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Archive for December, 2007

Why I’m Not Crazy About Surprise Lists

Saturday, December 22nd, 2007

I’ve never enjoyed surprise lists that much.  The concept is this: name a bunch of things that you think there is a better than 2/3rds chance of occurring that the market seemingly has less than a 1/3rd probability on.  Here are my problems with the concept:

  • First, the probabilities are squishy.  Who’s to say what the probability of a given event is?  Even if you have a prediction market going, those are subject to a variety of biases.
  •  Second, often the interpretation of whether one is correct or not is fuzzy as well.  Not all of the surprises are sharp events.
  • Third, an unlikely event can be more likely than it seems if it is spread across multiple parties, or if there are multiple legs to the prediction.  As an example, a prediction that “a major country will drop its dollar peg in 2008,” should be regarded as a decent probability, if only by accident.
  • Finally, I don’t find them easy to make money from.  Many of them are either not very actionable, or my relative payoff from being right versus wrong does not seem to compensate for the large number of times that the conventional wisdom proves correct.

All that said, surprise lists make for excellent journalistic copy because that have many “man bites dog” sound-bites.  That’s why we hear about them, and why they get promoted for publicity purposes.  But as for so many aspects of speaking/writing on investments, it is mostly theater, and shouldn’t be taken too seriously by serious investors.

Book Review: Financial Shenanigans

Saturday, December 22nd, 2007

A few readers asked me if I would review some books dealing with accounting issues. I’m happy to do that. I am not an accounting expert, and certainly not a forensic accountant, but my investing has benefited from being willing to look at the weaknesses in financial statements, and avoid companies where the economic results are likely worse than the accounting statements.

Howard Schilit, in his book, Financial Shenanigans, highlights seven areas where accounting can be fuddled:

  1. Recording revenue too soon.
  2. Recording bogus revenues.
  3. Boosting income with one-time gains.
  4. Shifting current expenses to a later period.
  5. Failing to record or disclose all liabilities.
  6. Shifting current income to a later period.
  7. Shifting future expenses to the current period.

There are several common factors at play here.

  • Beware of companies where earnings exceed operating cash flows by a wide margin. (1-4)
  • Watch revenue recognition policies closely. It is the largest area of financial misstatement.  (1-2)
  • Look for assets and liabilities that aren’t on the balance sheet, and avoid companies with hidden liabilities. (5)
  • When companies do well, they often hide some of the profitability, and build up a reserve for bad times. This will show up in an excess of cash flows over earnings, so look for companies with strong cash flow.  (6,7)

The book liberally furnishes historical examples of each of the seven main categories for accounting machinations, showing how the troubles could have been seen from documents filed with the SEC in advance of  the accounting troubles that occurred.  Now, aside from point 5, the other six points boil down to a simple rule: watch operating cash flow versus earnings.  I wouldn’t say that the cash flow statement never lies, but investors pay more attention to the income statement and balance sheet.  Aside from outright fraud, ordinary deceivers can manipulate one statement, and clever deceivers can manipulate two.  To do three, it takes fraud.

Now, suppose you have found a company where the operating cash flows are weak relative to reported earnings.  That is where this book can help, because it will give you ways to analyze whether the difference is accounting distortion or not.  For those of us who use quantitative methods to aid our investing, this is particularly important, because many companies are seemingly cheap on GAAP book and earnings, but a review of the cash flow statement will often highlight the troubles.

The book is an easy read, and does not require detailed knowledge of accounting in order to get value out of it.  For fundamental investors, I recommend this book, with the proviso that it only works with non-financial companies.  Financial companies are more complex (they are all accruals — the cash flow statement is not very useful), and can’t easily be analyzed for earnings quality from looking at the financial statements alone.

Full disclosure: I get a pittance from each book sold through the link listed above.

Municipal Tensions

Friday, December 21st, 2007

Tonight I want to point you to something that might make you uncomfortable.  Don’t worry, it is for a good purpose.

Depending on where you live in the US, various states and municipalities are more or less prepare for the onslaught of cash flow that they will have to pay baby boomer employees after they retire.  Here’s a very good summary of which states are prepared, and which are not, from the Pew Charitable Trusts.  As for pension benefits, they are relatively well funded, with 85% of the accrued benefits funded.  Other Retiree benefits (mainly health care) are only 3% funded.

