Tonight I pick up on the odds and ends.  Going along with last night’s theme of making mistakes, we had a saying in our office, “Great minds think alike.  Fools seldom differ.”  It helped us stay humble about our culture.  If we agreed, it might be because we were all bright, or all dumb.

As an aside, one of the brighter associates at the main office pulled me aside to ask about the foolish behavior of the client.  Having worked for a much larger and more professional firm, he was shocked.  I simply said (regarding the client), “It may be a rusty tub, but its OUR rusty tub.”  He gave me the grim smile of understanding.

Timing Purchases and Sales

I developed my own view of technical analysis while trading corporates.  I wrote about it in this post, A Fundamental Approach to Technical Analysis.  Here is the most relevant excerpt:

But not every fundamental investor agrees on what the proper prices are for buying and selling. As the old saying goes, “It takes two to make a market.” Sometimes, I will make it into the office and my trader will tell me that someone is aggressively selling a company that we own. I might ask him if our brokers have any feel for the size of the seller, and how desperate he is. The answer is usually “no,” but if we do get an answer, that can help dictate our trading strategy. We would want to buy more as the big seller is closer to being done. In fact, we want to buy his last block of shares from him, if possible. Sometimes that can be arranged by talking to our broker; other times not.

As another aside, this is simpler to do in the bond market than the stock market. The large brokers generally know who is doing what. Be nice to your sales coverages, and you’d be amazed what they will tell you…. Here’s a stylized example.

Broker: “You sure you want to buy that Washington Mutual bond?”

Me: “Yes, why?”

Broker: “Uh, there’s someone with size selling the name.”

Me: “How much size?”

Broker: “Best indications are eight times your order size.”

Me: “I can’t take that much down. Keep me in mind, and when he gets down to about double the size of my order, call me, and I’ll take the tail [everything that’s left].”

Broker: “You got it.”

There were other rules that helped me. Keeping the VIX on my screen helped me accelerate or slow down purchases and sales in a given day. Yield spreads lag behind option volatility even though the two should be closely related. Momentum of spreads also helped — falling and rising spreads tended to persist, so be more aggressive when the market was hot, and not when it is not. Beyond that, there were credit default swap [CDS] spreads, which were just becoming a factor then. I came to the conclusion that credit spreads moved a lot slower than CDS, so I developed a rule that said, “Don’t buy if CDS is above the credit spread. Wait for the CDS to fall below, then buy.” Worked well, and kept me out of deteriorating situations.

These rules also left me more calm and capable when the market was falling apart.  I also tended to build up a cash buffer when things were going awry, waiting for the eventual turn in the market.

Time Horizons

If I had to summarize it, it boils down to managing three time horizons:

• Daily — watch daily momentum and deal flow.
• Weekly-Monthly — how is the momentum going?  Gauge the speculative nature of the market.
• Credit cycle — where is the credit cycle in heading to the next peak or through?  How long till we get there, and what will it feel like as we near the peak or trough?

Thinking of it this way aids daily trading, and allows for clever trading in bear market rallies, and bull market pullbacks, while still watching the overall macroeconomic credit cycle.  You can’t get all three horizons in full; they fight each other at times.  Doing this means you can more intelligently weigh the costs of action and inaction, because the client needs income, and it helps you determine how long can you delay in providing income in order to avoid capital losses.

The client was growing like a weed.  That made my job easier and harder.  Easier because I could snap up every mispriced bond that was money good.  Harder, because during sharp rallies, I could not let cash build up too much.  I took the opportunity to buy AAA & AA bonds rather than A & BBB bonds, which gave up yield, but it was better than cash.

Scaling

One concept that aided me in trading was realizing that I did not have to be a big trader.  Moving in and out of positions slowly, as market conditions warranted was useful.  If the liquidity was available, and you were facilitating someone else’s bold move, that is another thing.  But the cardinal rule was, “Never demand liquidity unless it is an emergency, and you meet the strenuous test that you know something everyone else does not.  But, make others pay up for liquidity where possible.  You are doing them a service.”

Those ideas affect me today in my equity investing.  Most of the time I do small trades around core positions, and adjust my companies at a slow pace.  I make money while I wait.

Income Replacement

I was the risk manager as well as a corporate bond manager.  I understood that the policies written by the client had implied hurdle rates attached to them.  Selling a bond that was a good buy two years ago would realize a great capital gain, but would lead to a reduction in income most likely upon reinvestment of the proceeds.

The question was, and always will be, how to maximize the long-term well-being of the client.  Short-term gains matter little.  How can you build up a sustainable interest margin is the key.  Thus in my trading I looked at income replacement, adjusted for quality, maturity, liquidity, optionality, premium/discount, and a wide number of lesser variables.  Given that the client foolishly wanted me to trade aggressively, I did so, but matched off interest-rate related gains and losses, while building interest margins.

