Here are therebalan additional tickers for the upcoming reshaping:


And now for a reader question on the original reshaping candidates list:

What’s your ranking system? Have you written a note about it? Also, what was the criteria for inclusion in the list above?

I’ll probably suggest some other stocks as a function of the above. Also, as a value investor myself, I think the following pair of questions is worthy of reflection and debate: 1) Is undervaluation better thought of as a ranking factor or a safety factor – e.g. should one try to pick the most undervalued stocks so they go up the most, or should I try to pick stocks with most improving outlook and use undervaluation and/or low growth estimates as a safety net in case they blow up? 2) To what extent should I use the valuation measure that makes the most rational sense to me vs. the one that gives the best empirical match to market behavior ( fine to reference mean reversion in the answer, but I expect that one can fit data over a long time frame and still find important differences between the two).

Answering in order:

  • The ranking system comes in the next phase.
  • Inclusion criteria was that it looked interesting at some point in the last four months.  Anytime I get an idea, I write it down, and wait for the reshaping.  By waiting, I avoid making hasty decisions, or trusting the authority of another clever investor.
  • Undervaluation — ranking or safety?  Why choose?  They are by nature both at the same time.  Truly undervalued companies have higher upside and lower downside compared to more richly valued peers.
  • Your last question is one that I have thought about a lot and concluded that there is either no good answer, or the data involved is out of my reach.  If you use the one that matches market behavior, then you end up doing relative value trades, but if you use one that takes into account average valuation over time, you can play for mean reversion, but may miss some relative value.  If we had enough data, and a regression package that could do cross-sectional time-series, we could try to isolate both effects, and perhaps figure out when companies and factors are cheap, independent of each other.  Would love to try it, but that would be costly.

One more reader question:

I am interested in your feelings on GLYT. I have recently bought this company. The reported in-line earnings back in July but guided lower, and the market took out their frustrations on them.

They have shown growth both in revenues and earnings and have been pairing down their debt.

Let me know your thoughts

I’ve owned GLYT twice in the 90s.  Great management team; wish I’d never sold it, even though I made good money on it both times.  It’s more expensive today than when I owned it before, and the growth opportunities may not be as good as they were.  If it scores closer to the top of my list, I’ll take a closer look.

Here are my Industry Ranks October 2007 for the current portfolio reshaping.  Remember that my ranks can be used two ways.  If you are a value guy like me, you pick from the bottom quartile, the green zone, for out-of-favor industries.  I further filter that by striking out industries that in my subjective opinion, still have more pain to take.  That’s why housing, housing finance, and housing related names are absent.

If you are a growth or momentum player, pick from the top of the list, because in the short run, momentum tends to persist.  In the intermediate term momentum tends to mean revert.  I play for the latter of those two momentum effects, because I am not much of a trader, and I think the effect is more reliable, and tax-effective.

Later today, I’ll post my final list of additions to the candidates list for the portfolio reshaping, after running an industry screen.  Then over the next three days, I’ll get to work on the reshaping.

Actuaries are bright people.  Okay, present writer excepted.  That’s a danger when you give a talk to a bunch of them.  Every now and then you will end up with a questioner who is a bit of a crank.  Now, I have a soft spot in my heart for actuarial cranks, because I have done more than my fair share to question other presenters over the years.

At my talk yesterday, one actuary suggested turning the Social Security system into a defined benefit plan, and having it invest in stocks, which would provide cheap capital to corporations.  The Social Security system gets better returns. Everyone wins, right?

Well, no.  Here is what is amiss with the idea:

  1. It would favor public companies over private companies.
  2. Active managers would be useless, because the fund would be too big.  They would have to index.
  3. Initially the stock market would shift up as the money began to be invested, but once fully invested, P/E multiples would be so high that future returns would be lousy.  Once the liquidation phase began, this fund would be so big that stocks would fall in advance of the liquidation, even if everything were indexed.
  4. Marginal companies with lousy profitability would come public to take advantage of the cheap funds.
  5. Corporate governance issues would be tough; how does the government vote its proxies?  How would activist investors get treated?  Which side would the government favor?  If they left this in the hands of active managers to take care of, could the managers stand up to all of the political pressure?
  6. Do we really want the Socialism associated with the government owning 20% of every corporation?  What additional regulations might be put on corporations that are owned or not owned by the government?
  7. Would we give the Fed a third mandate to try to improve corporate profitability, because it would have a greater effect on the economy?
  8. Why limit the asset classes invested in?  Why not other bonds, loans, commodities, real estate (commercial and residential) and perhaps international investments?  At least if we liquidate international investments, we don’t hurt our own economy.
  9. For that matter, the US government could contribute all of its property to a great big REIT, and use it to fund a small portion of Social Security.  Of course, the deficit would rise as the government made dividend payments.
  10. Medicare is the tougher issue to solve; Social Security is small compared to it.  Solve that one first.

