me to manage the building fund, and for years, I beat the market, but DC area real estate still appreciated faster.

At the same time, many congregations in the denomination, had received buildings for low prices, or virtually free, but those were mostly in rural areas.  So at prayer meeting in January 2009, after losing a large amount of the building fund, I asked God to drop a building in our lap, as I could not see any way that I would ever do it through my investing, good as it was.

Two months later, we bid on a short sale for a house with a church use permit.  We had the assets free and clear for it, and closed in May 2009.

Here is my point to you: geographically constrained markets like the Bay Area — there is no good way for the liquid stocks and bonds to keep up with real estate price increases. Buying a house in the Bay Area is a tough matter, and it might make sense to match assets and liabilities.

You might want to try to buy real estate related assets in the Bay Area — not sure how you could do that, but it would be the investment closest to funding what you want to own.

As for investing for retirement 40+ years from now, maintain a posture of 70-80% risk assets, and 30-20% safe assets.  I have been 70/30 most of my life.  Optimal is 80/20, but I take more idiosyncratic risk, and 70/30 just feels better to me.  My investments are more concentrated, and the cash levels out the jolts.

Do I have a track record that is publicly available?

Yes and no.  I send it to those who inquire after my services, but I will send you a copy after I publish this.  I’ve done well, but I know that it might be due to chance.  That said, my clients get the same investments that I have, so my interests are aligned with them, aside from the fee they pay me.  I have no other compensation from my investment management.

On Several Questions from a Reader

As time has gone along, I realize that my blog is different.  I do things that most bloggers don’t do, e.g. book reviews, answer e-mails publicly, and a few other things.  Also, my audience is far more international than most, with a large contingent from India.  Well, here is another e-mail from a reader in India:

Hi David,

I am a big fan or your articles and read regularly when I get time. I respect you for what you are trying to do with your blog – it is a free education for people like us. I also write a blog but it is mostly a commentary sorts than educating blog like yours.

I am writing to you today because I want to seek out your advice on my portfolio (and my ongoing investment education). 

Screening technique

I normally use Reverse DCF with 15% discount rate, 3% terminal growth rate and future growth assumption of a quarter of historical (5 or 10 years) FCF growth rate. For eg. if historical FCF growth rate of a company is 40%, and reverse DCF suggest market is factoring 10%, that company gets shortlisted.

I also try to invest in companies with 5 years avg ROCE of more than 25% – assumption being management being prudent and high quality will generate good returns on capital available to them.

When I am done screening the stocks, I read their previous 2-3 annual reports to get the feel of the business, how do they money and what are the underlying risks etc. I also read their commentaries on the business prospects and any extraordinary or hidden/ contingent charges they might have. I try to find out what makes the business earn so consistent results.

The screen I use normally allow me to avoid the folly of forecasting. I avoid making an elaborate model and try to forecast future earnings and cash flows. I just try to buy the security at a good discount to what my Reverse DCF model suggests.

Selling strategy

Now, lot of my stocks (8/13) have doubled in 1-3 years duration. I, as a rule, take out my capital when my stock doubles i.e sell half of my holdings. I assume that whatever I have thought about the future prospects of the business could be wrong. Some of my stocks are trading below the level I took out my capital and some of them have turn out to be multi-baggers. What are your thoughts on this selling strategy.

I also have issues with a stock if it has been on my watchlist and has run up a bit. I think this is anchor bias everyone talks about. But I still want to know your thoughts. Do you buy in a single trade or do you build your position slowly.

One more thing, I know you write a lot about portfolio structure, what do you suggest to do if the business you have made the highest allocation to is generating lower returns and vice-versa.

I know I am bothering you a lot, but knowing your thoughts will help me a lot.

I also tried my hands on liquidation analysis that Peter Cundill speaks about in his book – There’s always something to do.

I bought a stock, which was trading way below its liquidation value ( if you buy the entire market cap, sell all the assets at half the prices, and pay off all the liabilities, you still will be left with some cash). I have read their ARs and have found nothing wrong with management, of course their business is not generating lot of profits. I have put a google alert on company’s name if there is some news report or some analysis on the company that may alert me if they’re fraud. So my question is how do you (or a retail investor like me) make sure that management is not fraud or accounts are not cooked.

I know these are lot of questions – that too from a stranger sitting in India but I’ll be happy if you give me some sense of direction – whether I am doing things right or what should I change.

