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Archive for February, 2013

Six Years at the Aleph Blog!

Thursday, February 28th, 2013

Thanks to all of my readers, whether you read me via RSS, e-mail, twitter, or natively at the website.  But I have a favor to ask… if you read me elsewhere, drop by the site every now and then, because not all of my commentary gets republished by those that reprint my work.  Also, not that we get a ton of comments at Aleph Blog, but I appreciate the quality of almost all of the comments we get here, even if I may disagree with some of them.  If you read me elsewhere and want to comment, come to Aleph Blog and do so, or, just e-mail me.

Now for a few housekeeping items.  1) People sometimes ask me for books to help explain insurance stocks, and in the past I have pointed to my own writings, especially this one.  My flavors of insurance series helps also.  I’ve also pointed to works from the Society of Actuaries, Casualty Actuarial Society, LOMA, CPCU, and others.  But now, I think this piece could be useful to some readers.  It’s relatively comprehensive, and not that long.  It’s not the way I do it, but it is well thought out.  It suffers from the same problem as one using the models of Aswath Damodaran; it’s too detailed.  I can’t think of anyone that uses such a model — it is overkill.  But maybe readers could what I would do with such a model: boil it down into something simpler.

That is what I am trying to do with my current series on analyzing insurance stocks.  There are three or so more parts left to write, and I should get them out in coming months.

2) Some people ask me how they can read the articles in my Major Article List, and I wish I could read them too.  Trouble is, has lost them.  They are there, maybe, somewhere in their computer systems, but since they changed the way that they named files, the links to most pre-2008 posts has been lost.

Now, if any of you think you have a way to find those posts, let me know.  There are pieces on that list that are gold, silver, and bronze.  I would at least like to get the gold ones back.

3) Sometime soon, I will create a small website for my business.  It will explain what I do for a living for those that might want me to manage money for them.  I will not link to it here; I try to keep a separation between the blog and my business.

4) I write about a lot of topics, and I tend to go in streaks on given topics.  It’s not what I intended when I started this, but I can understand why I have readers follow me and leave me.  My blog is consistent over a long period, but over intermediate periods it concentrates on one area, then another.

5) I’m not out of things to write about.  Here’s what I am planning for the future:

  • Completion of my work on a new asset pricing model
  • Completion of my “On Insurance Investing” series
  • More posts on the idiocy of US & Global macroeconomic policy
  • Buffett’s Shareholder Letter and Annual Report.  (Note: the letter gets more press, but the Annual Report has more substance.)
  • Commentary on new ideas from the CFA Institute… some good, some bad…
  • More commentary on investments that rip people off.
  • And more, I have a long list of ideas to write about, and many book reviews to publish

6) I would have never expected  it, but February 2013 was my highest readership level at the blog directly, despite the short month.  Thanks to all who read what I wrote.  I try to write good stuff; I do not aim to be controversial, though I know that some of my views are controversial.

7) When I started this six years ago, I would have never dreamed how much I would end up writing.  I thought I wrote a lot for RealMoney.  If anything, I have written four times as much per unit time, which means that as prolific as I was at RealMoney, I have written 4-10x as much here.  And it all started with an extended conversation with readers on Jim Cramer’s “blog,” which led me to do what I had resisted for two years — start my own blog.

As I have developed this blog, I now earn more than I did writing for RealMoney.  That’s not much, but every little bit helps.

8 ) You can’t believe how many people write me asking to do a guest post at my blog.  It happens about 15 times per month.  Then there are the scummy advertisers, who don’t want their advertisements to be labeled as such.  I have a strict policy that all advertising should be identified as such.  Why?  Because I never want to scam my readers.  When you come here, I want you to be comfortable that I am saying what I say for reasons of truth, not profit.  Profit is incidental here.  Truth is paramount.  I know how I could make this place more profitable, and I reject it because I would compromise my message.

9) I began with thanks to readers; I end there as well.  Truth, I treasure all of the emails giving me praise, but my internal response is “Wow, you’ve all been so great to me over the years.  It really gets to me, you know.  I hope I always make you proud.  That’s all.”  (What the Flash said to the citizens of Center City… yeah I know, a little dumb, but you had to see it.  Start it at 8 minutes.)

My main focus is on ethics in investing, and secondarily explaining how things work.  I hate seeing people ripped off by investment firms, or their dishonest governments.

I have no idea how long I will continue this blog, but I would love to do it as long as I live.

Sincerely your friend,


Two Insurance Questions

Wednesday, February 27th, 2013

First question:

Good afternoon.  I’m an avid reader of your blog and want to thank you for the work that you’ve done. I’m reading through the 10-Ks of insurers to try and educate myself and wanted to see if you can provide some advice.  I’m trying to find a guide/book that can help me understand the mechanics of the loss reserve developments show as an adjustment to each “vintage” year.  For example, I’m trying to understand if these are rolling reserves or if they are standalone on an annual basis.  I’m also trying to understand how changes in reserves flow through the income statement.  If you have a book that you can point me to, I’d really appreciate it.  Thanks for your help and have a nice weekend.

First, to any casualty actuaries reading me, if I get this wrong please correct me.  I am a life actuary by training, though I’ve tried to learn your discipline in broad from outside.

There are two main exhibits for P&C reserving in 10Ks — there are the loss triangles that go by accident year (i.e. the year in which the claim is incurred, rather than paid).  But the triangles show what has been paid, and how the incurred estimate changes over time.  With this, you can see how estimates of losses have proven liberal or conservative over time.

The second main exhibit breaks down reserve setting  for the current year.  It breaks into two main parts:

  • What reserves have you set for the business written in the current year?
  • How have you changed your estimate of losses incurred for prior years?

My article last night dealt with the latter of those questions.  What this implies is that good companies are very conservative in setting reserves for the current year, and lets the excess of those reserves release over time.  This may not juice stock performance in the short run, but in the long-run, it will lead to good results, because there will be few negative surprises from reserving.