The End

No good deed goes unpunished.  The neophyte corporate bond manager that excelled was eventually told by his boss in early 2003 that they were losing manager searches because he was not in the home office (far away), and that fund management consultants told them that multi-city firms did not work.  (Those who can’t do, consult.)

I was offered a move to the main office, or be severed.  Hearing this, I went and called my wife, using my cell phone in an out-of-the-way place.  Little did I know that there was a betting line in the main office favoring that I would come by 3-1.  My gift to those who knew me in the main office was that little win, because in early 2003, investment jobs were hard to find, and would I just give my job up?

Well, yes.  I had enough confidence in my abilities (under God/Jesus), that I looked to the needs of my family first.  We had friends that we did not want to give up in our congregation for the first time, and I gave my family the benefit of the doubt, saying that I would try other possibilities in the area for a year or so.

Informally, I let my colleagues in my office know in advance; they were friends.  So on the last day for my decision, I announced that I would take severance.  Then something weird happened.  They left me with trading authority for the next two weeks.  Ordinarily that is cancelled, because the unscrupulous use that to reward friends at the expense of the client.  Rather than do that, I used the opportunity to sell down positions that I was comfortable with, but were too large forthose that would inherit the portfolio I built.  I managed to get all positions but one down to a reasonable level, leaving a clean portfolio for my successor.

Parties

My colleagues in my office took me out for lunch; they gave me a great time.  The analysts came and thanked me because I genuinely listened to them, and never blamed them.  They even told me that I was the only portfolio manager they knew who could be a credit analyst.

A few days before that, Legg Mason took me out to dinner with a few of my colleagues.  I was mystified as to why.  Yes, I had traded with them a lot, but they had given me good value on my trading.  In the middle of the dinner, I said, “This is really nice, guys, but why so much for me?”  They looked at my sales coverage and said, “Didn’t you tell him?”  They picked up and said, “What you don’t know is that your willingness to trade with us allowed us to build up our corporates coverage; without you we would not have a business today.  Also, you were honest with us and kept us from mistakes when we were out of the market context.”

I was floored.  Really?  I did that much for you?  They said, “Whatever we can do for you, just ask.”  I asked for an interview with Bill Miller.  That probably exceeded their notional credit line, because that never happened.

As it was, I landed a job with a wonderful hedge fund, Hovde Capital, in two months, and was very grateful to them for hiring me.

Postscript

There is one story that I left out from the beginning, which still needs to be told.  When our little money management firm was being acquired by an arm of Old Mutual, the CEO of that firm balked at paying our credit analysts the salaries they were receiving, and was really annoyed at the bonus structure.  He said to me and the high yield manager, “Look, the only people I need are the two of you, and we can hire other analysts.”  The two of us knew that our analysts/friends were golden — analysts that would be hard to replace.

The prospective buyer of our little firm called the two of us to a phone conference.  Somehow it leaked to the analysts what was being proposed and when.  As we headed off to the meeting, one analyst who was Jewish, called out to me, “David, don’t forget you are a Christian!”  Surprised, I turned and said, “I won’t.”  What determination I had doubled.

The high yield manager and I went into the teleconference and held our ground.  Then the counterproposal came, “If you want to protect your analysts, are you willing to put your bonuses on the line?”  We looked at each other.  I nodded; he nodded.  I said, “If we don’t meet your expectations as a group, you hit our bonuses first.”

As it was, we did well, and we all got our bonuses.  But it was never lost on the analysts that we put them first, both as colleagues and friends.  It was one big reason why we continued to do great business together.

Though I was only a corporate bond manager for two very special years, where I did well against a tough market, the way I did business helped us to do well, by being ethical above all else.  In a bad environment, that can really help.  Even Wall Street differentiates between who keeps their word and who does not.

I would have loved to continue in that business.  It was a lot of fun, but jobs like that are not handed out willy-nilly.  All that said, I went out knowing that I had done my best, and was ready to do more for my next employer.

I appreciate my readers.  That doesn’t mean that I am the fastest to respond to e-mails, but I appreciate what they write, even when I don’t agree.  But here is an e-mail very relevant to tonight’s piece:

Great series, David.

If you have more posts planned, it would be interesting to know what the biggest mistake you’ve made that you learned from the most.

In my short tenure as a corporate bond manager, I had a very good run in the midst of a bad environment.  Sometimes I think my lack of formal training was a plus for analyzing a situation where little was going well.

But I did make my mistakes. One was Enron — don’t get me wrong, I urged the sale of Enron bonds, but was countermanded.  Could I have argued the cause better?

• Fast-growing company in a slow-growing industry.
• Management that could not take criticism.
• Growing profits, shrinking cash flow.
• We had a peek inside the veil, because we had financed some of their private deals.  The complexity was astounding.
• Opaque balance sheet.