Only ten states are more than 96% funded on pensions: Oregon, Utah, South Dakota, Wisconsin, Tennessee, Georgia, Florida, North Carolina, Delaware and New York.  Ten states are less than 70% funded on pensions: Hawaii, Kansas, Oklahoma, Louisiana, Illinois, Indiana, West Virginia, Connecticut, Rhode Island, and New Hampshire.

But as for other retiree benefits, 32 states have funded nothing at all (0%).  See the graph on page 42.  They will either pay it out of cash flow (from increased taxes), or decrease the benefits, because they are not guaranteed as pension benefits are.   Only one state is in good shape, Wisconsin (my home state), which has its other retiree benefits 99% funded.  Next best are Arizona (72%), Alaska (65%), and North Dakota (41%).   In a word — ugly.  Either promises will have to be rescinded, or taxes raised.

It’s worth looking at this report because these matters will be upward drivers of taxes starting about five years from now, and lasting for two decades beyond that.  It will be a big political fight.  Taxpayers will do their best to reduce benefits to state and local government workers who worked at lower salaried jobs, knowing that they would make it up on better benefits.  Alas, but the benefits may be less than expected.

Now as far as the US goes, Federal DB plans are unfunded, including Federal Employees, Social Security and Medicare.  Holding US Government bonds doesn’t count, those are just indicators of future taxation.  Higher future taxation from the US government will be a fact of life.  I don’t argue with it.  They’re bigger than me.

States and municipalities may be another matter, though.  Many municipalities are even worse funded than the states, and their taxation capabilities are more limited.  People can leave to go to other places in the US.

My advice: review the pension and other benefit funding levels of your state, and any other places that you get taxed (county, city, assessment district).  Figure out now whether your taxes are likely to rise or not, and ask yourself whether you can live with it or not.  This is somewhat cold-blooded, but you need to act on this in the next 2-3 years.  Five years out, and this will factor into land values and a wide number of other economic variables, making any move less economic.

The Virtue of Lunch with Friends

Friday, December 21st, 2007

I really enjoyed being an investment grade corporate bond manager.  I enjoyed interacting with credit analysts and sales coverages, and the hurly-burly of price discovery in markets that were thinner than optimal.  My credit analysts were professionals, and I never went against them; at most, I would explain to them why market technicals favored a delay in the action they proposed.  But I would never permanently disagree.  What they wanted to buy I would buy, and sell I would sell, eventually.  The level of communication evoked greater effort from them.  Machiavelli was wrong.  It is better to be loved than feared, at least in the long run.  I have gotten more out of associates and brokers by being altruistic than through transactional constraint.  People will give far more to someone that cares for them, than someone that threatens them, in the long run.  (The short run is another matter…)

Now, this is not my character.  I tend to be shy, and constant interaction pushes me out of my comfort zone.  But when others are depending on me, I push myself harder, and do what needs to be done for the good of others.  I can’t let down those who rely on me.

Yesterday I had lunch with three friends and a new friend.  Two were sales coverage, and two from the firm that I used to work for.  It was fascinating to hear the tales of woe in the structured securities markets (worse than I expected, and I am cynical).  It was also fascinating to consider why investors for a life insurance company, which has a liability structure that would allow them to buy and hold temporarily distressed assets, does not do so.   A lot depends on how short-term the investment orientation of the client is, and this client is definitely short-term oriented.

I talked about my new CDO model, and about what I write about for all of you who read this blog.  The summary of our discussions is that it is a tough environment out there, and one that is particularly not kind to complex securities.  After the lunch, which the sales coverages generously paid for (at present, I don’t know what I can do for them), I went back to the office of my old friends, and reacquainted myself with one of the best consumer/retailing credit analysts period, who is a very nice woman.  I also talked with my former secretary, who is sweet, and was always a real help to me and all of the staff.

Friends.  I am richer for them.  I am richer for being one.  Beyond that, it is excellent business to live life in such a way that your business dealings leave people happy for having dealt with you.  I am truly blessed for all the business friends that I have gained.

Options as an Asset Class

Thursday, December 20th, 2007

Well, my CDO model is complete for a first pass. There is still more work to do. Imagine buying a security that you thought would mature in ten years, but two years into the deal, you find that the security will mature in twenty years from then, though paying off principal in full, most likely. Worse, the market has panicked, and the security you bought with a 6.5% yield is now getting discounted at a mid-teens interest rate. Cut to the chase: that is priced at 40 cents per dollar of par. Such is the mess in some CDOs today.

