9 February 2013 – The Aleph Blog

Letters from Two Readers

Posted on 9 February 2013 by David Merkel

I wanted to drop you a line to commend you on your blog which I read with interest and almost universal agreement.

Your investment ideology and style is very similar to my own, and I enjoy the snippets of personal insight and glimpses of your life that you share.

I have worked in investment management for a number of life and general insurers in the UK and with a number of actuaries, some of these have been extremely able and had an outlook very similar to that which you hold. The more risk averse, countercyclical heads have tended to perform very strongly when given the time for their ideas to mature.

It is far easier to identify a good idea than to know when the market will come into line with your thinking!

Performance can be poor whilst you wait for the market to adjust, so you need have established your investment credentials beforehand. I have also seen a company destroyed by the unwillingness of a board to wait for investment performance switching managers and strategy at the peak of the TMT bubble, which ended up putting one of the strongest life funds into run-off.

Thanks for the words of encouragement.? It?s always challenging to strike the balance between earning returns and avoiding undue risk, much less having any sense of timing the risk cycle.? With bonds, it is a little easier, because you can tell when debt covenants, etc., and other terms of lending weaken.? We can see when incremental yield is most likely not going to be compensate for the risks involved.

The same applies to insurance ? stylistically, first pricing declines to technical levels, then terms and conditions deteriorate, then pricing declines further, until there is a disaster, capital reduces and pricing strengthens.

Thanks for writing.

I really appreciate the way you do twitter and blog. ?You always include your thoughts to some degree in your tweets, which I appreciate; and your blogging is great! ?I often read to hear about what your thinking and you do a good job of translating a lot of technical or specific information into applicable or at least thoughtful steps I can take.

I’m probably most amazed by your ability to find “truth” through mathematics due to your skills as an actuary. ?As a younger man in this business I’ve been from awed to disillusioned from the market and I still struggle to have a grasp. ?We use mutual funds predominantly so I don’t have to worry about knowing so much about the market and the individual goings-on but I still do a lot of asset allocation. ?Frankly, I think there is more risk in a poor asset allocation than a poor asset selection within that allocation.

Right now I’m thinking that high yield spreads are too tight and credit too frothy, but I read Third Avenue on high yield and they argue that we have a few years before that’s a problem. ?I guess what I’m asking for is advice on how to find the truth of where we are in the market cycle and how to take smart risks with my clients’ money. ?Should I be reducing or eliminating HY debt because of the “seemingly clear” overheated risk? ?If so, where do I find a decent return in fixed income or do I bite the bullet and stay short with little/no yield.

Especially for the more conservative investors who really need every penny to work out – it’s a hard balance to find right now. ?I don’t think I’m alone. ?Nevertheless, sorry for the long email. I hope to see something on your blog or a response if you find a minute of what must be a very busy life.

Yes, high yield is frothy, but it could get frothier.? Cramer had a saying, ?Absurd is like infinity.? Twice absurd is still absurd; twice infinity is still infinity.?? I read through the Third Avenue report? I generally like the way they do things though Marty Whitman got whacked in the financial crisis for owning too many low quality financials.

I learned early on from a junk bond manager who currently has five stars from Morningstar, that spreads are less critical to junk bond than dollar prices.? His view is that there is some irreducible risk in high yield, such that you need yield, not just spread, to guide your decisions.? Particularly when junk bond prices get so high that they are likely? to be called.? With such a steep yield curve for Treasuries, it is possible for option-adjusted spreads to rise as the bond price rises.

I can?t tell you what to do.? I can tell you what I am doing.? For my bond clients, I have assets? allocated half to emerging markets, both local currency and dollar denominated.? The governments of most emerging markets are run in a more orthodox manner than most of the developed markets, so I am comfortable with the risks.?? The rest is invested in short and longer investment grade corporate, and a small wager on the Swiss Franc appreciating.

I am happier getting yield from emerging markets than getting it from weak corporate credits. ?There are risks in the world today, and we could see high yield strategies fail.? After all, no one thinks about a moderate-sized war changing risk preferences.

That?s what I am doing.

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To all my readers, risk is sometimes not obvious.? In this time of abnormal monetary policy and large budget deficits, it pays to be careful.

The Education of a Mortgage Bond Manager, Part VI

Posted on 9 February 2013 by David Merkel

1) One thing that impressed me about working in a life insurance investment department is how many ideas we kicked around and abandoned.? I did not experience that to the same degree working at a hedge fund.? I think that is true for two reasons: 1) we have a significant balance sheet, and can take on illiquidity. 2) we are conservative, and aren’t going to take on marginal risks.