Here’s the second question:

I’ve been intrigued by the recent reader questions, specifically the last couple questions on insurance stocks (RGA, AIZ and others). It sparked a mini research project this weekend for me and I read through a bunch of your old posts, along with some of the company reports and conference call transcripts. I don’t have in depth knowledge of the insurance industry…. I like the business model and understand the basic business, but am not yet well versed with reading and deciphering balance sheet items and insurance industry specific metrics-although I’m getting there

My question is very general in nature. As a value investor, each month I go through 6 or 7 different screens (basic value metrics like P/E, P/B, P/FCF, etc…). I know you’ve said that insurance stocks tend to follow their book value over time, but can trade in ranges from 0.5 to 2.0 times book… and I’ve read through your thoughts on adjusting book value for intangible items and AOCI. But my question is basically: “Why is the market pricing so many insurance stocks so far below book value?” I know that the near term outlook for interest rates is that they’ll stay low, and I know the near term outlook for the industry isn’t great, but it seems like the market is pricing these stocks for poor results for years.

I know you can’t answer this question specifically, but I just wanted to hear your expertise on why you think these stocks are so far below their book value. I subscribe to Value Line and was reading the latest section on Life Insurers (section 8 from last month)… Value Line covers 10 or 12 of these stocks- RGA, LNC, MET, AFL, PRU, AIZ among others… and all of them seem to be priced at very low prices to earnings and/or book value. In the stock you like, National Western Life Insurance (NWLI), as I’m sure you know-it’s priced at .44 x book, and 6x forward earnings. Almost all of the stocks I looked at in Value line are single digit current P/E ratios as well.

The other thing I’ve noticed as I looked at the 10 year financial histories of these stocks is this: most of them are successfully growing their businesses (premium income seems to be steadily rising each year with most of them), and most of them are growing their book values. Some had the bad year in 2008, but many of them seem to be growing their book values at 10-15% per year consistently for the past decade.

So you have stocks that are selling at very low P/E ratios, very low P/B ratios (and low relative to their own historical valuations in both those categories), AND they are growing their book values (most of them at least).

I guess I’m just looking for some help as to what I could be missing? What does the market see that warrants these valuations?

Insurance is a mature industry.  It’s not a sexy industry.  Further, the accounting in insurance is complex, and few outside the industry understand it.  I have a huge book explaining the nuances of GAAP accounting for life insurers… it is complex.

Now there are some reserving issues with life insurers.  With secondary guarantees, there is little way to tell that reserving is adequate with Variable Products, or Universal Life with no lapse guarantees.

As such, I avoid the companies that are heavy with these products.  Part of the discount there is the distrust of the accounting, but the taint spreads to the industry as a whole,  and as such, the whole life insurance industry trades at a discount.  Some more so, some less.

That said, well-run insurance companies pay great dividends and compound book value at high rates.  Aside from NWLI, I don’t own any pure play life insurers,  Yes, I own SFG, but it is mostly a disability insurer.  AIZ offers funeral insurance, but it is #1 there, with weak competition.  I own RGA. a life reinsurer, but the issues are very different.

There are concerns in life insurance about crediting rate guarantees that can’t be met.  I don’t own any companies with that problem; that is a real problem.

I’m happy to own the insurers without accounting problems, which have low P/B & P/E ratios.  In the long run, their ability to compound returns will benefit any portfolio — it is only a question as to when serious and large investors realize this.  I am willing to wait for this.

Full disclosure: long NWLI SFG AIZ RGA AFL

On Equity Valuations

Tuesday, February 26th, 2013

From a reader:

I only recently stumbled upon your blog, but I’m hooked.  I can’t thank you enough for taking the time to share your financial insight, experience and wisdom.

I’m a new entrant to the financial services industry (3 weeks on the job) and feeling ill-equipped without a finance degree. I’m struggling with the application of equity valuation. I’ve read several DCF valuation books and can recite all the valuation ratios, but I still have trouble looking at a companies financial statements and using them to make a judgement on a companies stock price.

Do you have any book recommendations for mastering fundamental equity valuation? 

Any help would be greatly appreciated. 

Any book by Aswath Damodaran on valuation, or Michael Mauboussin’s book on Expectations Investing will give you the theoretically correct view on how to value any sort of company.  Also, this book by James Valentine is very useful.

But I want to make your life easier.  Typically, by industry there is one simple metric that drives valuation at any point in time.  That typically gears off of the maturity of the industry, and its need for additional capital.  For those that are math nerds, there is the true model, but us lesser mortals can’t run it.  But each industry faces constraints that others don’t, and so the true model in a given industry becomes simpler to a first approximation: focus on price-to-sales, price-to-book, price-to-earnings, or the PEG ratio, among other ideas.

These simpler valuation measures focus on what is tough to do.  Can we sell more?  Can we increase our profit margin?  Can we grow our business more rapidly?

This is why sell side analysts in a given industry do not use the full valuation models listed above, but use a partial version of them, as is appropriate to their industry.

It’s useful to know the overarching model, as the above books will give you. But practically, every industry is valued differently, because each one faces different constraints, and that drives their valuations.

On Insurance Investing, Part 4

Tuesday, February 26th, 2013

This will be a short but important part in this series on insurance investing.  It deals with the accounting, and applies to all areas of insurance.  Insurance accounting is complex. When an insurance policy is written, the insurer does not know the true cost of the liability that it has incurred; that will only be known over time.

Now the actuaries inside the firm most of the time have a better idea than outsiders as to where reserve should be set to pay future claims from existing business, but even they don’t know for sure.  Some lines of insurance do not have a strong method of calculating reserves.  This was/is true of most financial insurance, title insurance, etc., and as such, many such insurers got wiped out in the collapse of the housing bubble, because they did not realize that they were taking one big nondiversifiable risk.  The law of large numbers did not apply, because the results were highly correlated with housing prices, financial asset prices, etc.

