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Last Post Before I Leave Again

Saturday, June 28th, 2008

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What did I do last week while the market was being whacked? I bought some Reinsurance Group of America, Shoe Carnival, YRC Worldwide, SABESP, and Universal American. I reduced cash in the portfolio from 11% to 8%. It may have hurt me in the short run, but should be good in the long run.

I have modest concerns about the current profitability of Smithfield Foods, but no concern about their long-term profitability. They have an intelligent management team. I may buy some more soon.

Now, as to my comments yesterday regarding quantitative risk measures: yes, I am highly skeptical. Economics is not Physics. The relationships are not stable enough for the quantitative statistics to be valuable. I go back to what Buffett said, “I’d rather have a noisy 15% than a stable 12%.” If you have a long time horizon, why do you care about standard deviation or beta? If you have a short time horizon, why are you investing in risk assets?

Risk is not short-term variation, unless your time horizon is short. Consider my article on longevity risk.  All good risk management considers when the money will be needed. Risk is unique for each person, and can’t be summarized through a “one size fits all” statistic. What are the odds of not meeting the goals of the investor? How severe will the shortfall be? That is risk.

Personally, I am annoyed at the consultant community. They employ statistics that have little relation to future performance in an effort to earn fees. They get away with it because clients don’t get investing. They buy the concept of randomness, and ignore the managers with good processes that have been hit by bad short-run performance.

Eventually value investing wins. Do value investors calculate the Modern Portfolio Theory [MPT] statistics before investing? Of course not. They know that their job is to find undervalued businesses. They don’t care about market trends.

As you consider investments, ignore MPT. It is better (if you have a long horizon) to focus on overall investment processes, with a review of the names in the portfolio over time, to get a feel for the methods of the manager.

Full disclosure: Long SBS SCVL RGA YRCW UAM SFD

How I Evaluate Investment Managers

Friday, June 27th, 2008

This post will probably be too brief, but here goes.  The most important aspect of analysis is trying to gauge any sort of sustainable competitive advantage.  Qualitatively, do they really have something special going that other are unlikely to imitate?  Second, do they fit their paradigm?  If they are growth investors, do they use momentum?  If they are value investors, are they willing to be wrong for a while?

Third, how do they handle lesser questions like earnings quality?  Do they look at cash flow, free cash flow or earnings, and how do they justify their answers?  Do they have a decent decisionmaking process, given that managers that trade less tend to do better?

Finally, have they been successful?  Do they win, and do they win for the reasons that their methods would favor? Good track records that emerge for reasons other than managerial intentions are unlikely to be repeated.

Now what don’t I look at?  Sharpe ratios and other quantitative measures of risk.  The measures aren’t predictive of future performance, and the risk adjustment is too short term in nature.  These measures are backward looking, and not indicative of future performance.  Better to spend time sweating over how a manager chooses assets, limits risks, etc., than to focus on quantititive measures of risk that have no relation to long term performance.

I am NOT Your Public Relations Outlet

Friday, June 27th, 2008

Hi.  I’m back home, and happy, before a one-day turnaround where I leave again.  We were able to get the business of the church done one day ahead of schedule.  While at the meeting, I had no internet… there is something odd about my laptop that blocked them from connecting me, and, they messed up my laptop in trying to connect me, so that I can’t use my dedicated line.  Kinda sad.

One quick rant because when you get a boatload of e-mail at once, things get clearer.  I think someone has created a mailing list for economics/finance bloggers, because I have a number of semi-interesting press releases in my e-mail.  They would be interesting, but there are over a dozen of them, and none of them really fit my profile, aside from a professor asking me to review an academic finance article. (Me?! I’m on the hinterlands of the profession.)  I appreciate truly personal mail, but the faux personal mail, which is really PR, does not get me to move.

One other note: while I was away, since I did not have internet, during free time, I went through my files to cull through research that I downloaded to be read.  By the time I was done, I went through about 200 articles, and added 20 or so to my research files.  I could do a post on what I think is valuable in academic/professional finance research — I’m not sure how much my readers would value it.  That said, going through the research sharpened my views on what I think is valuable in academic research… so, at least I gained something from it.

I should be able to post more tomorrow, beyond that, I have no idea what kind of connectivity I might have.

I Am Gone

Monday, June 23rd, 2008

I will try to post when I am on the road, but I will be gone for the next sixteen days.  I have no clear idea of how much web connectivity I will have during that time, but to the extent that I can post, I will do so.

