Maybe I should call this article “the product that saw the light of day, after a long sleep.”  Barron’s had an article last week, “Top 50 Annuities.”  Guess what? Almost all of the annuities they featured were stripped down and low cost.  That’s the way things should be.  If you have time and interest, read the article; it’s a good thing.  Also note at the end the skepticism of investment managers, particularly hedge funds running insurers.  The skepticism is deserved.

That’s all.  A rare short piece.

You might recall my letter to Warren Buffett, and his response to me.  A number of my readers made some very nice offers to help me on this project.  Many thanks to you all, but I found a way to shrink the size of the project.  Look at this table:

 

NAIC #

Assets

Liabs

Surplus

NameGroupNotes

Pct

38865

443

199

244

CALIFORNIA INSURANCE COMPANYAU

0.2%

28258

92

49

43

CONTINENTAL NATIONAL INDEMNITY COAU

0.0%

14144

347

322

25

APPLIED UNDERWRITERS CAPTIVE RISK ASSURANCE COMPANY, INC.AU(2)

0.0%

35246

23

8

15

Illinois Insurance CompanyAU

0.0%

21962

11

11

Pennsylvania Insurance CompanyAU

0.0%

20044

1,083

346

737

BERKSHIRE HATHAWAY HOMESTATE INSURANCE COMPANYBHH

0.6%

11673

762

336

426

REDWOOD FIRE & CASUALTY INSURANCE COBHH

0.3%

10855

1,065

858

207

CYPRESS INSURANCE COMPANYBHH

0.2%

34630

459

321

138

OAK RIVER INSURANCE COMPANYBHH

0.1%

11014

11

4

7

BROOKWOOD INS COBHH

0.0%

35939

9

2

7

CONTINENTAL DIVIDE INSURANCE COBHH

0.0%

34274

335

50

285

CENTRAL STATES INDEMNITY CO OF OMAHACSI

0.2%

82880

18

4

14

CSI LIFE INSURANCE COMPANYCSI

0.0%

22063

19,090

11,072

8,018

GOVERNMENT EMPLOYEES INSURANCE COGEICO

6.3%

22055

6,444

3,695

2,749

GEICO INDEMNITY COMPANYGEICO

2.1%

41491

1,713

1,051

662

GEICO CASUALTY COMPANYGEICO

0.5%

14137

239

19

220

GEICO SECURE INSURANCE COMPANYGEICO

0.2%

14139

249

36

213

GEICO CHOICE INSURANCE COMPANYGEICO

0.2%

14138

249

41

208

GEICO ADVANTAGE INSURANCE COMPANYGEICO

0.2%

35882

184

70

114

GEICO GENERAL INS COGEICO

0.1%

22039

15,533

4,840

10,693

GENERAL REINSURANCE CORPGenRe

8.4%

27812

15,069

4,637

10,432

COLUMBIA INSURANCE COMPANYGenRe

8.2%

86258

3,101

2,513

588

GENERAL REINSURANCE LIFE CORPORATIONGenRe

0.5%

37362

748

182

566

GENERAL STAR INDEMNITY COGenRe

0.4%

11967

251

69

182

GENERAL STAR NATIONAL INS COGenRe

0.1%

38962

190

55

135

GENESIS INSURANCE COMPANYGenRe

0.1%

12319

176

76

100

PHILADELPHIA REINSURANCE CORPGenRe

0.1%

32280

130

61

69

Commercial Casualty Insurance CompanyGenRe

0.1%

20931

48

26

22

Atlanta InternationalGenReRunoff

0.0%

97764

20

5

15

IDEALIFE INSURANCE COMPANYGenRe

0.0%

31470

512

363

149

NORGUARD INSURANCE COMPANYGuard

0.1%

42390

416

316

100

AMGUARD INSURANCE COMPANYGuard

0.1%

14702

104

71

33

EASTGUARD INSURANCE COMPANYGuard

0.0%

11981

42

29

13

WestGUARDGuard

0.0%

11843

3,013

1,938

1,075

MEDICAL PROTECTIVE COMedPro

0.8%

42226

586

173

413

Princeton Ins CoMedPro

0.3%

13589

14

11

3

MedPro RRG Risk Retention GroupMedPro

0.0%

20087

127,340

48,479

78,861

NATIONAL INDEMNITY COMPANYNI

61.7%

20079

5,597

1,739

3,858

NATIONAL FIRE & MARINE INSURANCE CONI

3.0%

62345

