“Get financing when you can, not when you have to.”  Warren Buffett said something like that, and it is true.  My biggest early investment loss was Caldor, which Michael Price lost a cool billion on.  A retailer that could not hold up to Wal-Mart, Target, and Sears, Caldor expanded in the early 90s by scrimping on working capital.  Eventually a cash shortfall hit, and their Investor Relations guy said something to the effect of, “We have no financing problems at all!”  The vehemence cause the factors that financed their investory to blink, and they pulled their financing, sending Caldor into bankruptcy, and eventually, liquidation.

Caldor had two opportunities to avoid the crisis.  It could have merged with Bradlees and recapitalized, leaving it stronger in the Northeastern US.  It also could have done a junk bond issue, which was pitched to them eight months before the crisis, but they didn’t do it.  In the first case, the deal terms weren’t favorable enough.  In the second case, they thought they could finance expansion on the cheap.

Caldor is forgotten, but the lessons are forgotten today as well.  Today, overleveraged financial companies wish they had raised equity or long-term debt one year ago, when the markets were relatively friendly and P/Es were higher, and credit spreads were lower.

I know I am unusual in my dislike for leverage in companies, but on average less levered companies do better than those with more debt.  Caldor went out with a zero for the equity.  A few zeroes can really mess up performance.

Capital flexibility has real value to good management teams.  I don’t mind exess cash hanging out on the balance sheets of good firms.  Hang onto some of it, and maybe during a crisis you can buy a competitor at a bargain price.

But for the financials today, who has the wherewithal to be a consolidator?  Most of the industry played their capital to the limit, and are now paying the price.  Either the door is shut for new capital, or they are paying through the nose.

I don’t see anyone large who fits that bill of being a consolidator.  Maybe some of the large energy companies that have been paying down debt would like to diversify, and buy a bank.  Hey, feeling lucky?!  Lehman Brothers!

Look, I’m being a little whimsical here, but the point remains — run your companies with a provision against adverse deviation.  Be conservative.  For those that invest, avoid companies that play it to the limit, unless you are an investor with enough of a stake that you can control the company.

I’m going to be reviewing a few books on quantitative investing.  Many of these will not be suitable for everyone, and as I do these reviews, I will try to indicate what level of math skills you will need in order to benefit from the book.  For today’s book, you can get most of it if you can remember your Algebra 1, and understand basic statistics.  Knowing regression helps, and a little calculus wouldn’t hurt, but this book is mainly qualitative.  It describes,and there are many graphs, but formulas are not on every page.

Investing By The Numbers has been out a while (1999), and though it is a good book in my opinion, it never sold big.  Oddly, a lot of investment actuaries bought the book because of a review in the Investment Section newsletter, Risk and Returns.  I have one of the few signed copies.  When I met Jarrod Wilcox when he gave a talk to the CFA Society of Washington, DC, he was genuinely surprised when I asked him to sign my copy of the book.

Jarrod Wilcox, Ph.D., CFA, held important roles at PanAgora Asset Management and Batterymarch Financial Management.  He runs his own shop now, focusing on liability-driven investing, something that I have written about at RealMoney, and at this blog.  What do I mean by liability driven investing?  Just that your asset allocation should reflect when you will most likely need the money.

This book does not have one big overarching idea to guide it.  Instead, it has many models to share from different situations in the market.  There is something for every quantitative equity investor here, and I will mention the areas where I benefited the most:

  • Along with a few other books, including some from the Santa Fe Institute, this book confirmed to me that one has to look at investment using an ecological framework.  Many strategies are competing for scarce returns.  Often the best strategy is the one that has few following it, and the worst one is the crowded trade.
  • Why do value methods tend to work?
  • How do you avoid traps in calculating models?
  • How do investors with different goals and expectations affect the market?  What happens when you get too many momentum investors?  Too many growth investors?
  • Difficulties with the Capital Asset Pricing Model [CAPM] and Arbitrage Pricing Theory [APT].
  • If the market tends toward equilibrium, the forces guiding it are weak.
  • Behavioral finance as a means of bridging investment theory and reality.
  • Market microstructure: how do we minimize total trading cost?  Minimize taxes?
  • How is the P/B-ROE model derived?
  • How to model market anomalies?
  • When do different valuation methods pay off well?
  • How does international diversification help?  (Bold in 1999, but a bit dated now.)
  • How to manage foreign currency risk in an equity portfolio?
  • How do neural nets work and what challenges are there in using them?

