The trouble with VAR and other mathematical models of risk is that if it becomes the dominant paradigm, and everyone begins to use it, it creates distortions in the market, because institutions gravitate to asset classes that the model makes to appear artificially cheap.  Then after a self-reinforcing cycle that boosts that now favored asset class to an unsupportable level, the cashflows underlying the asset can no longer support it, the market goes into reverse, and the VAR models encourage an undershoot.  The same factors that lead to buying to an unfair level also cause selling to an unfair level.

Benchmarking and risk control through VAR only work when few market participants use them.  When most people use them, it becomes like the portfolio insurance debacle of 1987.  VAR becomes pro-cyclical at that point.

Sometimes I think the Society of Actuaries is really dumb.  The recent financial crisis demonstrated the superior power of long-term actuarial stress-testing versus short-term quant models for analyzing risk.  The actuarial profession has not taken advantage of this.  Now, maybe some investment bank could adopt an actuarial approach to risk, and they will be much safer.  But guess what?  They won’t do it because it will limit risk taking more than other investment banks.  Unless the short-term risk model is replaced industry-wide with a long-term risk model, in the short-run, the company with the short-term risk model will do better.

The reason why VAR does not effectively control risk is simple.  VAR is a short-term measure in most of its implementations.  It is a short-term measure of risk for short- and long-term assets.  Just as long-term assets should be financed with long-term liabilities, so should risk analyses be long-term for long-term assets.

This mirrors financing as well, because bubbles tend to occur when long-term assets are financed by short-term liabilities.  Risk gets ignored when long-term assets are evaluated by short-term price movements.

And, as noted above, these effects are exacerbated when a lot parties use them; a monocultural view of short-run risk will lead to booms and busts, much as portfolio insurance caused the crash in 1987.  If a lot of people trade in such a way as to minimize losses at a given level, that sets up a “tipping point” where the market will fall harder than anyone expects, should the market get near that point.

The idea that one can use a short-term measure of risk to measure long-term assets assumes that markets are infinitely deep, and that there are no games being played.  You have the capacity to dump/acquire the whole position at once with no frictional costs.  Ugh.  Today I set up a new client portfolio, and I was amazed at how much jumpiness there was, even on some mid-cap stocks.  Liquidity is always limited for idiosyncratic investments.

The upshot here is simple: with long term assets like stocks, bonds, housing, the risk analysis must be long term in nature or you will not measure risk properly, and you will exacerbate booms and busts.  It would be good to press for regulations on banks to make sure that all risk analyses are done to the greater length of the assets or the liabilities (and with any derivatives, on the underlying, not contract term).

There is probably money to be made in analyzing the foibles of money managers, to create new strategies by taking on the opposite of what they are doing.

What errors do most money managers make today?

• Chasing performance
• Over-diversification
• Benchmarking / Hugging the index
• Over-trading
• Relying too heavily on earnings growth
• Analyzing the income statement only
• Refusing to analyze industries
• Buy newsy companies
• Relying on the sell-side
• Trusting management too much

Let me handle these one-by-one:

Chasing performance

In writing this, I am not against using momentum.  I am against regret.  Don’t buy something after you have missed most of the move, as if future stock price movement is magically up.  Unless you can identify why the stock is underappreciated after a strong move up, don’t touch it.

Over-diversification

Most managers hold too many stocks.  There is no way that a team of individuals can follow so many stocks.  Indeed, I am tested with 36 holdings in my portfolio, which is mirrored for clients.  Leaving aside tax reasons, it would be far better to manage fewer companies with more concentrated positions.  You will make sharper judgments, and earn better returns.

Benchmarking / Hugging the index

It is far better to ignore the indexes and invest in what you think will yield the best returns over the next 3-5 years.  Aim for a large active share, differing from the benchmark index.  Make some real nonconsensus investments.     Show real moxie; don’t be like the crowd.

Yes, it may bring in more assets if you are never in the fourth quartile, but is that doing your best for clients?  More volatility in search of better overall returns is what investors need.  If they can’t bear short-term volatility, they should not be invested in stocks.

Over-trading

We don’t make money when we trade.  We make money while we wait.  Ideas take time to work out, and there are frequently disappointments that will recover.  If you are turning over your portfolio at faster than a 50% rate, you are not giving your companies adequate time to grow, turn around, etc.  For me, I have rules in place to keep from over-trading.

Relying too heavily on earnings growth

Earnings growth is far less predictable than most imagine.  Companies with high profit margins tend to attract competitors, substitutes, etc.

When growth companies miss estimates, the reaction is severe.  For value companies, far less so.  Disappointments happen; your portfolio strategy should reflect that.

Analyzing the income statement only

Every earnings report comes four, not just one, major accounting statements, and a bevy of footnotes.  In many regulated industries, there are other financial statements and metrics filed with the government that further flesh out the business.  Often an earnings figure is less than the highest quality because accrual entries are overstated.

Also, a business may be more or less valuable than the earnings indicate because of the relative ability to convert the resources of the company to higher and better uses, or the relative amount to reinvest in capex to maintain the earnings stream.

Finally, companies that employ a lot of leverage to achieve their earnings will not do well when financing is not available on favorable terms during a recession.

Refusing to analyze industries

There are two ways to ignore industry effects.  One is to be totally top-down, and let your view of macroeconomics guide portfolio management decisions.  Macroeconomics rarely translates into useful portfolio decisions in the short run.  Even when you are right, it may take years for it to play out, as in the global financial crisis – the firm I was with at the time was five years early on when they thought the crisis would happen, which was almost as good as being wrong, though they were able to see it through to the end and profit.

Then there is being purely “bottoms up,” and not gaining the broader context of the industry.  As a young investor that was a fault of mine.  As a result, I fell into a wide variety of “value traps” where I didn’t see that the company was “cheap for a reason.”