Even with a long-tailed P&C insurance coverage, setting the reserves can be more of an art than science.  That is why I try to underwrite insurance management teams to understand whether they are conservative or not.  I would rather get a string of positive surprises than negative surprises, and you tend to one or the other.

There are a couple ways to analyze this:

1) This had more punch when interest rates were higher, because insurance managements were more tempted to compromise underwriting, because they had compelling investment opportunities, but asking the anti-question, “How are you planning on growing the top line next year?” is a good one.

An inexperienced or liberal management team will try to talk about business opportunities.  An experienced, or conservative management team will say, “We don’t target top line growth.  We aim for growth in fully converted book value per share.  We only grow the top line when the market favors that, and ability to write risks at favorable prices is easy.”

Conservative investors should be wary of any financial company that is growing aggressively; finance is a mature industry, and sustainable competitive advantages are few.

2) What is the company’s attitude on reserving?  How often do they report significant additional claims incurred from business written more than a year ago?  Good companies establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves.

So get out the 10K, and look for “Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years.”  That value should be consistently negative.  That is a sign that he management team does not care about maximizing current period profits but is conservative in its reserving practices.

One final note: point 2 does not work with life insurers.  They don’t have to give that disclosure.  My concern with life insurers is different at present because I don’t trust the reserving of secondary guarantees, which are promises made where the liability cannot easily be calculated, and where the regulators are behind the curve.

As such, I am leery of life insurers that write a lot of variable business, among other hard-to-value practices.  Simplicity of product design is a plus to investors.

In all things as investors, aim for a margin of safety.  That is the hallmark of value investing.

My Theory of Asset Pricing

Saturday, February 23rd, 2013

From a reader on last night’s piece:

David, can you expand on this – ” I would revise the concept of the cost of capital to make it credit-centric.  All the efforts to calculate the cost of equity capital from equity market correlations are bogus.  They don’t make any economic sense.  In most cases, the cost of equity should not exceed the yield on an average CCC bond.”

All valuation classes teach the equity market correlation method so it would be interesting to hear your views.

Equity exists in many forms.  In securitizations, equity is the tranche that takes the first loss and controls the deal.  In a mutual insurer/bank/thrift, etc.,  the book equity is held by the dividend-receiving policyholders.  The real equity is held by management, who actually control the place, because the dividend-receiving policyholders will not vote them out.  In a credit tenant lease, there is the guy that owns the property, and typically he puts up a teensy amount of equity, because there is a “credit tenant,” one that has an investment grade rating, and the mortgage is secured by:

  • the property
  • the senior unsecured credit of the “credit tenant,” whose lease payments pay the mortgage, and go directly to the lender, and
  • the equity owner.

In practice, the first two offer real security, and the third is a joke, sort of.  The thing is, if commercial property values inflate, there is a *lot* of leverage the the CTL structure for the owner of the equity.  And, if things go badly, most equity owners own the property though a thinly capitalized subsidiary.  Can’t squeeze blood from a stone.  “Heads, I win. Tails, you lose.”

Then there are more normal examples, like public and private equity.  The ownership is clear, though control varies considerably, considering the stakes that control investors have.

Contingent Claims Theory

Leaving aside options on equity, the equity of an investment is the most volatile investment that funds the assets of an economic entity.  The equity of an entity controls the entity, and possesses a valuable option — the option to abandon it all, and hand the company over to the next most junior investor.

Option valuation can tell us a lot about about the cost of capital.  The put option inherent in any debt can be measured, giving the following observations:

  • The more of the company that is financed with debt, the greater the risk of owning the equity (the default option is near the money), and the higher the cost of equity is.
  • The more volatile the economic results of the company, the higher the probability of bankruptcy, and the higher the cost of equity will be.
  • The underlying volatility of a company’s assets radiates out through it liabilities, with liability volatility increasing as liability claims become more junior.

In essence, thinking like a securitization, where you have many, many levels of debt, and as debt gets more junior, its yield rises as its economic prospects become more volatile.  Equity is not debt, but it is the juniormost claim on the assets and cash flow of the firm, even while it has control, which includes the option to adjust the capital structure.  (Had to add that, because it is important, but not strictly relevant to my argument.)

Holding the equity is holding control, with a complex option to adjust the capital structure, including the possibility of giving up control under bad conditions, or selling out under good conditions.  But now consider options on the equity — those options also imply a cost of equity capital:

  • The more volatile the at-the money option is, the higher the cost of equity.  (And the higher will be bond spreads…)
  • Another way to think about it is how expensive it is to set a floor under and equity investment.  Volatile companies have higher insurance premiums for their stocks.  That implies a higher cost of capital.
  • Using options, we can create pseudo-bonds, where we can lock in a certain range of returns.
  • A capital structure hedge fund can trade corporate debt and CDS [Credit Default Swaps] against equity options — they all price off of the volatility of corporate assets in the short run.
  • For any capital structure, the return on the assets can be modeled over a variety of credit scenarios.  Those returns can translate into returns for the various liability classes — e.g. trade claims, bank debt, senior unsecured debt, junior bonds, preferred stock, equity, and given the current prices for each class, the yields and yield spreads can be calculated, as well as the probability and severity of loss.


Cost of equity is a function of the overall volatility of the value of corporate assets, and the degree of leverage the firm employs.  This is how the cost of equity should be calculated.  Using a method like this, I believe the estimated cost of equity would be lower than what MPT models would produce, and the equity would display significant optionality, having very low returns under stress and very high returns under the best scenarios.