Keep writing and educating,
Thanks,

I don’t use DCF or reverse DCF because of the many assumptions employed in DCF.  I am happier using simpler techniques like P/E, P/B, P/S, and then trying to critique them considering what I know about the company and industry in question.

As for you insistence on a high ROCE — that can work in India, but is less likely to work in the developed world, because few companies can beat the 25% threshold, that have reasonable valuations.

I take out assets from companies as they rise.  I do it more regularly and slowly than you do — it is a risk control mechanism.  On the downside, it is a way to make more money, by buying quality companies when they are down.

For more thoughts on selling, look at my portfolio rules seven and eight.

Regarding watchlist assets that have risen in value, I follow portfolio rule eight, and only buy assets that would be a net improvement to the portfolio.  Timing will almost never be right, but if you have a favorable valuation for the asset in question, and a sound balance sheet, you will do well.

Regarding portfolio construction, I only look at the likely future.  I will hold onto a company that has done badly, but still offers an opportunity of doing well in the future.  The objective is to be forward-looking.

I buy positions all-at-once, or as close to it as I can, because a few positions are illiquid.  There is no reason to delay in investing if your thesis is a good one.

Regarding crooked managements — the first question to ask is how are you going to grow revenues.  If the answer is at all unbelievable, run away.  There are other tests:

1) look at their results over many years, and compare it to their commentary.  Don’t give any credit for one-time (negative) events because over the long run, managements that have too many one time events are bad managements.

2) use statistics like normalized operating accruals to see if the accounting is conservative or liberal.

3) Analyze growth in book value plus dividends versus earnings.  Growth in book value plus dividends is a better measure of value than earnings is.

4) look at management incentives — the best managers are idealists.  They love what they do, and would do it for free. if they could.  You want a management team that is hungry; you son’t want a management team that feels full.

Thanks for writing me, and I hope you prosper in your investing in India.

Sincerely,

David

On Current Credit Conditions

This should be short.  Remember that credit and equity volatility are strongly related.

I am dubious about conditions in the bank loan market because Collateralized Loan Obligations [CLOs] are hot now and there are many that want to take the highest level of risk there.  I realize that I am usually early on credit issues, but there are many piling into CLOs, and willing to take the first loss in exchange for a high yield.  Intermediate-term, this is not a good sign.

Note that corporations take 0n more debt when rates are low.  They overestimate how much debt they can service, because if rates rise, they are not prepared for the effect on earnings per share, should the cost of the debt reprice.

It’s a different issue, but consider China with all of the bad loans its banks have made.  They are facing another significant default, and the Chinese Government looks like it will let the default happen.  That will not likely be true if the solvency of one of their banks is threatened, so keep aware as the risks unfold.

Finally, look at the peace and calm of low implied volatilities of the equity markets.  It feels like 2006, when parties were willing to sell volatility with abandon because the central banks of our world had everything under control.  Ah, remember that?  Maybe it is time to buy volatility when it is cheap.  Now here is my question to readers: aside from buying long Treasury bonds, what investments can you think of that benefit from rising implied volatility and credit spreads, aside from options and derivatives?  Leave you answers in the comments or email me.

This will sound weird, but I am not as much worried about government bond rates rising, as I am with credit spreads rising.  Again, remember, I am likely early here, so don’t go nuts applying my logic.

PS — weakly related, also consider the pervasiveness of BlackRock’s risk control model.  Dominant risk control models may not truly control risk, because who will they sell to?  Just another imbalance of which to be wary.

Book Review: The Risk Wise Investor

00001 What do you think about first when you look at an investment? Do you think of how much you might make, or how much you might lose?

Most successful investors think about how much they could lose, which makes this book a very good one to read, versus many investment books that spend little time on risk, but try to sell you on likely returns.

We win by not losing, while taking moderate and prudent risks.  This book encourages you in that direction.

Broadminded Wisdom

By broadminded, I don’t mean someone who is not willing to call some things right and wrong, but rather, someone who is willing to consider many facets of the problem as he suggests his advice.

He considers (chapter-by-chapter):

1) The modern problem of data overload, and how it distorts our decisions.

2) How good investment risk control is very much like the way we control non-investing risks in our own daily lives.

3) The long-term history of how financial risk management emerged, and how it has sharpened in the present era.

4) What level of risk are we trying to deal with?  Those that want to have no risk against extreme contingencies set themselves up for losses if society remains intact.  On the other hand, if you are only attempting to smooth out small setbacks, what happens when you face a true market crisis?

