17 January 2008 – The Aleph Blog

Thirteen Notes on the Nexus of Woe: Financials and Real Estate

Posted on 17 January 2008 by David Merkel

1) Let’s start on a positive note: Doug Kass says it is time to buy the financials.? I may never be as successful or clever as Mr. Kass, but I think he is early by one year or so.? And this is from someone who is technically overweight financials — I own six insurers, two high-quality mortgage REITs, and two European banks.? When it comes time to own financials, I may have a portfolio with 50% financial stocks, and I will pare back the insurers.

2) What of the Financial Guarantors?? Forget that I said I would flip the 14% MBIA surplus note, I did not expect that it would do so badly so quickly.?? The rating agencies are all concerned to potentially downgrade MBIA, Ambac, and others.? Downgrades are death, and rating agencies would only consider such measures if they knew that other companies would step in to continue their AAA franchise if they kick the losers over the edge.? Berky, by entering the financial guarantee space, has signed a death warrant for at least one of MBIA and Ambac, and who knows, Berky might buy the loser.

3)? Away from that, PartnerRe, one of my favorite companies, has written off its entire stake in Channel Re, which provided reinsurance to MBIA.? Leave it to that classy company to write off the whole thing, which implies bad things for MBIA as it relies on reinsurance from Channel Re, which it also partially owns.

4) Though this is a test of the financial guarantors, it is also a test of the rating agencies, which are in damage control mode now.? My view is the Moody’s and S&P will survive the ordeal, and come back fighting.

5) For a lot of nifty graphs on the subprime lending crisis, look at this article from the BBC.

6) Now, a lot of the subprime crisis is really a stated income crisis.? Think about it: income is such a standard metric for loan repayment.? If one lets borrowers or agents fuddle with income, should we be surprised that loan quality declines?

7)? Even the black humor of the credit crunch in residential real estate points out how much more residential real estate might fall in price, and with it the values of companies that rely on residential real estate.

8) The boom/bust nature of Capitalism can not be repealed.? As an example, at the very time that you want banks to want to lend more to support the real estate market, they insist on larger down payments.

9) At my last employer, and at RealMoney, I would often say that the biggest crater to come in residential housing was in home equity loans.? JP Morgan is a good example of this.? Should this be surprising?? I noted from 2004-2007 how much of the ABS market had gone to home equity loans, and felt it was unsustainable.? Now we are facing the music.

10) Now consider credit cards.? Even cards on the high end are reporting deteriorating loan statistics.? Unlike past history, many people are paying on their cards to maintain access to credit, and letting their home loans slide.? Worrisome to me, and to the real estate markets as well.

11) Even auto loans are getting dodgy in this environment. ? No surprise, given that lending quality and consumer credit behavior have both declined.

12) Commercial rents may seem to rise in some areas, but there are tricks that owners use to occlude the economics in play.

13) Now for long term worries, consider what will happen to the real estate market as the baby boomers age.? Houses in colder areas will get sold, and houses in warmer areas will be bought.? This article does not take into account reverse mortgages, which will also be prominent.? Aside from that, the idea that baby boomers will be able to cash out of their homes to fund retirement will be hooey, unless we let wealthy foreigners buy into the US.? There will not be enough buyers for all of the houses to be sold without immigrants buying them.

An Anomalous View of Stock Investing

Posted on 17 January 2008 by David Merkel

I was impressed with what Charles Kirk had to say regarding AAII and Stock Screening.? I’m a lifetime member of AAII, and I’ve used their stock screening software for years, long before I was a professional.? I was also impressed to note in the recent issue that two of my four buys in the fourth quarter were buys in the shadow stock portfolio, which has done very well over the years.

Back to Charles Kirk, if I can quote a small part of his piece:

When looking over the information, among many things I noticed include the fact that 7 stock screens have posted gains for every year over the past 10 years. Screens with this amazing consistency include Graham’s Defensive Investor, Price-To-Sales, Zweig, PEG With Est Growth, PEG With Hist Growth, and two of O’Shaughnessy’s screens – Small Cap Growth & Value and Growth. Few screening strategies can produce gains year after year as these have and there’s something to be learned from them.

Looking through and comparing the criteria between all of these screens, in essence they were seeking four simple things: 1) growing earnings per share over various time frames, 2) strong sales growth, 3) an attractive valuation (often using price-to-sales), and 4) relative strength.

Though I may quibble with O’Shaughnessy’s methodology, this is consistent with what he found in his book What Works on Wall Street.?? That said, though I am more agnostic about market capitalization, as I looked across the shadow stock portfolio, which is a small cap deep value portfolio, it confirmed to me that there are a lot of cheap stocks to buy in this environment.? There are good gains to be had in the future, even if past performance has suffered.

Now to approach it from a different angle.? I mentioned how much I like the CXO Advisory blog.?? One page to visit is the Big Ideas page, if you like academic finance papers.? I want to give you my short synopsis of what seems to work:

Cheap valuation, particularly low price-to-book (though I like cheap price-to-everything… book, earnings, sales, dividends, EBITDA)
Price momentum
Low accrual accounting entries as a fraction of earnings or assets
Piotroski’s accounting criteria
Low net stock issuance
Positive earnings surprises
Low historical return volatility
Illiquidity, which is a proxy for size and neglect

There are other prizes on that page, including mean-reversion, an improved Fed Model, Dollar-weighted vs. Time-weighted returns, limitations on academic financial research, demography, etc.

I would simply tell the fundamental investors in my audience to think about these issues.? Let me summarize them one more time:

Look for a cheap valuation.
Look for mean reversion, but don’t try to catch a falling knife.
Grab positive price momentum and earnings surprises.
Look for sound accounting, and management that is loath to dilute shareholders.
Avoid volatile stocks
Look for neglected stocks

That’s my my quick summary for what seems to work in stock selection.? I invite commentary on this.? I downloaded a lot of the papers cited, and will be reading them over the next few months.