If we calculate the cost of equity like this, it will be an enhancement to DCF, and not require the bogus assumptions of MPT, because:

  • Risk is risk of monetary loss, not correlation to an index
  • Beta is not a stable parameter; correlation coefficients are not stable either.
  • This fits with the way that actuaries would price complex credit insurance policies, if they thought hard enough about it.
  • This fits with contingent claims theory, which legally describes the claim structures for competing classes of liabilities.

This is my theory of asset/liability/equity pricing in broad. Comments are welcomed.

What I Would & Would Not Teach College Students About Finance

Saturday, February 23rd, 2013

Most of Friday I spent as judge at the Global Investment Research Challenge for Washington, DC and Baltimore.  I really like working with students.  They are so earnest, and they work so hard.

Last year, the company was Under Armour, which was tough because it was a growth company.  Very difficult to value.  This year, the company was Marriott, which I think is even harder to value because of its asset-light strategy.   Further, they have bought back so much stock that not only is the company’s tangible book value negative, but the unadjusted book value is negative too.

But for what it is worth, the students this year had similar views about the target company, and the range of target prices was small versus what I saw with Under Armour.

But when I listen to the students, I sometimes cringe, because I’ve studied statistics to a far higher degree.  Now, when I judge, I don’t take my views into account, because I know I am in the minority, and the students don’t know that they are getting bad methods for analysis.  Let them listen to their professors, who don’t have a clue as to how the economy really works, and express what they have learned.

But if I had control over what Finance students were taught, I would do the following:

1) I would reduce the math content for finance students and increase the qualitative understanding of markets.  No more MPT.

2) I would increase the level of understanding on how to relate with people, because that makes a big difference in negotiating trades.

3) I would want them to work in a simple business, like a hot-dog cart, or mowing lawns, so that they could begin to get an idea of how tough it is to earn a profit.  My best boss in my life grew up watching his parents’ delicatessen, and it shaped his view of how to make a profit.  I didn’t have that as a kid, but I did have two parents who pointed out to me that life wasn’t easy.  The profits of my Dad’s business were by no means certain, and evaporated in the early 80s.  My Mom reinvested much of my Dad’s earnings into her stock portfolio, far exceeding what most investors achieve, but with periods that would make you wonder.  I partly paid for some of my college education by encouraging my Mom to buy a company that she previously sold that several years later went private for a handsome price.

4) I would revise the concept of the cost of capital to make it credit-centric.  All the efforts to calculate the cost of equity capital from equity market correlations are bogus.  They don’t make any economic sense.  In most cases, the cost of equity should not exceed the yield on an average CCC bond.

5)  I would tell them that changes in inflation and real GDP don’t have as large of an impact on corporate profits as is commonly thought, both positively and negatively.  I would tell them to focus on the stock, and drop the complex model.  Few in the investment business work off a complex model, and if you need one, you can buy Value Line, which I like, which tries to use a single macroeconomic model for 1700 popular stocks.  (and I get the model for FREE, because my county library subscribes to the WHOLE ENCHILADA, and I can ride on their back.  Morningstar too.)  I’m generous with my insights, but I rarely pay for services, because I know that they can be obtained cheaply, most of the time.


I would teach students to think on a higher level.  Not this causes that, but this influences that, and a lot of other effects occur as a result.  This is similar to Howard Marks’ concept of “second level thinking.”

By the way, I would do the same thing for the SOA and CFA syllabuses.  Modern Portfolio Theory is garbage, and needs to be abandoned.  We understood the markets better prior to MPT,

I would teach students that markets are not neutral, and that there are people out there trying to deceive you.  I’ve had more than my share of charlatans that I have had to oppose.

In place of randomness, and statistics that imply randomness, I would teach about margin of safety, and tell them, “Do your hard work.  Analyze likely profitability.  Analyze free cash flow.  Analyze the likelihood that you are correct; make sure the price at which you are buying includes a significant margin of safety.”

I would tell them to analyze free cash flow.  Today, with the company Marriott, that was the only thing that mattered.  One team hit the nail on the head. The rest did not.  The team that hit the nail on the head is going to Toronto to compete in the North American competition.  Should they win, they go to the final round, I know not where.


Anyway, that is a start.  As with Buffett, who always thinks of what is the best way to earn and compound earnings, it is far better to analyze successful businesses than to analyze what academics think about business.  After all, what, academic has created a successful business?  Few, if any.

Sorted Weekly Tweets

Saturday, February 23rd, 2013



  • Cargill joins Wall Street banks as swap dealer Could b a good idea 4 any firm that does much commodities hedging $$ Feb 22, 2013
  • Office Depot To Buy OfficeMax? And Then There Were Two. 0 + 0 = -1 Combined company faces $AMZN undercutting them $$ Feb 21, 2013
  • U.S. Insurers Resist Push to Make Gun Owners Get Coverage It hasn’t worked that way with cars; this is a good idea $$ Feb 21, 2013
  • $OMX & $ODP merge — market doesn’t like it, combined companies worth less than before the merger rumor emerged $$ Feb 20, 2013
  • Buffett brand has more beans than Heinz The investor has won every advantage in the deal, writes Alice Schroeder $$ Feb 19, 2013
  • Bondholders Dislike Uncertainty in Berkshire-Heinz Deal Bondholders, Buffett *never* assumes acquired debt $$ #patsies Feb 19, 2013
  • Annaly Reversing Slump as Denahan Tries to Dodge Fed $NLY changes its character as Fed crowds them out of RMBS $$ Feb 19, 2013
  • The Pitfalls of Dividend Yield in the Oil Patch The higher the dividend yield the less $$ 2 pour in2 exploration/growth Feb 19, 2013
  • Reader’s Digest Is Bankrupt; Iconic Magazine Falters 2 much debt & competition from internet; private equity failure $$ Feb 18, 2013
  • Danone Stake Poses a Challenge for Heinz Investor Peltz Much harder 2 get changes in France than the US. Won’t work $$ Feb 18, 2013
  • US Airways Wins AMR as Horton Said to Wage Last CEO Push CEO job went 2 visionary who saw a way 2 create value $$ Feb 17, 2013
  • Amazon Sells Out Predator Drone Toy After Mocking Reviews Don’t like it keep quiet; mocking draws more attn & sales $$ Feb 17, 2013
  • What? Carl Icahn Just Thinks Selling Diet Shakes And Herbal Tea Is A Really Good Business nuances of synthetic long $$ Feb 16, 2013
  • McGraw-Hill Credit Rating Cut by Moody’s After U.S. Sues S&P Less 2 this than some say; it’s just business, baby $$ Feb 16, 2013