Buying newsy companies

Often managers think they have to have an investable opinion on companies that are in the news frequently.  I think most of those companies are overanalyzed, and as such, don’t offer a lot of investment potential unless one thinks the news coverage is wrong.  I actually like owning companies that don’t attract a lot of attention.  Management teams do better when they are not distracted by the spotlight.

Relying on the sell-side for analysis

Analysts and portfolio managers need to build up their own industry knowledge to the point where they are able to independently articulate how an industry makes money.  What are the key drivers to watch?  What management teams seem to be building value the best?  This is too important to outsource.

Trusting management too much

I think there is a healthy balance to be had in talking with management.  Once you have a decent understanding of how an industry works, talking with management teams can help reveal who are at the top of the game, and who aren’t.  Who is honest, and who bluffs?  This very long set of articles of mine goes through the details.

You can do a document-driven approach, read the relevant SEC filings and industry periodicals, and not talk with management ever – you might lose some advantage doing that, but you won’t be tricked by a slick-talking management team.  Trusting management implicitly is the big problem to avoid.  They are paid to speak favorably regarding their own firm.

Summary

This isn’t an exhaustive list.  I’m sure my readers can think of more foibles.  I can think of more, but I have to end somewhere.  My view is that one does best in investing when you can think like a businessman, and exclude many of the distractions that large money managers fall into.

A little more than two years ago, I wrote Goes Down Double-Speed.  I wrote it after the market had doubled from its lows two years earlier.  I want to update the piece and explain we have learned over the past 2+ years, and maybe discuss what could happen over the next 2+ years.  Anyway, here is the modified table of bull and bear markets:

Since the last piece, the gains have come slowly, validating my comment, “But it would be unprecedented for the market to continue to advance at a 3% [per month] pace from here.”  In long recoveries, gains first come quickly, then slowly, then near the end they often come quickly again.  Things are coming quickly again now, but who can tell how long it might persist.

Maybe Goldman Sachs can tell us.  After all they increased their price targets for the S&P 500 yesterday.  Now let me republish my updated bull market graphs from the prior piece:

And now look at the cumulative gain:

The predictions of Goldman Sachs are both believable and unbelievable.  Believable: it’s not historically impossible for a rally to last that long, or for it to be so large.  That said the probability historically has been low.

Unbelievable: Unless revenue growth kicks in, that means the profit margin, already at record highs, will soar to an astounding record.  But won’t revenue growth begin again?  That’s hard to say, but if revenue growth starts in earnest, the Fed will start removing policy accommodation, because bank lending will be perking up.  At that point, it is anyone’s guess as to what will happen.  Therefore, I rule out Goldman Sachs’ forecast as a possibility.

The rally continues to get longer in the tooth, and its has been aggressive this year.  I repeat how I ended the original piece: “Consider trimming some of your hottest positions.”

The foolish do the best in a strong market

“The trend is your friend, until the bend at the end.”  So the saying goes for those that blindly follow momentum.  The same is true for some amateur investors that run concentrated portfolios, and happen to get it right for a while, until the cycle plays out and they didn’t have a second idea to jump to.

In a strong bull market, if you knew it was a strong bull market, you would want to take as much risk as you can, assuming you can escape the next bear market which is usually faster and more vicious.  (That post deserves updating.)

Here are four examples, two each from stocks and bonds:

1. In 1998-2000, tech and internet stocks were the only place to be.  Even my cousins invested in them and lost their shirts.  People looked at me as an idiot as I criticized the mania.  Buffett looked like a dope as well because he could not see how the enterprises could generate free cash reliably at any intermediate time span.
2. In 2003-2007, there were 3 places to be — owning homebuilders, owning depositary financials or shadow banks, and buying residential real estate directly.  This was not, “Buy what you know,” but “Buy what you assume.”
3. In 1994 many took Mexican credit risk through Cetes, Mexican short-term government debt.  A number of other clever investors thought they had “cracked the code” regarding residential mortgage prepayment, and using their models, invested in some of the most volatile mortgage securities, thinking that they had eliminated all risk, but gained a high yield.  Both trades went badly.  Mexico devalued the peso, and mortgage prepayments did not behave as expected, slowing down far more than anticipated, leading the most levered players to  blow up, and the least levered to suffer considerable losses.
4. 2008 was not the only year that CDOs [Collateralized Debt Obligations] blew up.  There were earlier shocks around 2002, and the late ’90s.  Those buying them in 2008 and crying foul neglected the lessons of history.  The underlying collateral possessed no significant diversification.  Put a bunch of junk debt in a trust, and guess what?  When the credit cycle turns, most of those bonds will be under stress, and an above average amount will default, because the originators tend to pick the worst bonds with a rating class to maximize the yield, which allows the originator to make more.  Yes, they had a nice yield in a bull market, when every yield hog was scrambling, but in the bear market, alas, no downside protection.

I could go on about:

• The go-go years of the ’60s or the ’20s
• The various times the REIT market has crashed
• The various times that technology stocks have wiped out
• And more, like railroads in the late 1800s, or the money lost on aviation stocks, if you leave out Southwest, but you get the point, I hope.

People get beguiled by hot sectors in the stock market, and seemingly safe high yields that aren’t truly safe.  But recently, there has been some discussion of a possible “safety bubble.”  The typical idea is that investors are paying up too much for:

• Dividend-paying stocks
• Low-volatility stocks
• Stable sectors as opposed to cyclical sectors.

A “safety bubble” sound like an oxymoron.  It is possible to have one?  Yes.  Is it likely?  No.  Are we in one now?  Gotta do more research; this would be a lot easier if I were back to being an institutional bond manager, and had a better sense of the bond market pulse.  But I’ll try to explain:

After 9/11/2001, institutional bond investors did a purge of many risky sectors of the bond market; there was a sense that the world had changed dramatically.  At my shop, we didn’t think there would be much change, and we had a monster of a life insurer sending us money, so we started the biggest down-in-credit trade that we ever did.  Within six months, yield starved investors were begging for bonds that we had picked up during the crisis.  They had overpaid for safety — they sold when yield spreads were wide, and bought when they were narrow.