As a young investor using quantitative methods, I found the book useful, and still use a number of its findings in my current investing. Again, this is not a book for everyone — you have to want to do quantitative investing from primarily a fundamental mindset in order to benefit for this book.

Full Disclosure: Anytime anyone enters Amazon.com through any link on my site and buys anything there, I get a small commission.  This is my version of the tip jar, but best of all, it doesn’t cost you a thing, if you needed to buy it through Amazon already.

I like to think that I have a pretty strong stomach for risk.  I am used to losses.  I have my sell disciplines, and I act on them.  I also try to be forward-thinking about risk; not just reacting, but trying to anticipate what the markets are likely to deliver.  Every now and then, I get a surprise.  Here’s the surprise, which I got from The Big Picture (Barry’s blog).  Institutional Risk Analytics does some good work, and this article is representative of their work.  In it, they describe the two risks facing the large banks — risks from their assets, and risks from their derivative books.

The second link made me pause.  I know things are bad, and I can’t vouch for Institutional Risk Analytics’ risk based capital model for banks, but the level of notional derivatives exposure at many of the major banks to their tier 1 surplus made me pause.  There are two claims on surplus — losses from direct lending, and losses in the derivative books.

Those who have read me for a long while know that I think the derivative books at the investment banks are mismarked and possibly mishedged.  When accounting rules are not well-defined, and instruments are illiquid, even well-meaning managements tend to err in their favor in the short run.

This is significant in a number of ways, but the main one was pointed out in the first link, that with the continuing failure of small banks, how will the FDIC make depositors secure if a large-ish institution fails, when reserves are relatively low?  They need to raise their fees that they charge solvent banks to replenish their coffers.  They are also bringing back retirees with experience in dealing with insolvent banks.

So, are the banks in trouble?  Some of them are experiencing stress, and that is coming through higher credit spreads on their debt.  Given the higher costs entailed in funding for banks, it is all the more important in your investing to look for companies that don’t need much external finance.  After all, many banks may find it harder to lend.  Consider the difficulties in funding InBev’s purchase of Anheuser-Busch.  Large banks are straining at their limits.  They don’t have enough parties to sell loans off to, nor do they want to hold onto so much of the risk.

The bank loan and and bond markets are closely connected.  Troubles in one tend to spill over to the other.  Loans have a higher priority claim, so the yields are lower than for bonds.  As it is, investment grade corporate bonds, particularly financials, are facing higher yieldsThe high yield market has slowed considerably.

So, what does this imply?  The banks are hunkering down.  They are scrutinizing all risk exposures.  They aren’t expanding lending, which is showing up in MZM, M2, and my M3 proxy.  Credit is getting tough/sluggish.

Money Supply

Money Supply

And the degree of leverage that banks are willing to use versus the Fed’s monetary base is dropping, and hard (the graph covers 28 years).

Bank Leverage

Bank Leverage

So, I’m not optimistic here. I believe in the value of “long only” money management as having better chances of risk control than hedged strategies, but this is making me queasy. What it makes me think, is that the FOMC’s next move is a loosen. It hurt to say that, particularly given my dislike of inflation, but the solvency of the financial system comes ahead of inflation in the Fed’s calculus, even though loosening won’t help much.

With that, I am looking to continued problems in banks, and perhaps for the economy as a whole.  Our next president will have a fun time with this…

Just a quick post to give a mid-quarter view of my main industry rotation model.  The recent moves in the market have knocked many energy sector industries out of the hot zone (red), but any bounce in financials has not knocked them out of the cold zone (green).  I’m still not ready to play in the depositary and credit sensitive financial companies, my insurance exposure is cheap, and earning money with low-ish risks.  That said, this is the type of environment that reveals which insurers have been taking on too much risk with marginal bonds.



Remember that my industry ranks can be used in two modes: momentum mode (look at the red zone), and value mode (green zone).  I spend most of my time in the green zone, looking at industries where I think pricing power will return.  For me, the red zone is more useful for sale decisions.  When an industry is running hot, I delay selling out in entire, and content myself with trimming positions in order to limit risk when the eventual turn happens.

Many CFA charterholders blog, though it is a tiny fraction of the total pool of CFA charterholders.  Many of them contribute to Seeking Alpha.  Granted, if you look at lists of the most popular investment weblogs, few of the writers are CFA charterholders.  Why?  Well, having basic knowledge about investments and ethics does not mean that you can write about it well.  For those who can write well, there are other options, most of which are more remunerative.