The Four Stages of Investment Knowledge

Saturday, June 21st, 2008

Alas, but we are poor creatures, muddling along in a confusing market that denies many the ability to earn money.  WHAT HAPPENED TO THE NINETIES, WHEN MAKING MONEY WAS AS EASY AS HITTING THE BROAD SIDE OF A BARN?!  Uh, that was then, this is now.  We’re in a dead spot, a lost decade; old certainties are being tested, and many clever investors (alas for Bill Miller) are being weighed in the scales and found wanting.

This is actually a good time to become an investor, because it is a bad environment.  You develop your skills when expectations are low, and the battle is tough.  But you have to confront the four stages of investment knowledge.

Stage one is being puzzled, and knowing that you don’t know much.  There is extreme caution and risk avoidance, and so much of the market appears to be random.  But with some drive, there is a desire to learn, and that leads to stage two.

A little knowledge is a dangerous thing.  It can come in the form of articles like “Ten Best Stocks to Buy Now!” or “The Simple Formula That Beats the Market, in One Tiny Book.” Whatever.  The initial knowledge is typically a stripped-down version of what has worked in the past, and past results indicate future performance.

Stage Three is the rare point, because it comes after some failure in stage two, because the world wasn’t as simple as the few experts initially read would indicate.  Stage three admits that the prior knowledge was very limited, and that investing is more complex than previously thought.  This is a time of study, and modest experimenting in investing, learning risk control, and understanding oneself.  What am I good at?  Where do I grasp value better than others?

Stage Four is where the survivors prosper in a limited way.  They know that the market is fickle, and have learned that their methods may be good in the long haul, but may underperform in the short run.  They don’t panic, they keep learning, and they persevere in times of fear and greed.  They invest as if it were a business, and are prepared for bad times, and don’t go crazy during good times.

My own methods are geared to Stage Four.  I’ve been through all manner of markets (minus the Great Depression), and know how badly I can be hurt.  I am ready for losses in the short run, if I know gains are likely in the longer term.  I’ve gotten to the point where losses on individual stocks don’t bother me; I just maximize value from where I am now, without letting past losses or gains prejudice me.

Investing is a business.  Spend time studying.   Some of the book reviews on my site could be valuable in that respect.  Don’t let a few early losses get you down.  Investing is rewarding over the long haul; you can never tell when the game will get easier.  On a personal note, my worst time in investing was June-September 2002.  I lost big, but I did not lose confidence in my management methods, and made it all back and a lot more by the end of 2003.

Another way to say it is, “Be ready for losses.  Don’t let them knock you out of the game, but budget for them.  It is your market tuition.”  Ah, my market tuition.  Would that I could avoid the occasional “refresher course.”

Rethinking Comparable Worth

Saturday, June 21st, 2008

“Comparable Worth” was a faddish idea for economic leftists that flowered (thankfully it was brief) in the 1990s.  The idea was that you could measure occupations on a technical basis, measuring education, effort, responsibility, and other aspects of the job, and figure out what occupations should be compensated similarly.

That’s a pretty difficult problem to solve in the absence of markets.  Granted, there are some Human Resources (what a phrase) consulting firms that have models in narrow contexts to try to solve salary questions inside similar corporations, but the consultants true up their models to the markets regularly, and are covering a more narrow range of jobs.

I want to muse about a different kind of comparable worth this evening, one that many Americans (and others in “developed nations”) might not like.  It is my guess that we are seeing the slow erosion of wage differentials across developing and developed countries, particularly for goods and services that are part of global trade.

Now, I am not saying that an unskilled auto worker in China will earn as much as a non-union auto worker in the US, which is backed by more capital investment, and requires a smarter worker.  I am also not saying that unionized workers in developed countries won’t earn more.  The viability of the firms their unions serve may be compromised, though.  What I am saying is that global corporations can choose where they produce goods, and on a productivity- and quality-adjusted basis they will use laborers that give them the best deal.

As for jobs that are internal to an economy, such as working at a retail store, the adjustment will be slower.  Internal job wage differentials across countries depend on the overall wage differentials across countries.  As overall wage differentials narrow, so would internal job wage differentials.

Also, given how many commodities are priced globally, and those have become a more important part of the cost structure recently (though the effect is not that bad if one takes a long-term view… increased productivity means we use less commodities to achieve the same ends as 40 years ago), the factor share going to labor in developed countries is probably being squeezed a little.  So, what does this imply for workers in the US and the developed world?

As the rest of the world develops, their living standards will slowly converge with those in the US.  They will demand a greater share of the world’s resources in the process, making the affluent life more expensive.  This will in turn drive more technological innovation to make commodities stretch further.

