13 February 2013 – The Aleph Blog

Reply to a Reader

Posted on 13 February 2013 by David Merkel

From a Reader:

I really enjoy your blog. ?I have two questions for you. ?First, given your experience, how do you factor the price an asset into your risk assessment of an asset and the sizing of that position in a portfolio? ?I have recently re-read Howard Marks book The Most Important Thing Illuminated. ?It is probably the investment book I have re-read more times than any other except The Intelligent Investor. ?His approach to risk is the best I have read. ?Early in my investment career, I lost most of my money buying what appeared to be cheap stocks that were overlevered. ?So now I make sure the company is not a disintegrating entity (like the directory companies) and have reasonable amount of debt. ?I have used the benchmarks in How to Make Money with Junk Bonds by Levine. ?It one of the best books I have read about junk bonds with narratives like Graham’s old Security Analysis. ?As a result I have tried to size my positions based relative undervaluedness. ?I have played around with Kelly Formula to estimate relative size of positions but in the end have used a more qualitative approach. ?Currently, I have large positions (which will become smaller over time) in some radio and TV firms. I was looking at insurance and some financials as the next area to re-balance and you had mentioned AIZ in your blog and it looks good based upon by insurance valuation metric of (growth in BB & dividends/price-to-book ratio) – yielding almost 20%. ?The only other insurers even close is Fairfax Financial and EGI (a small Canadian auto insurer). ?You had mentioned and I agree with insurance you need to get to know the management. Do you the management of AIZ? ?There governance and incentives appear to be set up correctly. ?Given your insurance background, what is your take on some the life insurers such as Lincoln National (trading at a discount to book) and some of the other hybrids (like HIG and AIG)?

?The other question has to do with faith. ?How do you see your faith playing a role in your investments, vocation and family and the balance thereof? ?I too am an Evangelical Christian and find it challenging with a job (I am a partner in a business valuation firm), family (2 great kids and a beautiful wife) and a passion for investment analysis. ?

?You may want to check out The Corner of Berkshire and Fairfax if you have not already. ?If so inclined you may also want to go to Toronto in May for the Fairfax annual meeting, it the best gathering of value investors I have found by far.

I don’t do much with position sizing.? Every asset has the same target weight in my portfolio, aside from double-weights, for stocks of which I have certainty. I only have two double-weights: Reinsurance Group of America, and National Western Life Insurance.

Until I find that my trading is hindered by size of the float, I will try to maintain relatively equal allocations.

Assurant is a very well run firm, and the negatives around reducing premiums on force-placed homeowners insurance are overdone.? If it sells off significantly, it will become another of my double-weights.

Regarding your early problems with value investing, you have to remember that the core of value investing is not cheapness, it is margin of safety.? We make money by not losing it, and having positive surprises on our neglected companies.

As for HIG & AIG, I don’t find them attractive because they have had cultures of under-reserving.? Even with all they have gone through, I am reluctant to buy them amid cheapness and low operating ROEs.

Life insurers like LNC, which have written a lot of variable products business, are unattractive because the accounting does not reflect the real economics, and the guarantees they have written are under-reserved.

As for how my faith (in Christ) influences my investing, there is the usual — I don’t invest in any businesses that I could not ethically run as a sole owner.? Thus I avoid healthcare, entertainment, legal loansharking, and any company that is widely known to cheat people.

As for my time management, it has always been family first, work second, Church third, and other things behind that.? There is no other good way.

Beyond that, my blog is replete with analyses that tell people to avoid scams, and embrace opportunities when they are available.? Avoid complexity and invest in vanilla investments.? You will do best that way.

Full disclosure: long RGA NWLI AIZ

The Education of a Mortgage Bond Manager, Part IX

Posted on 13 February 2013 by David Merkel

The Negative Convexity Project

Me: We can’t buy the majority of Residential Mortgage Backed Securities [RMBS] anymore.

Boss: What! That is a staple asset class of ours.? There’s nothing illegal about life companies owning RMBS.

Me: nothing illegal, yes, but because of new cash flow testing rules which our client is subject to, the negative convexity of RMBS will force our client to put up more risk-based capital than they would otherwise have to.? Most RMBS will require so much additional capital that the additional yield is uneconomic, and that assumes we get the yield when we want it, ignoring prepayment and extension risks.

Boss: I can’t believe that we can’t buy any RMBS… are there any exceptions?

Me: There are a few.? You know about the odd RMBS classes that have positive convexity, but little yield?

Boss: Yes, Yes… but why would we want to buy that?? Our client needs yield!

Me: I know that.? Would that they could do something other than need yield to sell yield.? There is one type of RMBS that still fits, and it is the NAS bond [Non-accelerating security], last cash flow structure.? Also, some of the credit-sensitive RMBS bonds rated less than AAA don’t affect the convexity issue, but we might not want to buy them, because the additional yield per unit risk is not compelling.

Boss: So what do we do?

Me: Buy NAS bonds when they are attractive, and buy CMBS that is attractive, after that look to corporates that our analysts like.

Boss: You are right, but I hate to lose a staple asset class.

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What I wrote there took longer than a single conversation, and involved contact with the client as well.? The client was very conservative with capital, because they levered up more than most life insurers.? The results of detailed cash flow testing would affect large annuity writers like my client, and negative convexity would make them put up more capital, constraining the amount of business they could write.

Wait: negative convexity simply means your bond portfolio hates interest rate volatility — it does better when things are calm.? That is certainly true with residential mortgages, where people refinance easily when rates fall, and in that era, no one faced falling property prices.

It took some effort, but I made my case to the client and my boss, and we stopped buying most RMBS.? As an aside, it made asset-liability management tighter.

Alternative Investments

I was not totally hidebound with respect to derivatives.? I bought our first asset-swapped convertibles, and synthetic corporates.? If the risks associated with getting additional yield were small, I would take those risks.? In both cases, they converted other asset into straight corporate debt (plus counterparty risk).

But I wouldn’t do anything.? I grew to hate CDOs, as I saw how perverse the structure was. I remember one weird CMBS deal structure that added a note that combined the AAA, BBB & BB CMBS of the deal.? What a nice yield, but the riskiness was greater than my models would allow for the incremental yield.

Finally, for this piece, the “piece of work” broker that I have previously described pitched me a private placement debt deal for a power producer affiliated with his firm.? After hearing the initial spiel, I said, “Okay, soft-circle me for $25 million, subject to due diligence; send me all of the hard data via email and paper.”

My request should not have obligated me to buy the deal.? Indeed, when I got the hard data, and began estimating the counterparty risks, I thought the deal was a loser, so I contacted the “piece of work,” and said, “Sorry, but we are dropping out of the deal — it just doesn’t offer enough value for the yield.”? After some arguing, he eventually said, “Look, stay in the deal, and I promise you that I will get you out at par at minimum on deal day.? Okay?”

Sigh, even though he was number eight with us, he served an important firm that could potentially do a lot for us, so I agreed.? The day of the deal came, and indeed, he got us out at a teensy premium (I would have accepted par, maybe even a slight scrape).? The deal did horribly, at least initially, though I have no idea of what the eventual credit result was.

As my boss who taught me bonds would say, “On Wall Street, if you want a friend, get a dog.”? There are some honorable people on Wall Street, but the economics of Wall Street often leads to suboptimal results for clients, and indeed, the salesmen may be sweet enough, but they live to distribute paper; they don’t live to be your friend in any true sense.? Professional duty to company trumps friendship.