  • Write internal research for a buy-side firm that no one else sees.
  • Be a sell-side analyst for those who trade with your firm.
  • Write a newsletter for paying clients.
  • Manage money, and write an entertaining quarterly/monthly missive that adds to the subjective value of having money managed by you.
  • Write for RealMoney, or some other major media newspaper/website.

The thing is, for most bloggers, it is self-expression, not remuneration, that matters.  For me, it is giving something back to the broader investing community.  The retail investor does not have many friends.

So, it was with puzzlement that I read Susan Weiner’s piece called, “Investment Strategy Blogs Slow to
Influence Financial Advisors
,” as cited by Felix Salmon.  Now, don’t get me wrong here, becoming a CFA charterholder opened a lot of doors for me.  But the CFA Institute, with its curriculum does not have a monopoly on training smart investors.  For those starting out young, getting an MBA from a well-regarded school can often be a better choice.  On the buy-side, having a CFA charter has some punch, but not so much on the sell-side.

I wrote for RealMoney for 3.5 years before starting my blog.  Writing for RealMoney taught me a lot about how to phrase things in an interesting way.  Most of the contributors there were/are very good at expressing themselves.  Most are not CFA charterholders.  Almost all journalists aren’t CFA charterholders either.  Buffett is not a CFA charterholder, though his mentor, Ben Graham, helped found the predecessor to the CFA Institute.

My surprise as a blogger has been the quality of the information/advice that I have run across in blogging.  The best are reflected in my blogroll, but there are many others that I like but don’t read regularly.  Bloggers tend to be more pointed, sometimes more sensationalistic, than the financial press, and the sell-side.  But there is a virtue to blogging that the others lack: criticism.

Look, I make mistakes.  As a blogger who prizes his reputation (and honesty generally), when I make a mistake, I try to be fast to confess it.  Blogging is more interactive than other forms of media, so the feedback cycle is faster for those who take honesty seriously.  Those that make too many mistakes, or refuse to accept criticism, get marginalized, and quickly.

Blogging has another virtue, in that bloggers are willing to take more chances in what they say.  Those who are wrong too often are disregarded… it’s a tough environment out there.  But those who are willing to hazard unvarnished opinions about tough issues will gain a following, if they are correct often enough.  Ask yourself this, in the recent credit crisis, who has been more accurate in their predictions, the mainstream media, the sell-side, or leading finance bloggers?  My money is on the bloggers.

Now, the articles cited above glorify CFA charterholders, licensure, and the mainstream media.  None of those are guarantees of good investing or writing.  Those that I interact with in the mainstream media are pretty sharp, and I think quality has increased there over the last ten years.  TheStreet.com has something to do with that, in that they have trained a bevy of young smart journalists that can write, and they understand the markets better then 95% of the population.

I place more stock in a strong liberal arts education that does not neglect business and the hard sciences.  Like Buffett and Munger, lifelong learners tend to be some of the best investors and writers.  We are strong generalists.  The CFA syllabus imparts a limited set of knowledge that is very useful, but most CFA charterholders are mediocre investors.  As Ken Fisher said to me, “The first thing you have to do is forget everything you’ve learned in the CFA training.”  He also told me to forget what I learned from his books.  What is known is not valuable.  What do I know that no one else knows?  That conversation kicked off my current investing approach, of which, 40% of it derives from the useful CFA syllabus.  (Though the advanced investing syllabus for the Society of Actuaries has a few things to commend it that the CFA syllabus does not have.)

You can get a CFA charter.  You can pass the Series 7, and become a broker.  You can become a financial journalist.  None of those guarantee that you can add value.  The best in each of those areas become known for the quality of work that they generate.  The cream rises to the top.  So, I put out this challenge to those that are skeptical about financial bloggers.  Look at the sites in my blogroll, and tell me which ones have poorly thought-out opinions that will harm readers.  I maintain that they are all useful for both experts and retail investors, and are a useful supplement to conventional investment research that doesn’t take chances, because it is not in their interest to do so.

UPDATE: NOON 8/21 — One emendation, regular reader Steve pointed out one bit of sloppiness in the above post.  Where it says “CFA(s)” it should say CFA charterholder(s), or charter.  I have adjusted the post to reflect that.

“It’s not a solvency problem; it’s a liquidity problem.”  So many people say regarding some financial firms that are on the ropes.  I’ve never liked that way of expressing the problem.  Let me explain why.