2) Another thing that impressed me was how well the money was managed, and how poorly the liability writers thought it was managed.? I did a big study to analyze what we had earned for F&G Life over the prior seven years.? We beat single-A bond yields by more than 0.7%/year.? That’s huge.? That said, they kept asking for more.? I shake my head and wish that we were running a mutual fund; we would have gotten a lot of respect.

3) When I came, the client held no CMBS, after three years 25% of the assets were CMBS.? It made so much sense given the 10-year duration of the EIAs that were growing so rapidly.? Given my models, and the lack of yield from corporates, this was a big improvement.

CMBS, because it is noncallable, makes a lot more sense for longer-dated liabilities.? Hey, I was not only the mortgage bond manager, I was the interest rate risk manager.? I would not knowingly take bad risks.

4) When the merger happened, the boss decided to jump to another firm.? Unintentionally, I may have encouraged that, because when he asked me, ‘What would I do in this new organization?”? I said, “Let me draw it out for you,” showing that he would be CIO of insurance asset management.? He was crestfallen, and sought other avenues of employment.? When he announced his new job, there was a big change.

First, the St. Paul talked with me and the High Yield manager, and gave me authority to manage things, so long as the high yield manager agreed.? Basically, they trusted me, but knew I was inexperienced, so they wanted the high yield manager, who was far more experienced than me, to guide me.? There was an economic incentive here: the better we did, the less cash the St. Paul had to transfer to Old Mutual at the closing.

But after that, the analysts came to me and said “you be our leader.”? The high yield manager agreed.? When I asked why, they said, “We trust you. You have always had a better call on credit than the prior boss, and you understand our client better than anyone else!”

That led to something hard.? I called a meeting of the analysts and managers, but told the old boss, who was still with us, that he was not invited.? I almost cried.? He was our leader for so long, and a good one, but I had to take control.

Once I did so, I asked the analysts for reports on all companies where the stock price had fallen by more than 50% since bond purchase.? We began selling those bonds where it made sense.? Those sells were almost always good sells, and I wish I had not been countermanded by my new bosses on Enron (the greatest company in the world.)

I have more to say but that will have to wait for the next part.

How do Promoted Stock Scams Work?

Posted on 9 February 2013 by David Merkel

From a reader:

I’ve been following your blog for a little while and appreciate your analysis. I’ve been particularly interested in your coverage on the penny stock phenomenon and started doing some of my own digging. I’ve found a few “companies” that seem to share characteristics with the ones you have highlighted. Digging into the 10-Qs reveals all sorts of red flags around related party transactions, health of balance sheet, past history of management, etc. The question I’ve been trying to answer is how these companies continue to exist? In the cases I list below their sole purpose appears to be to move cash from unwitting investors to the management of the company.?

Would be interested in your perspective.

Wanted to respond to you earlier, but time did not permit.? But thinking about it, I realized that for penny stocks, the most relevant statement to analyze is the Consolidated Statement of Changes in Stockholders’ Equity/Deficit.? You can see what prices they issued stock at.? Proceeds divided by shares gives you the internal valuation of where the company is willing to offer shares.? Few ask, but all should ask, “If the company is willing to issue stock at 30 cents per share for salaries, services, etc., why does the stock trade for $1 per share?”

Sometimes a merger, or a purchase of a business can inject money into a company; sometimes debts are settled for shares. That can temporarily grow the company, and combined with a reverse split, it can give it a share price and a market capitalization that seems respectable.

Number two is the hidden bidding up of the shares through sham transactions where related parties buy & sell at progressively higher prices (netting to no loss, aside from commissions) until some speculators see the microcap stock and start driving it higher, possibly supported by promotional paid research.

But here’s the hard part for me: Sometimes the companies are involved, sometimes not.? Sometimes I can tell how the promoters make money, sometimes I can’t.

This is what I suspect: Promoters have several shell corporations for promotion and trading.? Let’s say one has 4 shells.? When A promotes a stock, B, C, and D trade.? When B promotes a stock, A, C, and D trade.? When C promotes a stock, B, A, and D trade.? When D promotes a stock, B, C, and A trade.?? Then each promoter can say they have no economic interest in the stock mentioned that they are “advertising.”

This is an ugly space.? Supposedly you can get a borrow on these bits of financial trash (in order to short them) through Interactive Brokers.