10,938

8,700

2,238

BERKSHIRE HATHAWAY LIFE INSURANCE COMPANY OF NEBRASKANI

1.8%

13070

1,841

692

1,149

BERKSHIRE HATHAWAY ASSURANCE CORPORATIONNI

0.9%

39136

1,203

487

716

Finial Reinsurance CompanyNIRunoff

0.6%

20052

1,419

705

714

NATIONAL LIABILITY & FIRE INS CONI

0.6%

42137

212

70

142

NATIONAL INDEMNITY CO OF THE SOUTHNI

0.1%

20060

173

49

124

NATIONAL INDEMNITY CO OF MID-AMERICANI

0.1%

22276

90

19

71

STONEWALL INSURANCE COMPANYNI

0.1%

37923

100

55

45

SEAWORTHY INSURANCE CONI

0.0%

36048

74

42

32

UNIONE ITALIANA REINS CO OF AMERICANIRunoff

0.0%

11591

63

51

12

FIRST BERKSHIRE HATHAWAY LIFE INSURANCE COMPANYNI

0.0%

10391

43

32

11

AMERICAN CENTENNIAL INSURANCE CONI

0.0%

13795

2

2

AttPro RRG Reciprocal Risk Retention GrpNI

0.0%

25895

675

234

441

UNITED STATES LIABILITY INS COUSLI

0.3%

26522

434

160

274

MOUNT VERNON FIRE INSURANCE COUSLI

0.2%

35416

161

59

102

US UNDERWRITERS INSURANCE COUSLI

0.1%

15962

171

23

148

KANSAS BANKERS SURETY COWesco

0.1%

Total

223,315

95,444

127,871

106,000

From 10K

This table lists all of Berkshire Hathaway’s domestically domiciled insurance subsidiaries, all 55-56 of them, maybe minus a few intermediate holding companies that are just shells.  The NAIC # uniquely identifies each company for the National Association of Insurance Commissioners.  Then comes the assets, liabilities, and surplus for regulatory purposes.  Then there are the groups that each subsidiary belongs to, and what percentage  of the total statutory surplus each one represents.

The table is sorted by the major subsidiary groups, and then in declining order of surplus.   Here is the key to the groups:

  1. AU = Applied Underwriters
  2. BHH = Berkshire Hathaway Homestate
  3. CSI = Central States Indemnity
  4. GEICO (what else?)
  5. GenRe = General Reinsurance
  6. Guard = AmGuard
  7. MedPro = Medical Protective
  8. NI = National Indemnity
  9. USLI = United States Liability Insurance
  10. Wesco = Wesco Financial

A number of the companies are not writing new business; they are in what is called “runoff.”  Two companies may have the same name “APPLIED UNDERWRITERS CAPTIVE RISK ASSURANCE COMPANY, INC.” but are domiciled in different states.

So, back to my challenge to understand the structure of Berkshire Hathaway.  The above table makes my life easy.  Really, I only need to get the reports of the following companies:

  • Berkshire Hathaway Homestate
  • General Reinsurance
  • GEICO
  • National Indemnity (really, the one most needed)
  • Medical Protective

Those five companies cover ~94% of the statutory surplus of  all of Berkshire’s insurance companies.  I can afford to get that data.  But how should I do it?

  1. I can buy it though the NAIC
  2. I could write Warren another letter asking for his approval to ask each company for their statutory statements.
  3. I could ask each subsidiary for their statements, and see how they react.
  4. I could troll the web, and see if they aren’t hiding out there.  One reader suggested that the Statements are out there on some state insurance department websites, but that would surprise me. That hasn’t been true in the past.

I am thinking of doing #2, but am open to advice.