My last reason is that for the most part, stocks don’t care who owns them.  In the long run, they are weighing machines, and not voting machines.  They will produce the stream of cash flows as a group that will be pretty invariant to who owns them.  Activist investors may have an effect in the short run, but on the whole, the effects of activism on the index returns as a whole will be paltry at best.

This tired idea of investing the Social Security trust funds in equities came up during the Clinton Administration (hopefully there will not be a second one).  I view it as the ultimate “dumb money” for the stock market.  If it were ever implemented, you would invest into the wave of new money, and create IPOs to sop up money.  Then once the money flow was largely deployed, you would sell along with other smart investors, and invest overseas.

My own view is that Social Security and Medicare should be wound down over a 80-year period.  They were bad ideas to begin with, but getting us out of that business with fairness to promises made would have to take two generations or so to complete.  I know, that’s a non-starter, but most reasonable ideas regarding social insurance programs are.  The eventual “solution” will come through higher ages for benefit receipt, lower benefits, higher taxes, limitation of inflation adjustments (already done, and quietly) and means-testing.  Not that I like it, but we will have to face realities eventually.

The same issues will apply to Medicare.  Eventually we will have a two-tier healthcare system (we won’t call it that), because we can’t afford the promises made to Medicare recipients.  It will be “The government pretends to pay us, and we pretend to treat you.”  It will be a mess, and that one should begin to come into clear focus within ten years.

PS — My talk went well yesterday.  If there is ever a recording of it on the web, I will put a link at my blog.

Russell Bailyn is a Wealth manager who wrote a basic book on finances, but gave it a twist to emphasize what resources were available on the web, and at financial blogs specifically. He covers a wide number of areas in a basic way, sometimes giving answers where “one size fits all,” or almost all, and sometimes explaining to readers what the right questions are when answers are situation-dependent.

Some of the areas he covers are:

  • Banking, budgeting and credit.
  • Financial planning and tax-deferred savings/investment
  • Investment types
  • Life insurance and annuities
  • Retirement and portfolio management

The book isn’t long at 220 pages, so as you might imagine, this book is wide, but not deep. I would recommend this book for people who are getting started in managing their finances, and want to take a more active hand there. Alternatively, it could benefit those who want to hire a financial planner, because they would better learn how to choose a planner, and better evaluate the advice that their planner gives them.

Because I am aware of most of the areas in the book, this is a book that I skimmed. That said, as I looked at critical ideas in the book, I found that I largely agreed with his ideas. As a trivia note, Alephblog and I get featured on page 177, in the chapter on portfolio management. If I had to featured in any chapter, I’m glad it was that one, because managing risk through proper portfolio management is near and dear to my heart.

Finishing off the presentation proved to be harder than I estimated, together with all of my other duties.  Well, it’s done now, and available for your review here.  For those looking at one of the non-PDF versions, you might be able to see the notes for my talk as well.


I’m writing this before I give the talk.  If I had it to do all over again, I would have made the talk less ambitious.  Then again, of the four topics that I offered them, they picked the most ambitious one.  When you look at the talk, you’ll see that it is a summary of the macroeconomic views that frame my investment decisions.  The presentation will run 40 minutes or so, plus Q&A.  Reading it is faster. 🙂


Enjoy it, give me feedback, and I’ll be back to normal blogging Monday evening.

Years ago, I created a spreadsheet to help young children learn their lowercase letters once they had learned their uppercase letters.  I created it for my two oldest, and now my youngest is using it.  My wife says that it has made that teaching task simple.

The spreadsheet generates seven unique random letters in uppercase on the left, and scrambles them in lowercase on the right.  Print a sheet, and the child draws lines to match the letters.  Hit the recalc [F9] button, and you have a new sheet.  With a little bit of coaching, the child gets the concept in a week or so.  The sheets are easy to use, and the limited matching doesn’t overload their ability to remember, particularly because a few letters on each page will be easy.

If it works well for you, let me know.

The Society of Actuaries presentation is a “labor of love” piece.  When I say that, I mean that it took a lot of effort to think through and put together.  If you have a subscription to RealMoney, you can look through the articles on my Major Articles List.  Most of them are still relevant today.  I wrote long-dated pieces for RealMoney that would stand the test of time.  For what they paid me, they really got their money’s worth. 🙂

I don’t have a lot to say tonight.  I’ll be back to regular blogging tomorrow evening, because my presentation will be done.

I’m still flooded by my workload, so just one comment this evening.  The Wall Street Journal posts an article on overly favorable (and smoothed) returns at hedge funds through securities that are mismarked favorably.  It was no surprise to naked capitalism, and no surprise to me either (point 26).  I’ve been writing about this issue off and on for three years now, because economic processes are messy, and tend to generate messy returns, not smooth returns, particularly once the easy arbitrages are glutted with yield-seeking investors.  Also, I know what the temptation is to mismark illiquid bond positions when incentive payments may be riding on the result (which is why we took the marking out of our hands at a prior firm).