Rest of the World


  • Waiting for a Crisis Wishful thinking on this side of the Pacific, but China needs to reduce the size of government $$ Feb 20, 2013
  • Cyberwar With China Is Here, Like It or Not Most systems can be compromised from inside by inviting someone 2 err $$ Feb 19, 2013
  • Spanish Debt Grows by Euro146 Billion, Largest Ever Recorded; Debt-to-GDP Highest Since 1910 Spain will leave EZone $$ Feb 19, 2013
  • G20 currency truce shortlived as Japan mulls foreign bond buys Japan decided G20 meeting gave a free pass to devalue $$ Feb 19, 2013
  • China’s New Leader Needs Grip on Wacko Next Door Instead, trade Taiwan for North Korea. Interests become aligned $$ Feb 19, 2013
  • Saxo Bank CEO Says Euro Is Doomed as Currency Woes Resurface CEO: “Right now we’re in one of those fake solutions” $$ Feb 18, 2013
  • Billionaire Miner Fights Rivals to Halt Digs on His Ranch Interesting Aussie mining claims law; u only own top meter $$ Feb 18, 2013
  • Mrs. Watanabe Dumping Australia Debt Signals Turn for Yen JPY Retail FX speculators try to pick a top for the AUD $$ Feb 18, 2013
  • How China’s President Is Earning A Nobel Peace Prize If true, many unlawfully detained in China may be freed $$ Feb 18, 2013
  • Ugliest Danish Banks Find No Buyers in Toxic Asset Trap 2 much leverage in system makes resolutions hard. Who can buy? Feb 18, 2013
  • BlackRock Sounds Covered Bond Collateral Alarm Weaker collateral & larger haircut did not work well 4 securitization $$ Feb 18, 2013
  • CDS Uncertainty Adds to Fear on Europe Bank Bonds Y don’t the protection buyers get paid by sellers? No auction poss $$ Feb 18, 2013
  • Hugo Chávez Returns to Venezuela I wouldn’t get 2 excited; rare that he would fully recover after so many operations $$ Feb 18, 2013
  • Japan flirts with equity targets to drive a stake in the zombie economy Targeting yields& equity prices doesn’t work $$ Feb 18, 2013
  • EU Economy and Horse Meat Scandal: Both Finishing last at the Gate – Germany to follow? EZone Core falters, what2do? $$ Feb 18, 2013
  • Celebrating the end of the eurozone affair ignores the heart of the matter Problems reappear after victory declared $$ Feb 18, 2013
  • Group of 20 chiefs take stand on exchange-rate policies Basically, nothing happened, everyone hopes it goes away $$ Feb 18, 2013
  • Hollande Tiptoes Toward Raid on Pensions With EU Pressure No way to make the budget balance; needs many, too little $$ Feb 17, 2013
  • Walking-Pace Trains Spur $17 Billion India Rail Revamp I don’t believe in the BRIC nations; all have huge problems $$ Feb 16, 2013
  • Auto Keiretsu Wracked by Antitrust Probes Friendly collusion 4 the purpose of quality, or profit? Not allowed in US $$ Feb 16, 2013




  • Cardinal Dolan Preps for Conclave Vote on New Pope “Bring Peanut Butter” & other tips for traveling Cardinals. ;) $$ Feb 21, 2013
  • Sewage Status Grows as Resource for Utilities to Skiers Amazing what we can do2 convert waste to power $$ Feb 21, 2013
  • Gasoline Pump Prices Soaring on Refinery Repairs, Oil Rally Rising crude prices & refinery outages raise gas prices $$ Feb 20, 2013
  • Ironing Out the Wrinkles—The Complexities of Madeleine L’Engle As a kid, I loved ML, opinion has always fallen since $$ Feb 19, 2013
  • Rotten Egg Gas Seen Offering Promise of Extending Life Hydrogen Sulfide – up to a limit we could all use more of it $$ Feb 19, 2013
  • What Doesn’t Kill Us Makes Us Stronger Small problems lead to product & service improvement & more robustness $$ Feb 18, 2013
  • Close Encounter by Asteroids Makes Case for Scrutiny We humans always fight the last war; remember the avian flu? $$ Feb 16, 2013


Credit Conditions


  • Junk Bond Froth Seeps into Emerging Markets I prefer emerging market gov’ts to corporate junk, they are run better $$ Feb 20, 2013
  • Bubbles and fraud: A smoking gun? Easy profits always brings out the worst in people; no wonder fraud increases then $$ Feb 20, 2013
  • The Indianapolis 500 of Corporate Bonds Yields The trend chaser are blowing out of credit; avoid 4 now, b cautious $$ Feb 19, 2013
  • Finra bond warning a real worrier Dog bites man. Many have predicted long rates would rise & they haven’t (so far) $$ Feb 18, 2013
  • Debt Bubble Born of Easy Cash Prompts Swedish Rule Review $$ policy should not be used 2 stimulate; 2 much debt kills Feb 18, 2013
  • Super-prime’s invisible driver Would u rather hold govt bonds or prime property? Which will lose less? @izakaminska $$ Feb 18, 2013