Onto the topic of the night. There have been a number of articles on volatility as an asset class, but I am going to take a different approach to the topic. Bond managers experience volatility up close and personal. Why?

  • Corporate bonds are short an option to default, where the equity owners give the company to the bondholders.
  • Mortgage bonds are short a refinancing option. Volatile mortgage rates generally harm the value of mortgage bonds.
  • Even nominal government bonds are short an inflation option, should the government devalue the currency. (Or, for inflation-adjusted notes, fuddle with the inflation calculation.)

Why would a bond investor accept being short options? Because he is a glutton for punishment? Rather, because he gets more yield in the short run, at the cost of potential capital losses in the longer-term.

Most of the “volatility as an asset class” discussion avoids bonds. Instead, it focuses on variance swaps and equity options. Well, at least there you might get paid for writing the options. Bond investors might do better to invest in government securities, and make the spread by writing out-of-the-money options on a stock, rather than buying the corporate debt.

I’m not sure how well futures trading on the VIX works. If I were structuring volatility futures contracts, I would create a genuine deliverable, where one could take delivery of a three month at-the-money straddle. Delta-neutral — all that gets priced is volatility.

Here’s my main point. Volatility is not an asset class. Options are an asset class. Or, options expand other asset classes, whether bonds, equities, or commodities. Whether through options or variance swaps, if volatility is sold, the reward is more income in the short run, at the cost of possible capital losses in asset classes one is forced to buy or sell at disadvantageous prices later.

Over the long term, in equities, unlike bonds, being short options has been a winning strategy, if consistently applied. (And one might need an iron gut to do it.) But when many apply this strategy, the excess returns will dry up, at least until discouragement sets in, and the trade is abandoned. For an example, this has happened in risk arbitrage, where investors are short an option for the acquirer to walk away. For a long time, it was a winning strategy, until too much money pursued it. At the peak you could make more money investing in Single-A bonds. Eventually, breakups occurred, and arbs lost money. Money left risk arbitrage, and now returns are more reasonable for the arbs that remain.

Most simple arbitrages are short an option somewhere. That’s the risk of the arbitrage. With equities, being perpetually short options is a difficult emotional place to be. You can comfort yourself with the statistics of how well it has worked in the past, but there will always be the nagging doubt that this time it will be different. And, if enough players take that side of the trade, it will be different.

Like any other strategy, options as an asset class has merit, but there is a limit to the size of the trade that can be done in aggregate. Once enough players pursue the idea, the excess returns will vanish, leaving behind a market with more actual volatility for the rest of us to navigate.

Crunchy Credit

Wednesday, December 19th, 2007

My head feels like mush.  I have been struggling over creating a CDO pricing model with the following features:

  • A knockoff of the KMV model, using equity market-oriented variables to price credit.
  • Uncorrelated reduced discrepancy point sets for the random number generator.
  • A regime-switching boom-bust cycle for credit
  • Differing default intensities for trust preferred securities vs. CMBS vs. senior unsecured notes.

Makes my head spin, but at least the credit model is complete.  The rest of the model can be done tomorrow.

Ugh, so what was I going to talk about?  Oh yeah, the short term lending markets.  So the ECB makes a splash by showering temporary liquidity on the short end of the market.  That will reduce Euribor-based rates, but not US dollar-LIBOR based rates.  Check with Dr. Jeff for more on that.  Now, Dr. Jeff and I might not agree on the significance of this move, because I discount temporary injections of liquidity.  What will happen to liquidity conditions when the temporary injection goes away?  My view is that they will go back to how they were before the temporary injection.  The only way that would not be so is if the temporary injection somehow changes the willingness of parties to take risk, and I think most large investors can see through the temporary nature of the injection.  The ECB can keep short-term Euribor down for a while, but unless they make some of the injection permanent, conditions will revert.  People and institutions can’t be fooled that easily.

Topic two: the WSJ article on the credit crunch.  The author posits two disaster scenarios:

  1. A financial guarantor going down, or
  2. Many money market  funds  “breaking the buck.”

Here’s my view:  The financial guarantors have been too profitable for too long.  There will be parties wiling to recapitalize them, though not necessarily at values that make current equityholders happy.  They are not going broke; the major firms will be recapitalized.