But does this sort of thing translate to stocks?  Tenuously, but yes.  Almost any equity strategy can be overplayed, even the largest and most robust strategies like momentum, value, quality, and low volatility.  In August of 2007, we saw the wipeout of hedge funds playing with quantitative momentum and value strategies, particularly those that were levered.

Those with some knowledge of market  history may remember in the ’60s and ’70s, there was an affinity for dividends, with many companies borrowing to pay the dividend, and others neglecting necessary capital expenditure to pay the dividend.  When some of those companies ran out of tricks, they would cut or eliminate the dividend, and the stock would fall.  Now, earnings coverage of dividends and buybacks seems pretty good today, but watch out if one of the companies you own has a particularly high dividend.  You might even want to look at some of their revenue recognition and other accounting policies to see if the earnings are perhaps somewhat liberal.  You also compare the dividend to what the cash flow from operations is, less cash needed for maintenance capital expenditure.

I don’t know whether we are in a “safety bubble” now for stocks.  I do think there is a “yield craze” in bonds, and I think it will end badly when the credit cycle turns.  But with stocks, I would simply say look forward.  Analyze:

• Margin of safety
• Valuation, absolute & relative
• Return on equity
• Likely and worst case earnings growth

And then balance margin of safety versus where you have the best opportunities for compounding capital.  If relative valuations have tipped favorably to less common areas for stock investing that considers safety, then you might have to consider investing in industries that are not typically on the “safe list.”  Just don’t  compromise margin of safety in the process.

I have not been a fan of this rally, and I have been selling into it.  I do have a rule for equity clients — cash never goes above 20%.  I have been close to that recently, and after rebalancing some companies that have hit the top of the weighting band, I have bought those companies with the lowest weights in the portfolio.  I have also added some stable companies in the recent past — Berkshire Hathaway, Ingram Micro, Validus Holdings, AFLAC, and CST Brands.

My next quarterly reshaping comes up next week, and again, I will be looking at neglected industries in the market for areas to purchase.  When the momentum runs this hard, I have to be content to trail (though I haven’t been trailing).  I have to ask where things will be three or more years from now, rather than ponder the next quarter.  The answer to that is more murky than I would want, because of abnormal economic policy.  It makes us all more skittish, and obscures price signals.

I have suggested in the past that a good solution in the face of uncertainty is to do half of what you would like to do. Doing half breaks the psychological stranglehold of fear and greed, because regardless of what happens, part of your decision was a success.

You could also start to make a “shopping list.”  Start looking for names that you would like to buy 10, 20, 30% lower, and set alerts.  Who knows how rapidly things will move when the correction or bear market comes.

You could keep a close eye on the 200-day moving average for the S&P 500, waiting for the index to cross under that as a sell signal, but if you want to be ahead of the crowd, maybe you want to use the 190-day moving average.

I tend to use industry selection and other factors, like balance sheet strength and reliability of cash flows as my main risk reduction tools rather than outright reduction of equities owned.  In general, I have been a good picker of stocks over the last 13 years, and I want to continue using that advantage.

With bonds, I am playing it safe with short and intermediate corporates, and taking reasoned chances with emerging markets debt.  Beyond that, I am thinking of buying long Treasuries as a deflation hedge.

The equity market is well above where long-term valuation measures like the Q-ratio, and CAPE10 would value it.  Most of that is due to low interest rates and high levels of QE.  How certain are you that both will persist, and for how long?  Personally, I think both will persist for some time, but not forever.  Profits attract competitors, and low rates discourage savers.

Though we don’t know when change is coming, we have to be ready for change.  Whatever you do for defense, make preparations now to be defensive; this era and valuation levels will not persist.

Aside from that, remember that when a system is so artificially supported, it relies on peace & continued support from governments.  Either could vary.  Peace is not certain, and neither is the current set of economic policies.  Be ready, because there can be all manner of surprises.

Full disclosure: long BRK/B, IM, VR, AFL, CST

US Economics

• For all the debt, there’s a shortage of bonds stks.co/cUj1 There isn’t a shortage of bonds, but of yield w/reasonable safety $$
• FED Very Low Inflation Panic Button: Soon DEFCON 2 stks.co/sDIg Argues that Fed will give up confident talk &continue easing $$
• Wake up! Neither political party cares about the rest of us. #deadlyduopoly
• Fiscal Policy. Oy! stks.co/dUhl Dick Fisher gives us nuanced view of economic policy; if u aren’t confused u aren’t thinking $$
• US Budget Deficit Shrinks Far Faster Than Expected stks.co/sD6D Still high, and now the Fed is absorbing almost all of deficit $$
• The Question the Fed Should Be Askingstks.co/eUhV The Fed is trapped in the imagination that they can resist debt deflation $$
• Wrong:Easy Money: Too Much of a Good Thing? stks.co/pD3E No matter how slowly they remove policy accommodation it will backfire $$
• Washington & Wall Street: Ben Bernanke’s Global Inflation Strategystks.co/fVol Japan imitates US: inflationary race 2 the bottom
• Fed Maps Exit From Stimulusstks.co/rChx Much wishful thinking on Bernanke’s part, will b really tough 2 remove accommodation $$
• Beware Volatile Bond-Market Moodstks.co/tCj8 Bond market will b very sensitive to every nuance of comments by Fed Governors $$
• Red Jahncke: The Federal Revenue Surge Won’t Last stks.co/fVZ7 People took gains taking advantage of low rates, easy huh? $$
• Daily Treasury Real Yield Curve Ratesstks.co/qCVk Interested in getting the real yield rates on TIPS? U can that & more here $$
• US High-Yield Bond Conundrum: First Warning from Bernanke? stks.co/aUGJCorporations can borrow, buy back stock, improve EPS $$
• Are US Lumber Prices Giving us a Warning? stks.co/aUGE Falling pretty rapidly; is this a sign of an economic slowdown coming? $$
• Bernanke: Big Banks May Face Higher Capital Requirements stks.co/hVVNModestly optimistic: Fed to reform margining 4 repos $$
• Wrong: Fed Maps Exit From Stimulusstks.co/eU99 At present, this is formless & void, w/the doves controlling monetary policy $$