US Politics


  • Obama’s Deficit Commission Leaders Offer New Debt Plan 50% cuts, 25% adjustments 2 Medicare, 25% close tax loopholes $$ Feb 19, 2013
  • How to Fix Too Big to Fail Without Taxpayer Bailouts: Rep. Campbell’s Plan Plan is reasonable; receivership4BK banks $$ Feb 19, 2013
  • Pentagon Budget Stuck in Last Century as Warfare Changes More smaller weapons, lower tech, fewer ppl, more skill&mobile Feb 19, 2013
  • All-the-Right-Skills Immigrants Ride US Hiring Wave: Economy Note many in US have those skills & get screened out $$ Feb 19, 2013
  • Obama Golf With Woods in Florida Risks Muddling Message Give Obama a break; he deserves a little fun too $$ Feb 19, 2013
  • Fiscal trouble ahead for most future retirees I predicted 20 yrs ago: Many Baby Boomers won’t b able 2 retire $$ Feb 18, 2013


Market Impact


  • Paulson Leads Funds to Bermuda Tax Dodge Aiding Billionaires After all that Paulson lost $$ rendering no tax savings Feb 19, 2013
  • Performance Tops Pedigree in Money Managers’ Fortunes Story of two $$ mgrs & how performance drove their stock prices. Feb 17, 2013
  • Upside: Why Most Value Investors Will Burn Out You have to be willing to look like an idiot & be patient 2b rewarded $$ Feb 16, 2013
  • Confidence on Upswing, Mergers Make Comeback 2 early 2 say. Profit margins r2 high & interest rates 2 low; unstable $$ Feb 16, 2013


  • Wrong: Let’s Downgrade S&P, Moody’s Ratings Oligopoly Writer does not understand the needs of regulators or bond buyers Feb 19, 2013
  • Wrong: Swelling US Labor Force Keeps Fed at Ease Every statistic I c on labor force participation says otherwise $$ Feb 19, 2013


Replies & Retweets

  • @TheStalwart Hey Joseph, thou hardest working guy on Wall Street, Congrats on your promotion at BI — it is well-deserved Feb 21, 2013
  • If I were long $HNZ now, I would sell; likely there is no better deal coming along, & upside is only 0.5% $$ Feb 20, 2013
  • “Johnson will report to 3G; they have all of the incentives to cut costs and recognize synergies…” — David_Merkel $$ Feb 19, 2013
  • SEC EDGAR seems to be down, at least the search function isn’t working… Feb 19, 2013
  • @TheStalwart pick a medium-nice suburb of Rome. I grew up in the county of Waukesha, WI, FWIW. Feb 19, 2013
  • “These aren’t bargains; buying them @ these prices assumes they grow rapidly for the next 5 years.” — David_Merkel $$ Feb 19, 2013
  • ‘ @groditi Yes, reviewing it tonight. Agree about conviction; book’s only drawback is that if you get his emails, not much new $$ Feb 19, 2013
  • “When I analyze mutual funds, I look at active share and process — are they doing it right? Do…” — David_Merkel $$ Feb 19, 2013
  • Illegal, you used “US postal service” & “innovate” in the same sentence $$ RT @ReformedBroker: CAN THE US POSTAL SERVICE STILL INNOVATE? Feb 18, 2013




  • My week on twitter: 34 retweets received, 3 new listings, 49 new followers, 39 mentions. Via: Feb 21, 2013


Book Review: The Great Rebalancing

Friday, February 22nd, 2013

great rebalancing

I’ve been waiting for this book for over 10 years.  When Michael Pettis wrote The Volatility Machine, he explained how emerging market countries imported the monetary policies of the developed countries.

Now, in the present mess of economic policies put forth by most governments in our world, he explains how the debt and trade imbalances will eventually have to balance.

We’ve had other economic eras where trade did not balance.  In the era of mercantilism, trade did not balance, because  the mercantilistic countries sought gold, and adopted policies that favored exports, so that their nation would receive gold.  Smart, huh?

Well,  no.  Gold is good; I like it, and it preserves value better than anything else, but when you take actions to disproportionately get gold, you overpay for it.  Then when you realize your error, and start to sell gold for goods, the market knows that you are selling, and the value of gold falls.

That is why countries that force growth tend to lose.  Because they force growth through overinvestment, they look like stars for a time, but eventually the declining marginal productivity of capital catches up with them, as it did with Japan in the late ’80s or early ’90s, and the Soviet Union in the 1970s.

Governments are no good at directing growth.  We knew in the late ’70s that import substitution did not work.   It took 20-30 years more to realize that export promotion does not work long-term.  Happily, my old professor Bela Belassa never lived to see his theories repudiated.  (He was a cold guy, but not totally; he had mercy on me once, and for that I am grateful.)

Back to Pettis: his main argument is that the surplus countries must take losses over loans to deficit countries.  The loans were made in bullish times, and from any reasonable standpoint, they were bad loans.  Therefore the lenders should compromise with the borrowers, and both sides take losses.

This applies to China versus America.  China will not get repaid in the same purchasing power as they lent.  If China wants to thrive, it will need to take steps it has been unwilling to take politically, and free much more of the economy from government and Party control.  Only that can boost domestic consumption as a fraction of GDP.

This applies to Germany versus the rest of the Eurozone.  They won’t get paid back in the same terms; either there will be discounts in Euro terms, or some nations will leave the Eurozone.  The alternative is Federal Europe, where losses are shared across the nation, much as California subsidizes Maryland.

One way or another, just as the mercantilists lost, so will the surplus nations lose today.  It’s just a question of when and how.


I can’t get into  SDRs [Strategic Drawing Rights] of the IMF as a currency.  Currencies either need gold or taxation authority behind them.  Further, taxation authority requires police power to enforce taxation, which is not the case.  SDRs are a cute idea that some academics fall for, but are not a real world solution.

For those who read his e-mails regularly, 25% of the book will be “old hat.”