Regarding the second fear, a few money market funds will break, but the wide majority of money market funds won’t.  Most short term debt managers are highly conservative, and don’t take inordinate risks.  To do so would threaten their franchise, which would be stupid.

Things are not good, don’t get me wrong, but it would be very difficult to destroy most of the investment markets on the short end of the yield curve.  Away from that, the actions of the ECB will only have modest impacts on USD-LIBOR.

Personal Finance, Part 8 — Taxes

Tuesday, December 18th, 2007

I’m not a maniac on avoiding taxes.  Living through the 80s and 90s, I saw many cases where people bought financial products that made them less after-tax money than many fully-taxable products would have made them.  Limited partnerships, life insurance, annuities, etc… I never saw the value in focusing on what the government would not get.  I was more focused on what I would get after taxes.

That doesn’t mean there aren’t clever strategies to avoid taxes, particularly if you are rich.  For the rich, taxes can be more of a negotiation.  How much work will the IRS have to go through in order to drag incremental dollars out of me?  (The same logic applies to corporations… I have seen it in action.)  Perhaps Leona Helmsley had a point, even if she overstated it, “Only the little people pay taxes.”  Maybe it should be, “Only the little people pay sticker price on taxes.”

Now, as for me, I have a Health Savings Account, a Rabbi Trust, IRAs for me and my wife, and a Rollover IRA from all of the jobs I have worked at.  It’s not as if I don’t try to manage my tax position.  But I don’t let it drive my investment decisions on its own.  I own my house free and clear.  I enjoy the benefits of flexibility in my finances; I have not used 529 plans, for example.  Where the investment fits my overall goals and objective, then I will consider how it affects my tax position.  In general, the higher dividend stocks go into my Rollover IRA, the lower dividend stocks into my taxable account.  I also gift appreciated stock through my taxable account to charity.

At present, I don’t own any munis.  That’s something I’ll have to revisit.

Now, here are two things to be careful about.  If IRAs grow too big there can be additional taxes on them.  I’m not too clear on the rules, perhaps readers can more fully flesh that out.  The other is that taxes are likely to be higher in the future, so avoiding taxes today may lead to more taxes tomorrow.  Also, I would question whether our government will honor the concept of a Roth IRA.  Social Security benefits were not supposed to be taxed, but today they are mostly taxed.  The same might happen to Roth IRAs at some point in time.   Congress giveth, and Congress taketh away.

My closing point here would be to not overcommit to any single tax strategy.  Congress changes the rules so often, that it is difficult to make long term decisions.  Stay flexible, and avoid taxes where it does not compromise your flexibility.

Booyah for Brainy Buybacks! (But not Brain-dead Buybacks.)

Tuesday, December 18th, 2007

Prior to the market hitting a spate of turbulence, for the last four years, I had rarely heard anyone say something bad about a buyback or a special dividend.  At that time, I tried to point out (at RealMoney) that buybacks are not costless:

  • They reduce financial flexibility.
  • They lower credit ratings and can raise overall financing costs, if overdone.
  • They can become a crutch for weak management teams that aren’t active enough in looking for organic growth opportunities.
  • They often don’t get completed, leading to some disappointment later, after the initial hurrah.
  • They can be a clandestine way of compensating employees, because they hide the dilution that occurs from shares received through incentive payments.  In a sense, shares are shifted from shareholders to management.  Buffett has the right idea here: pay cash bonuses off of exceeding earnings targets.  Nothing motivates like cash, there is no dilution, and managers don’t get compensated/punished for expansion/contraction in the P/E multiple.
  • A higher regular dividend could be more effective in some cases
  • Finally, does management want to make a statement that they don’t see any good incremental opportunities for their business on the horizon?  That’s what a large buyback implies.

But after reading a glob of articles criticizing buybacks, it makes me want to take the opposite side of the trade.  (Where were these writers during the bull phase?)  Buybacks can instill capital discipline, as regular dividends do.  A good management team, when considering an acquisition, should at the same time run the same numbers on their own common stock, to see whether the acquisition is an effective way to deploy capital.

The best buybacks are valuation-sensitive.  The company has an estimate of its private market value, and the buyback only goes on while at or below that value.  When a cheaper opportunity shows up to acquire a block of business, or a new line of business, or a whole business, the buyback stops, and the acquisition is executed.