US Politics

• Greg Lukianoff: Feds to Students: You Can’t Say That stks.co/iWK2 The first amendment should deal w/this $$
• Puerto Rico’s New Governor: We’re ‘Back on Track’ stks.co/iWK1 We’ve heard this before; ask how big unfunded accruals are $$
• White House Releases Benghazi Emailsstks.co/fW4S How many scandals can the Obama Administration bear at once? $$
• CBO Sees Deficit Narrowing to $642 Billion stks.co/fVoK Good as far as it goes, but nowhere near balanced, keep cutting please $$
• Republicans Risk Razing Arizona Edge by Losing Hispanics stks.co/eUHi US political landscape shifting; Red party lost West US $$
• Crop insurance expands, costs grow in latest US farm bills stks.co/cU8h Ag subsidies decline, but crop insurance costs rise $$
• Rating Firms Steer Clear of an Overhaulstks.co/eUHL There’s no other choice; this has worked out as I predicted $$
• In La-La Land, America’s Silliest Electionstks.co/iVOz In the dictionary, next to the word “hopeless” in a picture of LA $$
• How Many More ‘Red Lines’ Must Syria Cross? stks.co/sCKR Not so fast: how have results turned out in Iraq, Afghanistan & Libya? $$

Financial Markets

• Regulators Target Exchanges As They Ready Record Fine stks.co/iWJu Another type of trading on material nonpublic information $$
• “Give the Market the Benefit of the Doubt” and Invest in Stocks: @ritholtzstks.co/gWEh When do we reduce exposure then? $$
• Wrong: Kovacevich Says Only About 20 Institutions Caused Credit Crisisstks.co/dUfn Overlending on Resid RE caused the crisis $$
• The market isn’t merely crawling a wall of worry but we’re rapidly approaching the crown molding of disbelief.
• Rise of the Zombies: Fannie, Freddie preferred shares hit post-bailout highs yesterday on.wsj.com/12tcX6r Fool me once…
• Wrong: Warren pushes SEC, regulators on ‘too-big-for-trial’ banks stks.co/hW7fSounds good in concept; very hard to execute $$
• S&P Cuts Rating on Berkshire Hathawaystks.co/dUW6 | FD: + $BRK.B Maybe Buffett should own some McGraw Hill for protection $$
• Investors Flood Into Loan Fundsstks.co/jVtV People imagine that they can earn high yield off of levered junk w/little risk $$
• “The lower the gold price, the more nervous investors holding these positions will become.” stks.co/gW22Kinda perverse market $$
• Rethink your bond strategy for retirementstks.co/cU8r What if interest rates don’t rise, amid economic weakness? What then? $$
• Brokers Go Gray as Youth Unsustainable Without Cold Calls stks.co/pCogHappened w/life agents 2, eventually sorts itself out $$
• Stock Buybacks: We Separate Smart from Dumb stks.co/iVXm Check free cash flow & relative valuation; check soundness of buybacks $$
• Mortgages are investment du jour for hedge funds stks.co/bUB7 Hedge funds r weak holders & r buying in the eighth inning $$
• Farmland: The market ‘bubble’ you’ve never heard of stks.co/gVSL Watch debt financing levels; high levels would indicate bubble $$
• Fitch:US Corporate Cash Part I: Growth at an Inflection Point? stks.co/jVJkCorporations hoard cash b/c cost of doing so is low $$
• Does the Sohn Conference Make Hedge-Fund Geniuses Stupid? stks.co/jVBvMany investment “geniuses” were one-trick ponies $$

Europe

• EC ready to hit Chinese companies with sanctions over illegal subsidiesstks.co/rCo3 Currency wars may give way 2 trade wars $$
• Europeans must face up to prospect of massive debt restructuring stks.co/iVrN If Euro survives there will b bail-ins >Cyprus $$
• Greek Bonds Soar After Fitch Upgradestks.co/sCoB Fear gives way to greed as austerity solutions begin to ebb & recovery starts $$

China

• China’s outstanding corporate debt to surpass US stks.co/tD62 When China govt steps away, corporate defaults will surpass US 2 $$
• Grade A office rents under pressure after years of rises stks.co/rChi W/all of the overbuilding, what should you expect? $$
• @AlephBlog That last tweet was about office space in China.

Japan

• Japan Posts Surge in Economic Growthstks.co/bUaO Too soon; we need to see the effect on inflation, which will lag $$
• World’s Worst Bonds Brace for Losses on Abe Growth stks.co/pCtF Japanese bonds deliver significant losses in USD term 2 holders $$
• Yen at Four-Year Low Prompts Fujitsu to Raise PC Prices stks.co/fVjU Could it be that policy is finally creating reflation? $$

Rest of the World

• Euro-Style Bail-In Plan Means Bondholder Wipe-Out stks.co/hW7gCorrect; wipe common, preferred, bonds, deposits protected2limit $$
• Canadian Housing Bubble Review: Overpriced and Overbuilt stks.co/pCuPBubbles never deflate slowly; incentives lead to panic $$
• Commented on StockTwits: Yes, the US has shifted more to temporary workers & it will get worse under Obamacare, bu…stks.co/cUG9
• Canada’s shift to a nation of temporary workers stks.co/tCjD Puts pressure on lower-skilled workers to move among a few jobs $$
• @agnestcrane Feels like the Brazilian Govt is driving $PBR into the ground. Income is anemic, debt is rising, would b reluctant 2buy