Who would benefit from this book: Anyone who wants to understand international economics better will benefit from this book.  I cannot recommend it more highly.  If you want to, you can buy it here: The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy.

Full disclosure: I received a free copy from the publisher.  Though I have never met him, I have conversed with the author via e-mail.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Heinz Follow-up

Thursday, February 21st, 2013

I’ll keep trying until I get it right.  Aside from the terms of the warrants, most of the deal terms are known in terms of quantities, if not prices.  What I present benefits considerably from a comment I received.  Here it is:

Good analysis, though I think we know a bit more about how the debt portion will work than you imply. It appears to be very standard LBO mechanics: The sponsors (BRK and 3G) set up an acquisition vehicle, which drops down a shell subsidiary (Merger Sub), which, at closing, merges with Heinz, leaving Heinz behind as the surviving entity. This allows BRK and 3G to own and control the acquisition vehicle (referred to in the Merger Agreement as “Parent”), which will be a passive holding company, and Heinz will be below it.

The new debt raised by WFC and JPM will be primarily at this holding company level, though presumably the bank loans and revolving loan will be fully secured by Heinz’s subsidiaries and their assets, while new high-yield notes would be unsecured. From the 8-K with the Merger Agreement:

“J.P. Morgan and Wells Fargo have committed to provide $14.1 billion of new debt financing for the transaction, consisting of $8.5 billion of USD senior secured term loan B-1 and B-2 facilities, $2.0 billion of Euro/ British Pounds senior secured term loan B-1 and B-2 facilities, a $1.5 billion senior secured revolving facility and a $2.1 billion second lien bridge loan facility. The obligation of J.P. Morgan and Wells Fargo to provide this debt financing is subject to a number of customary conditions, including, without limitation, execution and delivery of certain definitive documentation. The final termination date for the debt commitment is November 13, 2013. Additionally, Parent also intends to roll over certain of the Company’s current outstanding indebtedness that is not subject to acceleration upon a change of control and that either does not contain change of control repurchase obligations or where the holders do not elect to have such indebtedness repurchased in a change of control offer. ”

Note that the reference to a bridge loan is common in these deals, but my expectation — consistent with past practice — is that while there is a committed bridge there is no actual intention to fund a bridge loan to the acquisition vehicle (Parent), and instead the idea is to market high-yield notes. But the committed bridge is there so BRK and 3G can close the acquisition, as in this agreement, consistent with market practice, there is no condition that the financing from the banks actually be in hand (a “financing out”), and, according to the disclosure, the banks’ conditions have been tied to the acquisition conditions — there won’t (or shouldn’t be) be situations where they can refuse to fund but 3G and BRK are still obligated to close. You can see Section 7.13 of the Merger Agreement to see some of the obligations of Heinz to prepare financials and market the debt (very common in LBO deals). So I think we can fairly safely say that the new debt belongs to Heinz, not 3G and BRK. There won’t be any support from the investors.

Note also that the above is why I am unsure about your calculations above about the “new debt” are slightly off — though I could be wrong and I welcome any correction. At least some portion of the new debt will be used to simply refinance the old debt (see Section 7.13(b)(ix) of the Merger Agreement, which requires Heinz to obtain payoff letters of its existing bank debt), though some Heinz debt will roll. But this would still mean that new debt would be more in line with $14bn, not $7bn.

That said, maybe the best way to think of this would be a pro forma cap table for the acquired company, showing what the total debt of the acquired Heinz would be.

In that case I still think you come out with an even more leveraged picture than you have above, though I think all of your points about BRK’s upside remain. And it also highlights to me another benefit BRK got from this, which was 3G’s expertise in packaging and structuring this deal, which is designed as essentially a regular way LBO. The only unique aspect is the 50/50 common equity ownership of the acquired entity (though PE shops do “club” sometimes) and BRK’s “mezzanine” financing of preferred and warrants, though I’ve seen sponsors do “sponsor loans” to fund acquisitions when they have extra cash and charge even more than 9%.

Final note on the warrants: It’s not clear that Berkshire would get control of the new entity even if they exercise the warrants. Buffett on CNBC repeated that 3G would have “day-to-day control,” despite the 50/50 equity ownership. This tells me that 3G has been given operational control regardless of the equity stake in the joint venture/LLC Agreement, and we simply don’t know if the exercise of warrants even given Berkshire greater than 50% equity ownership would change that. It might, but it might not. It’s very common in real estate deals for one party to put up 70-90% of the equity but cede day-to-day control to a minority partner, who, after satisfaction of a hurdle rate, takes a big commission or even splits the economics 50/50 for “finding and executing” a deal. Buffett undoubtedly has lots of experience in these kinds of structures and this one is tailored to this particular situation.

Hopefully these are helpful comments. I am a big fan of your blog.

PS — One correction to [what I said above]. I mistakenly said the bonds would likely be unsecured; given that the committed bridge loan is going to be second-lien secured, I’d expect the bonds to be second-lien secured bonds as well. This actually further supports the notion that this is a very leveraged transaction — the bond market is “hot” right now, so the idea that this deal needs secured bonds implies that the guys on JPM’s and WFC’s high yield desk already view this as a very leveraged deal.