When does a firm typically default?  When they run out of liquidity.  True, some firms voluntarily file for bankruptcy when they see that their assets are worth less than their liabilities, and don’t see any way out.  Some firms are forced to file for bankruptcy when they trip a debt covenant.  But most firms that find their net worth slouching into, or slouching deeper into negativity don’t file for bankruptcy.  They play for time.

They hold an option with an uncertain expiry date.  When will we run out of cash?  Any way to conserve cash or sell off assets could lengthen the time to expiry, and maybe, just maybe, the economy will turn, or the pricing cycle will turn for the products, or enough other firms will fail, that the remaining liquidity lowers financing rates enough that the company can re-liquefy and survive.

The thing is, a company’s liquidity only becomes an issue when its ability to generate cash flow adequate to service creditors is questionable.  A company can say all it wants, “But we have valuable assets.  We’re not near insolvency!”  Fine.  Sell some of those valuable assets and generate liquidity.  “But it’s a bad market, we don’t want to hit low bids.”  This explains why the solvency as well as liquidity is questioned.  The assets aren’t worth as much as previously imagined.  Perhaps on a fair value basis, during the period of stress, net worth is negative.

Will the banks extend short term loans against unencumbered assets?  Can the firm do a private placement with some prize asset as security? No?  Perhaps the assets are worth considerably less than thought.  A healthy premium of the value of assets over liabilities will almost always be able to attract financing.  But when you are close to the line in a bad environment, any small premium will seem like an illusion to lenders.

So, in a large majority of cases, if there are liquidity problems, it is because there are solvency problems as well.  Here’s one more test: if a firm is suffering from low liquidity, but has valuable assets, why not sell out to another public firm, or go private, and let private equity solve the liquidity problem?  After all, they would like to buy valuable assets at a discount, right?  Right?!

🙁 Well, I would hope so, but during bad periods in the credit cycle, that doesn’t happen often.  So, the way I think is this: most hard liquidity problems are solvency problems, and vice-versa.  They are non-identical twins that don’t stray very far from each other.

Okay, that was theory, now for practice.  Credit sensitive financials have been getting whacked lately, and deservedly so.  Here are the examples:

My examples should confirm to you that insolvency and illiquidity are closely related.  In my investing, I like owning companies that are not playing it too close to the line.  In bad economic environments, the line moves, and companies that thought they could survive can’t.  A warning to all of us who invest, and to those who manage companies: play it safe.  Never take risks that could endanged the franchise, and don’t invest in companies that do so.

Things look grim for Fannie and Freddie, if market reaction is the benchmark.  The action in their stocks, preferred stocks, and subordinated debt was ugly on Monday.  Not only did you have the article in Barron’s, which made the case that the equity of the firms wasn’t worth much, but you had selling of their senior debt, and guaranteed MBS by foreign investors.  It may not be that Fannie and Freddie fail, but that they get recapitalized by the government in a way that massively dilutes the equity.  Or, going back to my old idea, they get nationalized and become part of GNMA.  The equity and preferred stock go out worthless, and the subordinated debt gets some sort of haircut (partial conversion to senior, plus an earn-out based off the losses the the government has to bear).  I’m not sure a bailout is inevitable, but the odds are rising.

Now, Fannie and Freddie have been through a lot in the last three weeks.  Freddie has changed servicer guidelines possibly in an effort to forestall current period losses.  They have also both reported huge losses:



Then there is the insult added to injury, as S&P downgrades the preferred stock and subordinated debt.

So, after all of this, we should steer clear of the securities of Fannie and Freddie?  Steer clear of the common and preferred stocks, yes.  Subordinated debt, I’m not sure, but when I’m not sure, I don’t take positions.

Now, the senior debt is another matter.  Spreads are very wide, and the possibility of nationalization is significant.  As Accrued Interest says:

The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don’t know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury’s next move is.

I agree, and when I was a bond manager with a good thesis, I would ask which bonds offered me the best advantage.  This article ends with an idea that is practical to some institutional fixed income managers.  Both Fannie and Freddie have a small amount of long non-callable zero coupon bonds.  These bonds will have a significant rally in the case where the US government nationalizes them.  And, if the US government decides to let them slip into default, well, you are buying them at 20-35 cents on par value.  No way in an insolvency you get less than that.

The worst case scenario is that long interest rates rise generally, and the zero coupon bonds get killed.  Sophisticated managers could sell short Treasury zeroes to hedge.

PS — Now, as I wrote this, the estimable Jeff Miller put up a good post on the GSEs.  It is worth a read.