Other

• The New Science Behind Philanthropystks.co/qDJX This isn’t science, but gambling; putting $$ on longshots w/big payoffs
• Dodging companies before disaster strikes stks.co/rDGz The simple aspects of ethical investing r doable; don’t make it complex $$
• Secret Rocks and Gem Huntersstks.co/dUVz The $10B jewels industry is shrouded in beauty—and mystery. Is change about to come? $$
• In U.S., Apostrophes in Place Names Are Practically Against the Law stks.co/tD6VJust another sign of cultural stupidity $$
• @The_Analyst It varies a great deal, but mostly I go to bed late; today I am up early.
• Harvard-for-Free Meets Resistance as US Professors See Threat stks.co/fVoQOvercapacity in colleges coming 2a crisis state $$ #bye
• Why More Young Kids Cheat at Schoolstks.co/fVoP We r basically evil, not good, we should b surprised when children don’t cheat $$
• North Jersey Data Center Industry Blurs Utility-Real Estate Boundariesstks.co/aUKZ Data centers r about energy costs & space $$
• Martin, CEO of ING U.S. on Growth Outlook $VOYA stks.co/sCXN CEO seems flustered, did not answer the questions he was asked.
• Bloomberg Isn’t The Only Company Able To Spy On Users stks.co/eUHm Wise 2 ask 3rd party vendors 4 how they keep ur data private $$

FWIW

• My week on twitter: 32 retweets received, 25 new followers, 37 mentions. Via:20ft.net/p

I have a saying that when there is no news, the market reveals its true direction.  That applies to individual securities as well as the market as a whole.  Why?

Think of institutional traders, who drive much of the market.  They are so big that they have to spread out their orders over time, or they would move the market against their positions.  On days when there is no news, volume tends to be light, displaying the actions of the big traders.

Valero recently spun off CST Brands, which was their retailing arm, selling gasoline, and things you find at convenience stores.  Seems cheap to me.  Over the last few days it has been rising on no news.  To me that means some institutional investors are buying.

I’ve seen the same thing happen when a stock falls on no news.  That’s usually a bad sign if you are long, because it means someone is selling for a reason you are not aware of.  Now, if you have done your homework, and know more than the seller, a lower price is to you advantage if you want to buy more.  The trouble is, you don’t know how much the seller has to unload.  To use CST Brands as an example again, I received some shares as a result of holding Valero for clients (and me, I get what my clients get), but I estimated how much index related selling had to happen as a result.  I bought a full stake for my clients at the point where the total volume from the prior “when issued” trading, plus actual trading on the first day hit my estimates.  It was close to the low for the day, though someone more enterprising could have picked up shares cheaper during the “when issued” trading, if he was clever.

But sometimes when there is news, you need to try to gauge whether something is an over- or under-reaction.  My favorite example here is RGA, the prominent well-run life reinsurer.  Once every eight quarters or so, they report a lousy quarter.  Why?  Because of the law of small numbers.  The large claims inside a life reinsurer are few, but make a considerable difference to the earnings when a bunch of large policy deaths happen at the same time.  The general public does not get this, so when RGA has a bad quarter, it is usually a good time to be a buyer.

The same applies to P&C reinsurers during crises.  I added to my reinsurance holdings post-Sandy, because I knew that the reinsurers would take relatively few claims because they don’t cover flood for residential, though they might have commercial-related claims.  As it was, none of my insurance holdings had any significant claims from Sandy, and the portfolio did well.

Toss out another example, but Endurance Specialty is one of the leading underwriters of crop insurance.  Crop insurance was a horrible place to be last year, and that put pressure on ENH as a stock.  But that neglected all of the other lines of business of Endurance that were performing well, as well as the risk controls that Endurance placed on its crop insurance business.

Perhaps the broad message here is to know your stocks well, so well that you can gauge whether a  market reaction to news is overdone, underdone, or meh, normal.

Analyzing the reaction to news (or no news) bonds and other assets as well.  When I was an institutional bond manager, I would watch the results of trading on the slow days, because it would give a clue to what the “big guys” were doing.  Also, when an event that has been anticipated occurs, like a ratings downgrade on the bonds of a troubled company, the market reaction says a lot, because often there are many who were waiting to buy once the downgrade happened, so price rises a lot at the downgrade.  (Think of the USA downgrade by S&P.)  The reverse is true for downgrades that are more of a surprise.

In summary, all news is not equal.  The reactions to news, and the lack thereof, can tell us a lot about the intentions of large market actors.  Do your homework well, and prosper off of the knowledge that it gives you regarding reactions, over-reactions, and under-reactions.

Full disclosure: long VLO CST RGA ENH

I wrote this piece once, and lost it, 1000 words.  Going to try again.

1) The first thing to realize is that diversification across insurance subindustries usually does not work.

Do not mix:

• Life & P&C
• Financial & Anything
• Health & Anything

Maybe you can mix P&C, Mortgage & Title, after all Old Republic survived.  The main point is this.  Insurance is not uniform.  Coverages are sold and underwritten differently.  Generally, higher valuations will be obtained on “pure play” companies  Diversification is swamped by management inability.  These are reasons for AIG and Allstate to spin off their life operations.

2) Middle-sized companies tend to do best from a valuation standpoint: the large have nowhere to grow, and the small are always questionable on their viability.  With a few exceptions, I like sticking with focused mid-cap companies with my insurance names.

3) Be aware of total subindustry capital relative to need.  After a big disaster, those that underwrote well will have capital to deploy into a stronger underwriting environment, where capital is scarce.  But don’t make too much of it because capital has become very fluid in insurance; the barriers to entry and exit are low.  Still, it is best to be an investor after a disaster, when everyone is running scared.  When total capital is high, and companies are fat, dumb, and happy, it is time to leave.

4) It’s good to look through the Statutory statements [regulatory statements filed with state insurance regulators] of their operating insurance subsidiaries to look for odd entries.  Occasionally, you will run into problems that do not have to be reported under GAAP accounting.  (Note: they should be reported under the spirit of GAAP, but not the letter of GAAP.  I have a saying, “It is okay to violate GAAP to be more honest, but not to be less honest.”)