I’m not sure how I could have missed that one filing at the SEC that listed the deal terms for debt.  As it is, I decided to sit down and calculate out what the balance sheet of Heinz might look like post-deal.  Here’s what it looks like as of the last 10Q:

Amount ($B)

Amount ($B)



ST Debt and LT Debt <1 yr


Other Current Assets


Other Current Liabilities


Long-term Debt


Total property, plant and equipment, net


Other non-current liabilities


 Intangibles & other noncurrent assets


Total Liabilities


Common Equity (mostly)


Total Assets


Total Liabilities & Common Equity



That leaves a tangible net worth of negative $2.63B.  Given that they are paying $23.4B or so for Heinz, that means Intangibles & other noncurrent assets will be $26.1B.  Now here’s what the balance sheet would look like if none of the existing debt is refinanced:

 Amount ($B)

 Amount ($B)



 ST Debt and LT Debt <1 yr


 Other Current Assets


 Other Current Liabilities


Senior Secured Bank Loans


Senior Secured Revolver


Second-lien bank bridge loan


 Long-term Debt (mostly usec’d)


 Other non-current liabilities


 Total property, plant and equipment, net


 Total Liabilities


 Intangibles & other noncurrent assets


Preferred stock


 Common Equity


 Total Assets


 Total Liabilities & Common Equity



And here is what it looks like if the debt is refinanced in entire:

 Amount ($B)

 Amount ($B)



 ST Debt and LT Debt <1 yr

 Other Current Assets


 Other Current Liabilities


Senior Secured Bank Loans


Senior Secured Revolver


Second-lien bank bridge loan


 Long-term Debt (mostly usec’d)

 Other non-current liabilities


 Total property, plant and equipment, net


 Total Liabilities


 Intangibles & other noncurrent assets


Preferred stock


 Common Equity


 Total Assets


 Total Liabilities & Common Equity



In this latter scenario, I wonder what assets back the pledge for securing the bank debt.  There are not enough tangible assets to do so.  That said, I know that the real value of Heinz resides in its brands, not its tangible assets.

After the deal completes, Heinz will not produce a lot of profits for the common stockholders, because Buffett’s preferred stock and the additional debt will eat up most of the gross profits.  3G will have an incentive to increase the gross profits as a result, or else their $4B investment will not be worth much.

This is an aggressive deal.  Much as I think Buffett got the better deal vs 3G, it is by no means certain that increasing profits at Heinz will be easy.  10 years out, this will be a case study for many business schools.

Another Note on the Purchase of Heinz

Wednesday, February 20th, 2013

I need to correct one thing that I wrote yesterday: 3G and Berkshire Hathaway each own 50% of Heinz, once the transaction is done.  I mistakenly thought that both sides were putting up equal amounts of capital, when they are only putting up equal amounts of common equity.

So when you look at the financing of the $23 billion purchase price for Heinz it should look like this:

Common Equity 3G$4.0B
Common Equity BRK$4.0B
Warrants BRK$0.1B
Preferred Stock BRK$8.0B
New debt for HNZ (to be raised by JPM and WFC)$7.1B
Total Consideration$23.2B

The equity interest of BRK is equal to that of 3G, and if things go well with Heinz, whatever the form of the warrants are, Buffett can add to his equity interest by paying a fixed price.  We don’t know the terms of the warrants — how much stock it covers, what is the strike price, how long does it last, and any other provisions.  What we do know is that though Berkshire claims to be the passive investor here, it possesses the right to become the dominant investor economically, even if it does not take control as a result.  This is a major reason to reject the thesis that BRK is 3G’s banker.  Far better to say that 3G is Buffett’s highly paid servant.  They will do the dirty work, the grunt work, and Buffett will benefit more under most scenarios.

Also, Wells Fargo & JP Morgan will be raising the debt portion of this offering.  I see it looking something like this: an entity allied with Berkshire and 3G floats bonds and raises cash.  The cash goes to shareholders, along with the cash from BRK and 3G, paying off HNZ shareholders at $72.50/share.  The debt attaches to Heinz and not BRK or 3G.  Another way would be a bridge loan prior to the merger that gets paid off by a debt offering and special dividend after the merger.

This of course makes the bond market jumpy.  The long debt of Heinz has sold off, whereas the shorter debt has not.  Here is an example of one that is in-between.  The bond market fears a lot of long-dated issuance, and a possible downgrade to junk.  $7 Billion of new debt is a lot, when you only have $5 Billion of debt, and another $8 Billion of preferred stock coming.  That is a quadrupling of common stock leverage.

What we don’t know:

  • The exact mechanics of how the debt portion of the deal gets done.
  • The terms of the warrants.

Now think for a moment about this from the perspective of 3G: Heinz has $1B of net income.  Buffett gets $720 million of preferred stock dividends. New debt might absorb $200 million in interest after tax.  That leaves around $80 million of profits, half of which go to Berkshire, for your $4 billion outlay, a 1%/yr return.  But consider if active management raises income to $2B, profits become $1,080 million half of which go to Berkshire, and returns to you are 13.5%/yr, leaving aside dilution from BRK option exercise.

What I am trying to show is that the tables are skewed here in favor of Buffett, again.  He has set up a deal where his partner will be very motivated to cut costs, realize synergies, etc., because they don’t make much if they don’t, while he makes out fairly well under most scenarios:

  • Heinz does very well — BRK exercises warrants gets majority of economics and control
  • Heinz muddles — BRK receives preferred dividend, does well.
  • Heinz does badly — BRK receives preferred dividend, does well. Might have to write down equity stake.
  • Heinz does very badly — BRK preferred dividend halted, buys remainder of Heinz by converting his preferred stock to equity.  3G loses it all.  Buffett brings in competent management for his now wholly-owned subsidiary.

It’s a lot easier for Buffett to win relative to 3G.  3G needs strong demand to win.  Buffett doesn’t.

Final note: I am not that impressed with William Johnson, the present CEO — earning  a <4%/yr return on your stock over 15 years does not even double capital for those who were willing to hang on so long.

Yes, sales have grown, but what matters to corporations if profit, not volume.  On thing thing I learned in the insurance industry — it’s easy to get sales. What is hard is getting profitable sales.  Yet how many CEOs gain bonuses partially off of sales and other meaningless criteria — far better to use something like five-year increase in fully converted tangible book value per share.  It better measures how value has  grown for shareholders.

Other things to read:

Full disclosure: long BRK/B and WFC


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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