Now, perhaps some will say that the solution is to cut off or limit free trade.  That won’t work.  The US is so dependent on free-ish trade that any significant reduction of trade would drive inflation up in the US.  Beyond that, the US benefits from its reserve currency status.  Where else does a country get goods and services, and hand over bonds denominated in their own currency?  What a sweet deal for the present — an inflationary pity when it ends.

I started out my career with a goal of being a development economist, and doing work in the Third World.  That ended when I learned that the models used by the development economists did not work, and that capitalism and free trade did work.  When the developing world began to make great strides after the end of the Cold War, I was happy.  I’m still happy about it today; poverty is slowly but steadily being eliminated across a wide swath of the globe, and that is a good thing for most.  But to many Americans (and others in develop nations) who are finding themselves out-competed by foreign competition, this is not a happy time.

Be aware of the global competitive position of your industry, and adjust your career accordingly.  Build up your own ability to deliver special (hard to duplicate) value for your employer and work where your personal competitive advantage is maximized.  That’s not easy, but the easy path probably embeds a future that is less well off.

Recent Portfolio Moves

Saturday, June 21st, 2008

Selling 70% of my National Atlantic stake freed up cash, and I deployed half of that today in a variety of rebalancing trades.  Today I bought some Jones Apparel, Valero Energy, Hartford Financial Services, and OfficeMax.  I sold some RGA to buy some MetLife, in order to get cheaper RGA.

Today’s actions brought cash in the portfolio from 14% to 11%.  It’s a good time to be adding to positions in a modest way.  If the market declines further, I will continue to slowly reduce cash and add to positions.  One nice thing about the rebalancing discipline is that I don’t time the market, but it often seems like the rebalancing discipline forces buying low and selling high, in ways that most investors would not want to emulate, because I am constantly leaning against the wind.

Starting on Monday, I’m going to be on the road until July 8th.  My ability to blog and follow the markets will possibly be impaired, because I will be busy the first week with the annual meeting (Synod) of my denomination, and the next week, with my parents’ 50th wedding anniversary.  I will be in rural Western Pennsylvania and Northern Wisconsin, respectively.  The first is a lot of work; the second, a lot of fun.  In both cases, Internet access may be spotty.

I’ll leave a few standing orders out to take advantage of further declines in the market, especially if the NAHC deal fails on Monday.  Beyond that, I will start in on the next portfolio reshaping when I return.  For those that want an early preview, here are my current industry ranks.  It’s been a good year so far, but who can tell, the market can spin on a dime, and once again find a new way to make fools out of us all.

Full disclosure: long NAHC JNY VLO HIG OMX MET RGA

Downgrades Come Easy, Upgrades Come Hard, Upgrades to AAA? — Forget It.

Friday, June 20th, 2008

We’re not quite to the endgame yet, but the jig is up for MBIA and Ambac, after the downgrades from Moody’s at the holding companies to Baa2 and A3 respectively.  Wait, why I am I mentioning the holding companies?  Isn’t it the operating subsidiaries that matter?

Well, yes, for sales and regulatory purposes, but the ratings at the holding companies matter for a different reason — notching.  But let me tell a story first.

Failure improves markets by introducing risk-based pricing.  In the late 80s and very early 90s, virtually all of the life insurance industry was rated AAA/Aaa, or A+ from A.M. Best.  Taking advantage of the good opinion that the raters had of the industry, many life insurance companies issued Guaranteed Investment Contracts [GICs] to institutions for their Defined Benefit and Defined Contribution pension plans.  The insurance companies levered up issued AAA liabilities, and invested the proceeds in lower rated bonds, commercial mortgages, limited partnerships, and other things yet more risky.  (These were the days prior to risk-based capital.)

After a few failures hit — Pacific Standard (who?), Executive Life, Mutual Benefit, Fidelity Mutual, Confederation, and the near miss on the Equitable (what a story — I was on AIG’s failed takeover attempt team), the rating agencies went into full scale defense mode, downgrading every company in sight.  It was everything a company could do to retain its ratings — and there were almost no ratings upgrades until 1996 or so.

The rating agencies are ratchets. (or, do I mean rackets? ;) )  Downgrades come easily, upgrades come hard, and almost no corporate credit ever gets upgraded to AAA.  But, in this case, the downgrades have come for this industry in the way that I predicted earlier this year:


David Merkel
Moody’s Downgrades XL Capital Assurance
2/7/2008 3:34 PM EST

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade).

Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)

Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.

Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

Once your insurance operating subsidiary is downgraded below AAA/Aaa, there are many classes of business that cannot be written anymore.  Revenue dries up.  What’s worse, is that the rating agencies no longer have any practical reason to not downgrade further; the revenue model is broken for the rating agencies, and if there are highly rated new entrants, there is no reason to care about the company; the industry will survive, and the rating agencies will get fees.