Here’s an example: I ran across a life company that had to post an extra statutory reserve because they would lose money if interest rates rose.  That’s a significant admission, and the company was invested far more aggressively than almost all the other life companies we were tracking.  We shorted it, and got ripped as the credit markets surged 2003-2005.  We got out with a small gain when their earnings proved inadequate as interest rates rose, and credit losses rose.  But it took a long time.

At this point, I would be looking for special reserves established for secondary guarantees established for Term and Universal Life, and Variable Life & Annuity policies.  There is no specific requirement to hold those reserves on a GAAP basis, even though there may be general principles that would encourage additional reserves or disclosures.

5) There are ways of multiplying capital across subsidiaries — Subsidiary A reinsures liabilities of subsidiary B, while Subsidiary B reinsures liabilities of subsidiary A.  This is a way to create hidden leverage, so be aware of what is being done at the subsidiary level.  Doing these sorts of things is dumb, though legal.

Reviewing leverage is a good idea as well, where it is located, and what conditions it has.  The practice of insurance subsidiaries issuing surplus notes to parent companies has become all too common, which allows subsidiaries to write more business at the risk that when a subsidiary becomes impaired, the domiciliary state takes it over, and the parent company gets little to nothing.  (Payments on surplus notes can only be made with the approval of the insurance commissioner. In insolvency surplus notes typically receive nothing.)

The thing is, it is a lot harder to produce return on assets than return on equity. Though part 6 focused on ROE, in the short run, insurance companies can improve their ROE through substituting debt for equity.  The same applies to insurance companies that write GIC Medium Term Notes.  It’s just a cheap way of making a little extra income arbitraging your subsidiary’s high claims paying ability rating.  It fascinates me that regulators have allowed the insurance industry such latitude with deposit contracts that are called annuities, but have never once been annuitized.

Another hidden source of leverage are financial reinsurance agreements.  Down in the insurance subsidiaries, companies trade away a portion of future profits for surplus today.  These are usually bad deals to enter into, but because some insurance companies have a sales culture that requires continual growth, even if the sales that don’t justify the cost of capital required to back the policies.

6) Free cash flow is difficult to determine for financials, this applies to insurers as well.  Each regulator has rules on how much can be paid in dividends to their holding company.  Typically, subsidiaries can dividend away surplus so long as they are still strongly capitalized after the dividend.  (If it is large, they may have to petition their regulator for approval)  So if you want to approximate free cash flow for an insurer, try the following:  (Income or loss outside your insurance companies for the current period) + (Distributable Income from insurance companies for the current period).  The latter figure is statutory income +/- any decrease/(increase) in capital required to maintain the remaining business with adequate financial strength, calculated separately for each subsidiary.

7) Last note: on DAC/VOBA [deferred acquisition costs, value of business acquired; they  are similar, so I will just talk about DAC].  Once I had to convince a boss that though it is an intangible, like goodwill, it is not like goodwill in that it is more rigorously tested for recoverability.  If DAC gets written down (as opposed to amortized) that means that the future sum of profits on some of the insurance business is expected to be less than the acquisition costs deferred for the business.

Now, DAC can be done conservatively, by product and class year.  The more disaggregated it is, the more conservative, generally.  A few cells getting written down is no big thing.  But DAC can be as liberal as having one cell, which means if DAC is written down, the total value of future profits from existing business has been reduced — the company is worth a lot less.  The change in value is even more than the reduction in the DAC, because in the writedown process, the discount rate on the DAC went from a positive number to zero.  All other things equal, a DAC asset is worth more the higher its discount rate.

S0 pay attention: if DAC amortization is high relative to net income before tax, it means there isn’t that much margin for adverse deviation in the DAC.  Also, all other things equal, lower levels of DAC as a fraction of net worth are better.

Close with a story: before Mony Group was bought by AXA, it was doing DAC for the company as a whole.  A value investor, seeing the discount to book value, and sensing opportunity bought a lot of Mony.  Profitability was so bad, they had to write down DAC.  Book value declined & price to book value declined as well.  The value investor agitated for a sale, and AXA stepped in, buying it for moderate premium to where it was trading.  The group I was with went long for an arbitrage trade on a cash deal.

But the value investor thought the premium wasn’t high enough and agitated for more.  Because the takeout price was 70% of book, the idea seemed plausible.  But when you factored in the DAC earning 0% and a few other items, it looked generous enough to me.  So when the price got several percent above the deal terms we sold our stake and went short as much as we could find without having to pay much interest on the borrow.  Bit-by-bit the stock price moved down until a few days before the deal would close, when the price collapsed below the deal price, and we covered.  We even arbed a little more on the long side, but the trade was over.

And the point is this: it may look cheap, but test your assumptions on the values of assets and liabilities before committing a lot of capital to a any insurance stock.  GAAP, Tax and adjusted Statutory income validate book value, so a cheap stock with a low return on equity or assets is often not cheap.

From a reader who I appreciate:

David, I am curious if you have thoughts about insurance companies (especially P&C) hedging political risk … the answer to this question obviously will carry over to healthcare quickly.

Recently, my state (Corrupticut) was hit by hurricane Sandy. Many municipalities (but not all) still had extensive flood control, hurricane gates, levies, etc from the 1970s — the last time we had really active hurricanes.

In an effort to bump up property tax revenue, several municipalities allowed developers to build McMansions right on top of, or in place of, sand dunes that had existed for centuries. The dunes blocked the view or some such nonsense. Quite predictably, these municipalities had much higher damage than those who maintained dunes and other protection.

Our idiot governor decided to keep his heel on the throats of insurance companies to make them pay — and the insurance companies called his bluff. “Fine Mr Malloy, we will stop selling home owners insurance in your state — good luck getting a mortgage without any insurance. Gee whiz, the lack of mortgages probably will devastate home prices. You should have thought of that before you chased us out.”