5) Should you consider risk to be a quantitative or qualitative matter?  The author opts for both.  I would argue you are better off with the qualitative, and a businessman’s instinct on the quantitative, as opposed to that of an academic.

6) Learn to train you emotions.  Do not give into fear or greed.

7) As a result, add to risk assets in bad times, lighten up in good times.

8 ) Think for yourself, and don’t follow the crowd.

9) Control what you can control, hedge what you can’t control, if it makes sense

10) Realize that not all risks are the same size — focus on the big ones that are within your capacity to minimize.

11) Risk management is a process.  Identify the outcomes you want to avoid and avoid them, considering what you might give up in the process.

12) Consider what great risk management looks like outside of finance, and use the analogies to aid your investing.

13) How good financial advice can help, and what that looks and feels like.  The book gives many good questions to ask those who might advise you.

14)  Dealing with financial panics and crises.  There are no easy answers here, but if you can invest more when things are at their worst, or when things stop getting worse, you can do well.

The book has a summary, where it draws all of the stands of thought together.  If after reading the book, you follow the summary, you will have a useful way of managing your investment portfolio.  Now that said, managing investment risk is not easy, because markets are not stable.  You need to be ready to not do so well during booms, while being willing to take risk when things look really bad.  (But maybe wait until prices cross the 10-month moving average…)

Quibbles

None.

Summary

This is a very good book on risk control in investment management, and most investors, retail and professional, could benefit from it.  If you want to, you can buy it here: The Risk-Wise Investor: How to Better Understand and Manage Risk.

Full disclosure: The author asked me if I would like a copy and I said “yes.”

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Book Review: The Secret Club that Runs the World

la_ca_0506_the_secret_club_that_runs This is a very good book; I learned a lot as I read it, and you will too.

In this book, Kate Kelly takes on the economic sector of commodities.  This involves production, distribution, trading, hedging, and ultimate use.

There are many players trying to profit in many different ways.  There are hedge funds, commodity trading advisers, investment banks, producers, refiners.  Some do just one facet of the commodities sector; some do everything.

This book is replete with stories from the run-up in commodity prices, and all of the games that went on.   It tells of those who made a lot of money, and those that want  broke working in a very volatile part of the economy.

It is a book that gives a testimony that information is king, and those that understand future supply, demand, and transportation costs can make a great deal of money by buying cheap, transporting, and selling high.

That said, the math can get overly precise versus the real world… the book gives examples of hedging programs that were too clever by half, ending in disaster when prices moved too aggressively.

With hedging, simplicity is beauty.  But after some success in trading well, companies think that instead of hedging, let trading become a profit center of its own .  Far from reducing risk, risks rise beyond measure, until the scheme blows up.

The book also considers non-market players like politicians and regulators, and how they are almost always a few steps behind those they regulate.  A key theme of the book is whether market participants can manipulate prices or not.  I would invite all market participants to consider my writings on penny stocks.  Can the price be manipulated?  Yes.  For how long?  Maybe a month or two at best.  In bigger markets like commodities, I suspect the ability to manipulate prices is less, because there are more players trading, and the power is equal between buyers and sellers.  There are powerful parties on both sides seeking their advantage.

The Glencore/Xtsrata merger and Delta Airlines hedging program/buying a refinery occupy a decent amount of the book.  Glencore/Xstrata illustrates the desire for scale and control in owning production in trading assets in commodities.  Delta Airlines illustrates the difficulties involve in being a heavy energy user in a cyclical, capital-intensive business that carries a lot of debt.  It’s too early to tell whether owning their own oil refining operation was the right decision or not, though typically companies do better to specialize, rather than vertically integrate.

One you have read this book, you will have a good top-level view of how the commodities sector operates, and thus I recommend the book.

Quibbles

The book title is vastly overstated.  There is no secret.  Just becuse many people don’t know about them doesn’t mean they are secret.  There is adequate data about them if you look.

There is no club.  Yes, some move from one position in one firm to a position in another.  Some even become regulators.  That is common to most industries.

They don’t run the world.  At most, they have a weak hold over commodities markets, because the traders have better data on global supply and demand than most large producers and consumers do.  That information allows them to profit on spreads, but it doesn’t let them move markets.

Summary

Given my quibbles, I thought it was a great book.  A marketing guy probably wrote the title, so I give the author a pass on that.  If you want a readable high-level view of the commodities markets, you can get it in this book.  If you want to, you can buy it here: The Secret Club That Runs the World: Inside the Fraternity of Commodity Traders.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Aiming for Transparency

Here’s another letter from a reader:

David,

I’m starting this fund, and I wanted to get your opinion.