Having been an actuary in financial reporting for twelve years, I know what the pressure is when someone above you in the hierarchy asks if your reserve is wrong.  It is rarely asked when the reserves are too low.  Few managements are so farsighted.  It is always asked when income is too low, and adjusting reserves downward is so convenient.  And who will notice?  Few, I’m afraid, but most actuaries I know are highly ethical, and resist these pressures.

My target here not insurance companies, though, but the investment banks.  Actuaries have detailed rules for setting reserves.  We have societies and ethics codes.  Those who work at the investment banks are not typically CFAs, which is more of a buy-side thing, so there is no industrywide ethics code there.  Also, the value setting rules for many investment banking assets and liabilities are far more squishy than for insurance liabilities.  Finally, investment banks frequently hold the same instruments as the hedge funds, and get their pricing marks from the same sets of sources.  I suspect that the positions are similarly mismarked, and they are big enough to hide it, because derivative books are never unwound.

Well, almost never.  Buffett phrased it well in his 2005 Annual Report: (pp. 9-10)

Long ago, Mark Twain said: “A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way.” If Twain were around now, he might try winding up a derivatives business. After a few days, he would opt for cats.

We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re’s derivative operation. Our aggregate losses since we began this endeavor total $404 million.

Originally we had 23,218 contracts outstanding. By the start of 2005 we were down to 2,890. You might expect that our losses would have been stemmed by this point, but the blood has kept flowing. Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above.

Remember that the rationale for establishing this unit in 1990 was Gen Re’s wish to meet the needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It’s difficult to imagine what “need” such a contract could fulfill except, perhaps, the need of a compensation conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for “imagination” when traders are estimating their value. Small wonder that traders promote them.

A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B.

You can bet that the valuation differences – and I’m personally familiar with several that were huge – tend to be tilted in a direction favoring higher earnings at each firm. It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.

I dwell on our experience in derivatives each year for two reasons. One is personal and unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operation. Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were
particularly worrisome because their potential to explode could not be measured. Moreover, if severe trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets.

So I failed in my attempt to exit painlessly, and in the meantime more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.

The second reason I regularly describe our problems in this area lies in the hope that our experiences may prove instructive for managers, auditors and regulators. In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.

Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered – and improved – the reliability of New Orleans’ levees was before Katrina.

When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot

I could go on about this, but it’s late.  There are other weaknesses in the system as well.  A good rule of thumb is that whenever there is a lack of natural counterparties, there will be pricing difficulties.

Closing comment: When I was at a Stable Value conference in 1994, I ran into some investment bankers and talked to them about this topic.  I asked them how they hedged their synthetic wrap exposures.  They said they didn’t hedge because it was riskless “free money.” I pointed out the scenario under which they could lose money, and asked how their auditor could sign off on the lack of the hedge.  Their comment went like this: “When we find an auditor capable of auditing our derivative books, we hire him and pay him ten times the salary.”

In a world like that, who knows what problems may lurk in the derivative books, because the auditors stand a better chance of figuring out the truth than the ratings agencies and regulators.

Tickers mentioned: BRK/A, BRK/B

I’m swamped with putting the finishing touches on my talk for the Society of Actuaries, so this post will be brief.  When it’s done, I’ll be posting it here for all of my readers.  When the transcript gets published, I’ll post that as well, but that takes a while.

A few observations, some of them obvious, because we’re at an interesting juncture in the markets now:

  1. The equity markets are near new highs.  Who’da thunk it?
  2. Equity implied volatilities have returned to a semi-normal state, and corporate credit spreads have tightened, but lagged.
  3. Fixed income implied volatilities look high.
  4. Fed policy, if LIBOR, narrow money, or the monetary base is the measure, hasn’t worked that well.
  5. Fed policy, if the stock market or total bank liabilities is the measure (credit expansion), has worked pretty well.
  6. The dollar has bounced, but I would expect it to retrace the losses.
  7. We’re experiencing a small period of macroeconomic quiet amid the start of earnings season.  Earnings season should be good overall, with weakness in housing-related areas, and strength in export-related areas.
  8. Banks should be able to end the logjam in the LBO debt markets.  The cost is feasible.
  9. Residential real estate prices are still weakening, and provide most of the drag on the US banking system and economy.
  10. Inflation is rising with many of our trading partners; the US may begin absorbing some of it.
  11. Our trading partners are going to have to choose between controlling their interest rates, and following US policy, or letting their exchange rates rise further.
  12. In this environment, I am trimming my equity portfolio slowly as positions hit the upper end of their trading bands.  20% of the portfolio is within 5% of the upper rebalance point.  Almost nothing is within 10% of my lower rebalance point, so I’m not likely to add anytime soon.