All up and down the coast line, insurance companies are telling state and local governments that sand dunes, levies and sea walls must be restored and maintained — or insurance will not cover anything.

States along the gulf of Mexico (ie hurricane Katrina et al) enacted laws prohibiting developers from taking down mangrove fields.

I heard rumors (not sure if they are true) that re-insurance companies have told underwriters that they will not accept pools that contain policies in states that allow destruction of natural flood barriers.

Perhaps most recently, New Jersey’s governor told his MTV “J Wow” constituents that they were going to restore sand dunes regardless of whether it looked good.

I seriously doubt that corrupt populist politicians (like the governor of my state) will stop promising to seize private property to buy votes … but it also seems they have pushed the P&C insurance industry too far. Hard to imagine that anyone will knowingly operate at a loss.

And Hugo Chavez not withstanding, most national governments won’t jeopardize their own regime to subsidize a practice that also threatens their regime.

The US government doesn’t have the trillions needed to allow FEMA to insure McMansions built where sand dunes once stood.

Whether the US ends up with “universal healthcare” or not — the federal government does not have the money to keep the current healthcare system growing 8-10% per year while the economy grows less than half as fast.

The end result is obvious — stupid government policies will fail long term. Maybe common sense will prevail again. Maybe the government will bankrupt itself and become irrelevant. Hard to guess which.

But in the short term — how can the insurance companies hedge political risk?

One of the reasons for high storm damages over the past ten years has been the pressure from developers to develop land that is beautiful, but subject to flooding risk  from storms.  In the present time, that has led insurers to raise prices on such developments, and/or refuse to insure, allowing state-sponsored captive insurers to absorb the risk on behalf of the taxpayers.

Insurers have gotten smarter, in my opinion, and most have learned to resist the actions of the states, sacrificing business volume for profitability.  They understand that there is a “Knot at the Bottom of the Rope,” below which you can’t go any lower.  So if a state is making certain classes of business unprofitable, stop underwriting those classes of business.

Contract law favors the insurers.  They can’t be compelled to take losses against their will, except by contract.

Eventually politicians have to face reality, lest they go the way of Argentina, or worse, Zimbabwe.  Insurers, though they may not be loved, reflect a fair estimation of risk.  Politicians in the short-run may try to bend the view of risk to voters, but if contract law is observed, no change will happen.

Look, we would all like Santa Claus behind us bailing out our every mistake and trouble, but in the real world, where resources are limited, claim payments flow according to contract.

Yes, the reinsurers push on the insurers, and that leads to reductions in coverage.  They have economic incentives as well, and they are all the more sharp, because they really get hit when things get bad.

Finally, you are correct that the US can’t maintain its current approach to healthcare.  If we were smart, we would eliminate the corporate tax deduction for healthcare, and return the system to the free market.  If you want health insurance, let it be done outside of the tax code.  That could help balance the budget.  As I listen to many screaming, I would add, “And let’s eliminate the interest deduction on mortgages, and the charitable donation deductions.”

We have to clean up the tax code such that most tax preferences disappear, so that the budget can balance.  Balanced budgets promote growth, because people do not fear higher future taxes.

This piece is the sixth out of seven in a series that I have been writing at Aleph Blog.  Here are links to the first five pieces:

• On Insurance Investing, Part 1 (reducing share count)
• On Insurance Investing, Part 2 (growing fully convertible book value per share)
• On Insurance Investing, Part 3 (price momentum and mean reversion)
• On Insurance Investing, Part 4 (Management & reserving conservatism)
• On Insurance Investing, Part 5 (Management quality & product quality)

Recently I decided to spend some time analyzing the insurance industry.  It’s a different place today than when I became a buy-side analyst ten years ago.  Why?

First, for practical purposes, all of the insurers of credit are gone.  Yes, we have Assured Guaranty, and MBIA is limping along. Old Republic still exists. Radian and MGIC exist in reduced states.  The rest have disappeared.  In one sense, this should not have been a surprise, because the mortgage and credit guaranty businesses never had a scientific model for reserving.  I’m not even sure it is possible to have that.

Second, the title insurers are diminished.  Some, like LandAmerica are gone. Fidelity National seems to be diversifying itself out of insurance, buying up a restaurant chain last year.

Third, health insurers face an uncertain future.  Obamacare may disappear, or Obamacare could slowly eliminate insurers.  It’s a mess.  Insurers debate to what degree they should compete in insurance exchanges.

But beyond all of that, valuations are fair-to-cheap across the insurance industry.  Part of that may stem from ETFs.  Insurers as a whole are smaller than the banks, but not as much smaller as they used to be.  Now, if you are a hedge fund, and you want to short banks, you probably have the best liquidity shorting a basket of financials, which shorts insurers as well.

That may be part of the issue.  There are other aspects, which I will try to address as I go through subindustries.

Offshore

By “Offshore” I mean P&C reinsurers and secondarily insurers that do business significantly in the US, and who list primarily on US exchanges, but are not based in the US.  Most of them are located in Bermuda.

In 2011-2012, many of them were challenged by the high levels of catastrophes globally.  But the prices of the reinsurers did not fall because pricing power returned, and investors expect higher future earnings as a result.

Before I go on, I need to explain that what I will use to give a rough analysis of value is a Price-to-Book vs Return on Equity analysis [PB-ROE].  For more details, you can read my article here.  The short explanation is that companies in the insurance business (and other financials) are constrained by the amount of equity (net worth) that they have.  The ability to earn a return as a percentage of the equity [ROE] drives the market valuation as a fraction of the equity [P/B].

Here is a scatterplot for PB-ROE for the Offshore group:

Companies above the line may be overvalued, and companies below the line may be undervalued.  ROE is what is expected by analysts for the next fiscal year, not what has been obtained in the past.