 It is best explained on YouTube in 55 seconds: let me know what you think https://www.youtube.com/watch?v=frwOrQd3f6w. It (hopefully) will provide incentive for transparency in funds.

 Thank you!

Okay, I can’t embed the short video, so click on the link above and watch it — it is less than a minute, and well-done.

To the writer:

I admire your efforts at providing transparency here, but let me tell you where I think this may have unintended negative consequences.

Anytime you provide total transparency, you invite front-running, if the manager is any good.  New ideas are often most potent at their beginning, and given the delay between notifying mutual fund shareholders, voting and implementation, critical time is sacrificed, and some of your shareholders may front-run you.

Imagine a person investing the minimum in your fund so that he could front-run your picks with a greater amount of money.  But even if front-running does not happen, it is generally wise to move rapidly once the manager has come to a decision.  The delay from having shareholders vote on it is likely a money-loser.  Also during times of crisis, the manager may have some of his best ideas, but when average people are scared, will they be willing to pull the trigger?  I have my doubts.

In general, I favor investment methods where decision-making is done by individuals.  If I were running a hedge fund, or a large mutual fund, I would delegate all decisions to the sector/industry analysts.  Let sharp opinions prevail.  I’ve worked in areas where groupthink muddies investment decisions — it does not lead to outperformance.

Transparency

You don’t need to have shareholders vote on investments to have transparency.  You could do what I do, because all of my investors have full transparency.

I manage separate accounts using Interactive Brokers.  We buy and sell as a group.  We all get the same buy and sell prices.  I don’t trade often, but any investor can monitor his/her account all day long.  They can set up a daily download so that they can see what actions have been taken, if any.  There is total transparency, to the degree that my investors want to make the effort.  And remember, making investors go through a lot of effort is a negative.

If I Were in Your Shoes

If I wanted to give your investors transparency, I would give them access to a website showing the portfolio in real time, set up in such a way that only they could see it.  I would not let them vote on investments.  If you are hiring a manager, let him manage.  Second-guessing and delay are a waste of time and money.

Now those are my thoughts, and maybe your views on running a democratic fund are important to you.  Do what you think is best — just remember that democracy is not the same as transparency, and to achieve transparency, democracy is not needed.  Information is power, and you want to be careful in how you share it.

All that said, I hope you succeed, and that it works out well for you and your shareholders!

One More Note on Failure

Recently, we had a problem at the Merkel house: a toilet overflowed and the water did not shut off, flooding the room, and leaked into the basement.  Why did this happen?  Two things went wrong at the same time:

  1. The toilet needed to be plunged, because there was a blockage preventing water discharge, and
  2. The flapper malfunctioned, and so water continued to flow.

If only one of these problems had happened, we would have had an ordinary problem.  I can plunge a toilet, easy.  I can hear the toilet singing, and know that the flapper is up, jiggle the handle, and end the problem.

Most of the time, when we plan against failure, we look at solutions that address single failures.  We do not contemplate two things going wrong at once.

Yet, when we look at big failures in investment, there are often two things that went wrong at the same time.  Usually it follows a pattern like this:

  1. Take a risk that in ordinary times often works out, but
  2. You don’t get that times are not ordinary, and so the odds are actually stacked against you.

I have several examples for this.  Taking on debt to buy a house was a wonderful strategy until overall debt levels to finance housing got to high, but at that time, the momentum effect of rising house prices was sucking people into buying houses, because they thought it was easy money.

Financial stocks were the market leaders for many years up through 2007, as investors assumed that ordinary risk control would protect the banking system.  But what happens when debt levels are too high, so that many debts are incapable of being paid?

As Warren Buffett has said (something like), “We get paid to think about the things that can’t happen.”  Multiple failures leading to large bad results are worth thinking about.  So what aren’t we thinking about now?

  • Failures in retirement security systems as the Baby Boomers age.
  • Failures in government debt as overleveraged governments can’t make debt payments.
  • Inflation rises rapidly as the economy revives amid increased lending from banks.
  • Deflation persists as the central bank tries to force-feed credit to an already overleveraged economy.

(There are many patting themselves on the back thinking that the Central Banks and Governments got us out of a crisis, when they only delayed the crisis.  High nominal debt levels relative to GDP create their own crisis.)