Much of my thinking here boils down to how good the management team is.  A management team of moderate quality should not keep a lot of excess capital around, because they might make a dumb move with it.  A high quality management team can run with more excess capital.  In one sense, moderate quality managements should shrink their businesses, while high quality managements should try to grow their businesses organically, and through small in-fill acquisitions that enable  them to access new countries, markets, products, and technologies cheaply, that they can then grow organically.

There is no simple answer here.  Buybacks can be smart or dumb, depending on management talent, what external opportunities exist, and where the private market value of the company is.  We can entrust Berky and Assurant with excess capital; it will get used well eventually.  Other companies, well, there are some that should keep the capital tight, because the management teams are not good strategic thinkers.

For the less competent management teams, (and, no, you don’t know who you are, that’s part of being less competent), you can look at the problem this way: either you shrink your company through buybacks, or activists will come and try to force you to do it, ejecting you in the process.  That may not sound fair, but hey, this is the public equity markets.  Sink or swim.

Full disclosure: long AIZ, and a critical admirer of Buffett.  Ticker mentioned: BRK/A

Personal Finance, Part 7 — Debt

Saturday, December 15th, 2007

I was shopping this evening, and as I went to check out, the two checkers were discussing with a third party their financial woes.  One was making her payments after a workout, and would be free of her debts in a year.  The other had declared bankruptcy, and it would be eight years (or so) before things would normalize for her.  As for the one making payments, her parents had gone through bankruptcy two years ago.

I talked with them for a little while, and both had reverted to lifestyles where debt was not even an option.  Well, good for them, in the short run.  They are learning discipline (the hard way).

I’m not an ogre on debt.  It can be useful, but you have to be careful with it.  I have been debt-free for the past five years, and have enjoyed the freedom that it has brought me.  I take enough risk as it is, why should I magnify it through leverage?  Borrow for a home?  Fine in the right environment.  My advice would differ in 1998 vs. 2005.  Borrow to finance consumption?  No.  Never right.

I feel the same way about companies that I own.  I prefer companies that are less levered, and companies that borrow on a nonrecourse basis.  When we borrow, we are making a statement about the future — that we can presume that it will be good, hey, even better than today.  That’s a tough statement to make.  Avoid debt if you can, and save your debt capacity for times when assets have been crunched, like early 2003.

PS — One more note: because of the AMT the advantage of borrowing money to buy homes is diminishing, because the AMT erases mortgage interest deduction.

Not Dissing Warren the Wonderful

Saturday, December 15th, 2007

Look, Barron’s can say what they want about Warren Buffett, and his company Berkshire Hathaway, but I have just one thing to say here: Berky is the ultimate anti-volatility asset.  When the hurricanes hit in 2005, I told my boss that the easy money, low-risk, low-reward play was to buy Berky.  My boss liked to take risks, so that idea was shelved. Too bad, it was easy money.  After all, who could write retrocessional coverage (Reinsuring reinsurers) except Berky?  Every other writer was broke or disabled…

Now we have a different type of hurricane.  Prior bad lending practices are destroying lending/insurance capacity in mortgages and elsewhere.  This could be an investment opportunity for Berky.  Thing is, outside of the Sovereign Wealth Funds, Berky has one of the biggest cash hoards around, and during times of panic, where assets get sold at a discount, cash is valuable.

So during times of panic, we should expect Berky’s valuation to expand.  This is one of those times.

One final note: suppose Buffett, much as he doesn’t want to be an asset manager, decides to take Ambac private.  How would he do it?  Think of what he has done in other cases: he creates a nonguaranteed downstream holding company, capitalizes it to a level necessary for a AAA rating, and buys Ambac.  Warren never guarantees the debt of subsidiaries that he buys.  Why should he reward bondholders of his target companies?  Isn’t it enough that he pays the debts?

Well, yes, sort of.  Warren has never sent a subsidiary into insolvency, but he clearly reserves the right to do that.  Bondholders have given him that right, and I would not blame him for using that right under extreme circumstances.

That said, Berky’s excess cash offers opportunities at present, because Buffett can use that cash to snap up distressed assets when he chooses to do so, and at minimal risk to Berky if an acquisition fails.

Tickers mentioned: BRK/A, BRK/B, ABK

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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