UPDATE — 11 AM 8/19

Manto’s comment below is correct, and I apologize.  Bonds originally issued as discount bonds have bankruptcy claims equal to their accreted value.  Bonds issued at par, that subsequently become discount bonds have a claim value of par.  Why did I make this mistake?  I improperly generalized from my experience trading discount bonds, and other structures (such as zero-to-full bonds created from bonds originally offered at par) where the claim would be par in bankruptcy.

It was only two months ago when I wrote my surprisingly well-received post, Ten Notes on Crude Oil: The Fixation. It was surprising to me because I’m not an expert on energy issues. I’m just a good generalist portfolio manager who knows a little about a lot. So, I have to be careful what I say, and candidly say that I’m not sure, when that’s the case.

Here’s a graph of the price of crude over the last year.  Over the last two months, it was up fast in month one, and down faster in month two.  What a ride!

One Year Chart of the front month future of WTI Crude Oil

One Year Chart of the front month future of WTI Crude Oil

As prices rose in late June, President Bush called for lifting the restrictions on offshore drilling in the US.  If opening up ANWR was tough, this would be tougher, as there is a visceral feeling against drilling in states with significant coastal populations, even if the rigs can’t be seen from shore.

Another hurdle would be the lack of equipment capable of doing the drilling in the short run.  Think of all the industries with relatively tight capacity constraints that would be stimulated if the ban were lifted.  Drill-ships and rigs, specialty steel, coal, industrial gases… and more.  It would be quite a project.

As crude oil rose over $130/barrel, the exchanges moved to put limits on oil contracts.  Two weeks before the peak, credit conditions were leading shorts to cover positions.  Refiners began to let their crude inventories fall because it was getting more expensive to finance them.  So, as the market approached the price peak, there were a wide number of financing issues pushing the market around.

One week after the price peak, the demise of SemGroup made the headlines.  They were reportedly short the crude oil market, and were forced buyers covering near the peak.  Capitalistic markets are unstable, and that is mostly good thing, because it motivates market players to respond to the need.  At any significant peak/valley, some player that was taking significant chances gets uncovered as a fool who took big risks without a sound capital base, exacerbating the peak, and, the decline, though the fool doesn’t get to benefit.

As the price peak passed, this article posited why we would see oil down below $100.  The summary answer is demand destruction and supply encouragement.  High prices are the solution — users don’t buy as much, and suppliers see reason to produce more.  As for demand destruction, it is well underway in the US, but in places where prices are subsidized, or are artificially high due to taxes, the process is slower.

Every market has momentum players.  Momentum is a really simple strategy; do what the majority are doing.  That exacerbates the swings in the market, but given the needs of hedgers, whether they are producers or users, momentum tends to occur anyway for reasons of fear.

No surprise that high oil prices lead to conservation efforts on the part of corporations, as well as individuals.  High prices solve themselves.

One month after the recent peak, journalists point out the recent price peakHindsight is 20/20, gentlemen.  I understand the need to explain what is going on, but I have more respect for those that take a position before the reversal, when it is painful to do so.

Crude oil is inelastically supplied and demanded, so it it should be no surprise that the price is volatile.  Small changes in expectations can produce big results, as is posited in this article on queueing theory.

I am not a peak oil “true believer.”  I believe that it is more likely than not.  As a result, I offer some time to the other side, because we can learn from them.  How much of the recent price spike is supply and demand, and how much  is speculation?  Hard to disaggregate, because speculation is normal to capitalistic markets.

Buffett: my guess is that he is accumulating a large stake in ConocoPhilips.  I could be wrong here; badly wrong, as he could be selling off.  But COP is cheap, has a large refining capacity, as well as significant E&P efforts around the globe.

Finally, a book review.  I was going to do reviews of two books on opposite sides of the peak oil question, but the book on the negative side was never sent to me

As for the pro-peak oil book, Profit from the Peak: The End of Oil and the Greatest Investment Event of the Century, my disappointment was that it was not written by an expert in the industry.  He posits that not only are we at peak oil, but we are at peak energy.  We are at or close to the peak in many forms of energy: coal, uranium, natural gas, etc.

This is a bold claim, an one that I think will be partially falsified, as men make efforts to expand energy with the incentives that come from high energy prices.

Full disclosure: long COP, also anyone entering Amazon.com through a link on my site, and buying anything, ends up giving me a commission.  No increase of cost to you.  It is my version of the tip jar.

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