The fit is fairly tight, and indicates mostly logical valuations for this group.  The companies that are possibly overvalued are: Arch Capital [ACGL] and Renaissance Re [RNR]. Possibly undervalued: Tower Group [TWGP] and Endurance Specialty [ENH].

Now, this simple model can fail if you have an intelligent management team that has a better model.  Arch Capital and Renaissance Re may be that.  But with an expected ROE of less than 20%, it is hard to justify their valuation, when the average stock in this group needs an expected 11% ROE to be valued at book.

Why such a high ROE to get book?  Earnings quality.  Reinsurers have noisy earnings due to catastrophes.  You don’t give high valuations to companies that run hot or cold.  But the trick here is to see who is accumulating book value the fastest – they tend to be the stars over time.  Endurance and Arch have been good at that.

Life

The life insurance business would be simple, if it indeed were only life insurance.  Much of the industry is handed over to annuities, and all manner of asset gathering.  Even life insurance can be made more complex through variable and variable universal life, where assets are invested in stocks, and do not receive a rate from the company.

Part of the trouble is that variable products are not simple, but the insurers offer guarantees for a fee.  When I see those products, my reaction is usually, “How do they hedge that?!”

Thus I am concerned for insurers that are “equity-sensitive” as I reckon them.  Here is the PB-ROE scatterplot:

A tight fit.  The insurers that are seemingly undervalued are equity-sensitive ones: Phoenix Companies [PNX], Aegon [AEG], and ING [ING].  Those that are overvalued are Citizens [CIA], Eastern Insurance Holdings [EIHI], and Atlantic American [AAME].  For the undervalued companies, I am unlikely to buy because I am skeptical of the accounting.  I would look further down the list and consider buying some companies that are more reliable, like Assurant [AIZ], National Western [NWLI], and Fortegra Financial Corp [FRF].

One more note: to get book value in Life Insurance, you need a 9.8% ROE on average.  That’s high, but I expect that is so because investors are skeptical about the accounting.

Property & Casualty

This graph gives PB-ROE for the entire onshore P&C insurance industry:

It’s a good fit.  Again, the casualties of the last year weigh on the property-centric insurers, but for the most part, this is logical.

Potential underperformers include First Acceptance [FAC], Employers Holdings [EIG], and Erie Indemnity [ERIE].  Below the line: Hartford Financial Services [HIG], Hilltop Holdings [HTH] Hartford Financial [HIG], and United Insurance Holdings [USIH].

Again, these are only screening tools.  Before buying or selling, understanding management and reserving quality, and riskiness of the lines of business makes a considerable difference.  Erie Indemnity has an “asset light” model where it manages insurers, but does not bear underwriting risk.  Hartford has a significant life insurance and annuity exposure.  Models are models, and we have to understand their limitations.

Health

With Obamacare, I don’t know which end is up.  It could end up being a giant sop to the health insurers, or it could destroy the health insurers in order to create a government single-payer model, rather than the optimal model for cost reduction, where first parties pay directly, or pay insurers.  You want reductions in medical costs, get the government out of healthcare, and that includes the corporate deduction for employee health insurance.

My rationale is this: it could mess up the private market enough that the solution reached for is a single payer solution. I’ve talked with a decent number of health actuaries on this. The ability to price risk is distinctly limited. Young people pay too much, older folks too little. That’s a formula for antiselection. I think Obamacare was badly designed. I will not achieve its ends, and when the expenses start coming in, they will be far higher than anticipated. That has been the experience of the government in health care in the US. Utilization is underestimated, the further removed people from feeling its costs.

There are many models for profitability here, which makes things complex, but here is the present PB-ROE graph:

It’s an okay fit, with the idea that the following companies might be undervalued: Wellpoint [WLP] and Humana [HUM].  And the following overvalued:  Molina Healthcare [MOH].

I don’t regard myself as an expert on the health insurance sub-industry, so treat this with skepticism.  I include it for completeness, because I think the PB-ROE concept has value in insurance.  One more note, the PB-ROE model thinks of this as a safe investment subindustry, because to have a book value valuation, you have to have an ROE of 1.8%.

Financial Insurers

This group comprises the surviving mortgage, title and financial insurers, and two companies in the ghoulish business of buying life insurance policies from sick people.  Here’s the PB-ROE graph:

This graph is weird, because it slopes down, and does not have a good fit.  That’s because we’ve been through a rough period financially, and in many cases GAAP accounting does not do a good job with these companies that take a lot of credit risk.

We can still look for companies that have high price-to-book, and low ROEs – note Life Partners [LPHI] and Radian [RDN] as possible sell candidates. We can also look for companies that have low price-to-book, and high ROEs – note Assured Guaranty [AGO] and MBIA [MBI] as possible buy candidates.

This subsector is more difficult than most, because credit is not an underwritable risk.  It is feast and famine.  We are in a period of feast now, so in some ways what is bad is good.  The more risk, the more return.  But winter may come soon – who knows what the Fed may do?  In general, I avoid this subsector for longs.

Insurance-Related Companies

This is a group that is a non-group.  It comprises brokers and insurance service providers.  Here’s the PB-ROE graph:

It doesn’t look like much of a group.

As it is the potential outperformers include Brown & Brown [BRO], and Aon [AON], two leading insurance brokers.  A potential underperformer Willis Group [WSH], another leading insurance broker.

Summary

Insurance is complex, and the accounting is doubly complex, which is a major reason why many stay away from it.  But insurers as a group have had reliable and outsized returns over the rememberable past, which should encourage us to do a little kicking of the tires when a decent amount of the industry trades below its net worth and is still earning money with little debt.

In my opinion, this is a recipe for earnings in the future, and why I own a lot of insurers for myself, and for clients.

In the final part of this series, I will go over some nuances of insurance accounting – I leave it to the end because it is kind of dull, but can make a lot of difference, because some companies look cheap and aren’t really cheap.

Full disclosure: long AIZ, ENH, NWLI for clients and myself