Now, supposedly, New York doesn’t want to take the operating subsidiaries into conservation because it would trigger acceleration clauses in the CDS.  If those contracts were written at the operating companies, the insurance commissioner has the power to nullify any seniority those contracts possess — you can’t favor one insurance claimant over another.

But Dinallo wants to favor municipal claimants, which is probably illegal.  They could force the capital into the operating company, but they would rather see the municipal business reinsured.

Oh, notching — once a holding company is rated lower than Aa3/AA-, there is no way to get a subsidiary to have a Aaa/AAA rating.  The rating agencies will not allow it to happen.

So, I don’t see good things ahead for the guarantors.  Two final notes: Ambac tells Fitch to take a hike.  Fitch won’t do it.  Expect a downgrade soon.  Triad goes into runoff; my old colleague John must be smiling… he always thought they wrote the worst business.

Inflation and Stocks

Thursday, June 19th, 2008

I read this article today, and it made me want to write on the topic.  This is a concept that I learned early in my investment career.  It is worth understanding, so that you can do better in investing.  Inflation is negative for stocks, but it is a small negative — for every 1% that the inflation rate goes up, stocks decline 2% on average.

That’s not very big.  So why do stock investors panic over inflation?  They panic because the Fed might respond to inflation, and raise real (inflation-adjusted) interest rates enough to quell inflation.  Rises in real interest rates are far more negative to the market — a 1% rise in real rates hurts the equity market by 10%.  Why such a big impact?

The impact is large, because when real interest rates are high, capital is scarce.  Go back to my “Fed Model” article which is very different from other “Fed Models.”  High corporate bond rates raise interest costs for corporations, reducing profits, and raising discount rates (cost of equity capital).

At present, real interst rates are negative — in nominal dollar terms, this is not a bad time to own stocks.  Think of the dividend discount model for a moment.  Inflation runs through earnings and the discount rate, so the effect is muted.  Real rates run through the discount rate only — poison.

Is there any hope in an era where inflation is rising, and where real rates may rise?  Value investing always offers some hope, but that’s not my main point here.  Inflation manifests itself differently in different eras.  Look for the areas that are in short supply.  They will be the areas where corporations will have pricing power.  Those areas will outperform the market, even if the market as a whole declines.  At present, I am looking at energy stocks, food stocks, and others.

Inflation is bad for the market, but don’t let that stand in the way of looking for what might offer relative profit in this environment.

Ten Notes on Residential Housing

Wednesday, June 18th, 2008

I’m waiting for the day when I can write upbeat stuff about housing…  when I can buy homebuilder and mortgage stocks and crow about my gains.  I hope I live two more years. ;)  (Many thanks to Calculated Risk for their excellent coverage of residential housing.)

1) The first thing to note is that residential real estate values are still falling nationwide.  That affects Mortgage Equity Withdrawal [MEW] and derivatively, consumption.

2) Now, housing prices are likely to fall another 10-15%, which is what I have been saying for a while.  That will lead to more situations where there is negative equity, and more defaults, as they happen with negative equity and negative life events.

3) Foreclosures are making up a larger percentage of all sales, which is not a positive in the short run for prices.  In Sacramento, and some other places in California, foreclosures are the majority of sales.  As a result, it is no surprise that housing sales are at a lowForeclosures have risen rapidly across the country, not boding well for future sale prices.  Even in Florida, foreclosures are gumming up the market, and are getting reconciled slowly.

4) The GSEs are in a tough spot.  The government pushes them to make suboptimal loans that their shareholders don’t like.  I guess that’s a part of their deal.  As it is, the GSEs are playing a large role in many loans today.  Private capital doesn’t step up in an environment like this.

5) Labor mobility is limited when housing prices fall.  Pretty normal, if infrequent, in my opinion.  I faced this back in 1989; employers offered limited housing perks to new hires.  In three years, this will be gone.

6) Now, it should be no surprise for lending standards to tighten now.  We always shut the barn doors after the cows are in the fields.

7) Mortgage rates are rising, largely due to the reaction of the bond market to Fed chatter.

8 ) Prime ARMs will fuel the next wave of delinquencies.  If home values fall enough, any class of lending is vulnerable.

9) It should not surprise us that housing starts are low in an environment like this.  The bigger the boom, the bigger the bust.

10) I am not generally a Tom Brown fan.  He is too perma-bullish for my tastes.  He may have a correct technical point on subprime losses, but it may misrepresent losses for the financial sector as a whole.  Subprime is small.  Alt-A and Prime are much bigger, and losses are growing there.

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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