I would encourage you to think about your investments, and ask the following questions:

  • Are there hidden factors that could lead to a big failure?  (Think of what happened to mortgage REITs in 2008 when the repo market crashed.)
  • How well would the investment fare if inflation went up significantly?
  • How well would the investment fare if real interest rates went up significantly?
  • How well would the investment fare if we hit another patch where financing is not available?  Can the investment self-fund?
  • How much future prosperity does the current price of the investment embed in its valuation?

I know, glum words.  But this might be a good time to look at what you own, and ask how survivable it is under stressed conditions.

All for now.

The Reason for Failure Matters

When I was a young actuary, say in the early 90s, my boss came to me, and gave me an unrequested lesson.  He said something to the effect of:

Most pricing actuaries make assumptions.  Well, I test assumptions.  That involves checking how actual results are coming in expected, but in the early phases of a new product, you are living under the law of small numbers — you don’t have enough data to be statistically credible.  You should still do the statistical analysis, but I take it one step further.

I pull the first 10-20 claim files and look at the cause for the claim.  If the qualitative causes are not chance events, but are indications that the business is being sold improperly to those who know they are close to death (or disability) and evade the limited underwriting of the group coverage, that means the group is low quality, and the program should be discontinued, or severely modified.

He then told me about some credit life insurance that the company was offering through two well known, prestigious banks, and how the deaths were coming in from non-random causes: AIDS, Cancer, Drowned in the Hudson River, Murder, etc.

He fought to get that insurance line shut down, and it took him five years, as the line manager argued there was not enough experience.  The line manager tried to get my boss fired, and finally, the line manager was fired.  But if the company had listened early they would have lost $10M.  As it was, they lost several hundreds of millions of dollars.

Now, most of my readers don’t care much about insurance, but this tale is meant to illustrate that reason for losses matters as much, and sometimes more than the absolute amount lost.  Now to illustrate this for a different and perhaps more timely reason:

Wups, wups, wups, wups, pop, Pop, POP, Yaaaaaauuughhhh!

Maybe I am growing up a little, but I am trying to have better titles for my articles.  The subheading above would have been my title.  But let me explain what it means:

The credit cycle tends to be like this: in the bull phase, a long period (4-7 years) with few defaults and low loss severity followed by a bear phase, a shorter period (1-3 years) with high defaults and high loss severity.  This is a phenomenon where history may not repeat exactly, but it will rhyme very well.

In the bull phase of the credit cycle there are a few defaults, but when you analyze the defaults, they occur for reasons unrelated to the economy as a whole.  What do the failures look like?  Fraud (think Enron), bad business plans from a megalomanic (think Reliance Insurance, ACH, Southmark, etc.) , a sudden shift in relative prices (think Energy Future Holdings), etc.  Bad banking — think Continental Illinois in 1984.

In the bull phase, companies that fail would fail in any environment.  But now let’s talk about the transition between the bull and bear phase — that is the “pop, Pop, POP.”

As the credit cycle shifts, a few companies fail that are closely related to the crisis that will come.  They are your early warning.  Think of the subprime lenders under stress in 2007, or the failure of Bear Stearns in early 2008.  Think of LTCM in 1998, or the life insurers that came under stress for writing too many GICs [Guaranteed Investment Contracts] in the late 80s and invested the money in commercial mortgages.

As the cycle moves on defaults become more closely related to the financial economy as a whole.  Fed policy is tight, and a bunch of things blow up that borrowed too much money short term.  This is when the correlated failures happen:

  • Banks, mortgage insurers, and overly leveraged homeowners default 2008-2011.
  • Dot-coms fail because they can’t pay their vendor finance.
  • Mexico and the mortgage markets blow up in 1994.
  • Commercial mortgages blow up in the early 90s.
  • LDC loans blow up in the early 80s.

To the Present

The present is always confusing.  I get it right more often than most, but not by a large margin.  We have companies threatening to fail in China and Portugal, but I don’t see much systemic lending risk in the US yet, aside from what is leftover from the last crisis.

It is worth noting that deleveraging has occurred more in word than in deed over the last five years.  Yes, debt has traveled from public to private hands, but that only defers the problems, as governments will either have to inflate, tax more, or default to deal with the additional debts.

I am not trying to sound the alarm here.  I am trying to tell you to be ready.  During the intermediate phase between bull and bear, the weakest companies fail from unrecognized systemic risk.  Personally, I think I have heard the first ‘pop.”  It is coming from nations that did not delever, and that may suffer further if the bad debts overwhelm the banking systems.

Are you ready for the bear phase of the credit cycle?  Screen your portfolios, and look for weak names that will not survive a general panic where only the best names can get credit.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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