I made all of those points and still lost; my new bosses were not deep when it came to corporate credit; they were skilled in other areas of the bond market.  I eventually ended up selling the Enron bonds at an unfavorable price.  Would that I had sold on the date of the default, rather than a month later.

Then there was the Teleglobe situation, where I erred in many ways.  BCE, Incorporated had a unregulated subsidiary called Teleglobe.  Think of Global Crossing, and other marginal telecom ideas.  BCE was a sound company, and they offered verbal support for their subsidiary, but would not put it into writing, and formally guarantee their debt.

I did not know the company well, and I had no stock price to give me aid.  Stock prices are more sensitive than bond prices, and can give warnings before bond prices move dramatically.  My analyst went off to a telecom/technology conference, where the S&P analyst disclosed over dinner that she was likely to downgrade Teleglobe because of the lack of explicit support from the parent company.

Now given the broader picture, this should have been obvious.  There were too many situations where implicit support did not translate into real support, and Teleglobe, most than most, needed support.

My analyst called me after the comment from the S&P analyst, and I asked, “Should I sell?”  He said I should wait; he wanted to gather a little more data.  We had our opportunity to sell at $90, and waiting missed that.  By the time he returned, the S&P analyst indicated that a downgrade was likely, and the pseudo-price fell to $70.  But, we were now determined to sell.

So I called my favorite broker, who was at the only firm making a market in Teleglobe bonds.

DM: “What’s the market in Teleglobe bonds?”

FB: “$68/$72.”

DM: “Very good.  I sell you $XX Milllion of Teleglobe bonds at $68.”

FB: “I’m sorry, that’s not a real market, that is an indicative market.”

DM: “So where is the real market?”

FB: “We’ll take an order from you.”

DM: “You mean there is no real market?  You brought this deal to market, you have to maintain a market.”

FB: “We’ll take an order from you.”

DM: (Pause) You have an order for $XX million Teleglobe bonds at $65.

FB: “We will do our best for you.”

To this day, I have no doubt that she was serious with me.  Teleglobe bonds after that point traded in the $50s, but never at the main broker.  As I learned later, they had 10+ times more Teleglobe bonds than I did, and were trying to minimize their own exposure.  They lost a lot more than I did.

When BCE sent Teleglobe into bankruptcy several weeks later, we sold the bonds at $20.  The eventually went out as a zonk.  No value.

Lesson learned: bonds are asymmetric.  You are paid to be cautious regarding failure.  When in doubt, sell.  Also, don’t take your broker at face value always.

The fallout from the Teleglobe failure was twofold.  1) the client accused us of incompetence, because we had missed on Enron, KMart, and Teleglobe. 2) My boss asked me how I could have missed it, and I said, “I was following it and did the best I could.  But I am following over 500 credits.”

Sadly, he made the wrong decision, and hired another corporate bond manager, and we split the portfolio.  It led to poorer portfolio management.

Another error: I am not politics-sensitive.  I am more interested in doing what is right for clients, than what looks best.  So when the client proposed value destroying ideas that would benefit them directly, I argued against them.  The asset manager took me out of direct client contact, aside from actuarial risk management, but asked me to tell them what was up, because the client asked for weird things.  The same applied inside the asset manager, where my willingness to take or avoid risk was in sync with opportunity, but out of sync with the firm.

I had learned to avoid undue pessimism from the high yield manager who sat next to me, and that often made me more optimistic amid gloom than others in the firm.  I was not a pea in the pod, and perhaps that made those that had acquired my firm wonder about me.  I never did anything more than make my opinions known, but that is enough for some to take umbrage.

Maybe the point is this: you can be right in the long run, but wrong in the short run.  What eventually happened to the client?  Well, I mentioned all of the dismissals before, but as God would have it, the client was sold yesterday to hedge-fund manager Phil Falcone.  The new CEO of Old Mutual said:

But just to remind you of the background of the transaction, we bought US Life in 2001 with the aim of building a Life business in the United States. This has proved to be a poor acquisition for the Group, and we acknowledge it, largely due to taking excessive credit risk, the impacts of which came to a head in the 2008 global financial crisis. So we said in March we intended to explore the sale of the business.

Old Mutual pumped in hundreds of millions in capital, in addition to what they paid for it.  They lost badly.  But they did not list the real reason why they lost, which gives me little confidence that they will do better in the future.  They lost because their US life division sold policies at levels that did not cover the cost of capital.  In order to avoid the inevitable losses from selling policies too cheaply, they pushed those who invested for them to try to make it up by taking much more risk.  The risk didn’t come first; what came first was a bad management culture that pushed sales growth at the expense of everything else.

Hopefully, Mr. Falcone will see that and realize that sales aren’t everything, and dial back investment risk.  But who can tell?

My main errors came from mis-estimating people.  I was not strong enough to change the culture, and I should have realized that, and tried to be more incremental.  As it was, I was right, but frozen out from being able to effect change.

Final episode tomorrow, most likely…