15 August 2008 – The Aleph Blog

The Value of Being Approximately Right

Posted on 15 August 2008 by David Merkel

Buffett said something to the effect of: “I would rather be approximately right than precisely wrong.”? Everyone should agree with that maxim, but in the business world, many processes don’t work that way.

Take auditing as an example.? I’ve only experienced it as an actuary working in financial reporting, and it amazed me to see the detail work that they went through of checking cash flows (which should be done — how else do we detect fraud?), but with little to no attention on reserving assumptions.? Spending time on the “bigger picture” questions is important, and shouldn’t be neglected.

Or, consider earnings spreadsheets that analysts do.? They can be valuable, but I find it more valuable to look at the broader industry picture to see if an industry as a whole has a favorable economic picture, or, might be close to a turning point.

Then again, I think more like a portfolio manager, and less like an analyst.? That makes me better for some tasks, and not others.? My boss at Provident Mutual taught me the you need to identify the main 2-3 drivers of future profitability, and focus on them, because they will drive 80-90% of the results.? (I call this Cioffi’s Rule.)? If you get the main factors right, you will make more money than most investors.

Sometimes, I get labeled a lightweight because I don’t dig deep on certain issues.? I’m just trying to stay focused on the important issues.? Now, on financial stocks today, I own a bunch of insurers that put me over market weight for financials, but I own no credit-sensitive companies.? Even high-quality names are under stress.? (Consider the rate American Express had to pay to borrow money recently.? And I thought MetLife had it bad.? Ah, to be a corporate bond manager again… there are bargains to be had if one has an adequate balance sheet.)

What we don’t know is a significant factor.? I need to see some significant failures before the financial sector will be interesting.? I’m not investing to be courageous.? I’m here to make money over the cycle on a risk-adjusted basis.? It’s not that I avoid risk, it’s that I avoid taking it when I don’t see that I am paid to take it.

Also, even though my portfolio is concentrated, with 35 almost-equally-weighted companies, I avoid going “socks-and-underwear” (as my Dad would say playing Sheepshead) on any single company.? Even on industries, I try to be measured in my overweight positions.? But the objective is to take risk when you are being paid to do it, and avoid it otherwise.? Focusing is a popular strategy, and those who do well at it do very well.? Those who fail at it fail big.? On average, the strategy of focusing doesn’t of itself add value.

My eight rules help me be approximately right.? That doesn’t mean that I don’t make mistakes.? I make mistakes, and sometimes they are big.? But, my mistakes haven’t been frequent and big.

Consider this as you invest.? Focus on the big factors that affect profitability, and look for positive industry trends that are underdiscounted, and negative industry trends that are overdiscounted.? And, in the process, only buy companies that you know will survive.? More money is lost buying marginal companies than is gained.? Remember the margin of safety concept.? Your first job is not to lose money, so choose wisely.

Full disclosure: long MET

Ten Notes on Credit Risk

Posted on 15 August 2008 by David Merkel

1) The Modigliani-Miller Theorem asserts that the value of assets at a firm is independent of how they are financed.? The dirty truth is that less levered public firms are more profitable, and generally better investments than highly levered public firms.? Why?? High levels of debt often lead managements to think short-term, and they make more errors.? Yes, some firms will do amazing things when the debt gun is pointed at their head.? More will fail, or muddle.? Perhaps this is a place where private equity does better than heavily indebted public companies, because they are out of the spotlight.? Equity Private, if you are listening, what do you think?

2) Too many foxes, not enough rabbits?? Perhaps true for now.? There is a lot of money in vulture funds relative to the opportunities at present.? That might change as we get near the nadir of the credit crisis, but it does set up an interesting dynamic.? If you were managing a vulture fund, when would you deploy your cash?? It’s a tough decision — too early, and you don’t get the good deals, and the same if you are too late.? Personally, I would do a time-scale, and allocate relatively evenly over the next 18 months.

3) Counterparty risk is still a threat.? Well, sort of.? The investment banks are pretty sharp at limiting their own risks to their clients.? The real risks are the willingness of the investment banks to offer credit to each other.

4) Securitization will come back.? It is too powerful of a technology for it not to come back.? The only question is when.? Deals are still getting done where the GSEs guarantee the risk.? Beyond that, little is getting done.? Better disclosure will help in the long run, but in the short run, it doesn’t mean much.

5) The credit crisis is over!? Well, not according to Caroline Baum and David Goldman.? Both are acquaintances of mine.? Many know Caroline Baum, whose ability to explain the Fed and the credit markets is superior.? David Goldman is less well known, but this is what I wrote at Barry’s site today:

David Goldman is a bright analyst and underrated. I met him back when he was with First Boston, and I was a mortgage bond manager. His commentary at CSFB and BofA helped make me a better investor.

I don’t normally push multimedia, but I thought the interview was a good listen.

6) Default rates are rising on junk grade corporates.? Odds are they will be higher still in 2009.? When junk grade default rates move up, it is typically for three years or so, and in this case, we have more low-rated debt as a percentage of the market than at any time in the past.? Is it possible that we could eclipse the default rate of 2002?? Yes, but I would not put a lot of money on that; I feel the odds are 50/50.? Many corporations are highly levered but prospering from global demand, not US demand.

7) As I suggested regarding ACA Capital Holdings, they ended up owned by their policyholders, who get an equitable interest in the assets of the company, though not enough to settle their claims.? For the bond insurers that are insolvent, this is the paradigm that will be followed as bad guarantees get settled.? And, this will probably be applied to Bluepoint, Wachovia’s subsidiary.? I agree with Calculated Risk, it is an interesting statement that Wachovia would not put fresh capital into it.? Just another sign that the equity is worth zero to Wachovia.

8) The bond insurers aren’t totally dead, though.? They are finding ways to exit debt they have guaranteed, and convert it to more liquid, valuable debts. Hey, every bit of risk shed is a plus, and they can report income in the short run from that.

9) The asset sales go on, as investment banks reconcile their SIVs and CDOs.? The tough part is taking the losses (surprise).? This is normal, because in illiquid markets where there is a lot of credit risks, there are few trades, and when things go bad, prices shift dramatically lower.

10) I have a bias against universal finance.? No company can manage all financial businesses well.? There are different risk control disciplines in different areas of finance, and when you put them together, risk control gets neglected in some businesses.? This was true at UBS, and now they are unwinding the mess.