As an aside, note that the sum of $128 billion of statutory surplus is far more than the $106 billion listed in the latest 10-K.  That is because of capital stacking, which is a form of double counting.  Lower lever subsidiaries surplus gets counted in their intermediate parent companies.  But if I eliminate all of the lower level companies, I only end up with $100 billion.

This is a different approach to Berkshire Hathaway, approaching it as a group of  insurance companies that owns businesses.  It is very different, yet successful.  When I get the data, I hope we all learn a lot.

During a panic, it is useful to reflect on the degree to which the real economy has been driven by the financial economy.  In the Great Depression, the degree was heavy; in the seventies, it was light.  Today, my guess is that it is in-between, which makes it difficult to figure out the right strategy.

Again, this was written in 2002 or so.  As I posted last night, the banks were in relatively good shape then.  I made a lot of money for my clients buying bank floating rate trust preferred securities at ~$80.  There was no security that we did not clear at least $10 on, and most cleared $20 within a year.  One even went from $68 to $100, plus a healthy coupon.  In bond terms those were a series of home runs.  As an aside, as a bond investor, I focused more on net capital gains than most, and that helped us in a rocky era.  I often gave up current income to gain the potential for capital gains, which was the opposite of most of my competitors.

So in 2002 it was reasonable to buy banks as the willingness to supply of credit grew.  But there are limits to how much credit you can have in an economy without things getting screwy.  An economy with too many promises to pay becomes inflexible; far better to finance more of the economy with equity, but that requires a Fed that works properly, like it was under Eccles, Martin and Volcker.  Under men of less courage, like Bernanke, Greenspan, Burns, Miller, Crissinger, and Young, it simply paves the way for asset bubbles and price inflation.

In 1929 and 2008, though, it was relatively easy to know that the financial economy had grown too large for the real economy.  Total debt to GDP levels were at records.

Or think of it from this angle: in 2004, I was recruited by another financial hedge fund to be their insurance analyst.  I talked with them, but ultimately I refused, because I felt the boss was probably less competent than my current boss.  A major part of his presentation was how amazing the outperformance of financial stocks had been over the prior 10 years, implying that it would be the same over the next 10.  That outperformance was not repeatable because the capital of the banking and shadow banking industries had gotten so large that there was no longer any way that they could extract a high return out of the rest of the economy.  As it was, the effort to do so made them take on asset risks that killed many companies, and should have killed many, many more, had economic policy been handled properly.

This is one reason why my long only portfolio was so light on financials, excluding insurers, going into 2008.  I sold the last of my banks in 2007, realizing Europe would be no safe haven.  I retained one mortgage REIT that cratered as repo fell apart, teaching me a valuable lesson that I had bought something cheap, but not safe.  That was my only significant loss during the crisis starting in 2007-2008.  Repo funding is not a safe funding source during crises, and this is something that is not fixed from the last crisis, along with portfolio margining, and a few other weak liability structures.

With respect to the eras starting in 1929 and 2008, the key concept is debt deflation   When there are too many debts, there will be too many bad debts.  That is the time to only only companies with strong balance sheets that will not need to refinance under any conditions.  That eliminates all banks and shadow banks.

I can’t guarantee that we are past the crisis, because we haven’t seen what will happen to the economy when the Fed starts to lessen policy accommodation, much less tighten.  As it is, for the most part, I not only own companies that are cheap, but primarily companies that are safe.  Value investing is “safe and cheap,” not just cheap.  This applies to financials as well, but many value investors lost a lot of money on financials because they ignored credit quality near the end of a credit boom.  Many credit-sensitive companies looked cheap near the end of the 2007, but they were cheap for a reason — they were about to get pelted by a ton of losses.

As an aside, do you know how hard it is to get a value manager to short something trading at 50% of book value?

I know how tough that is.  I’ve been through it.  He would not bite.

The company had asset risks as well as liability risks.  I extrapolated the liability cash flows to realize the long-term care  policies the company had written would likely bankrupt them.  But when the boss came to me pitching it as a long because one his buddies thought it was dirt-cheap, I uttered, “Gun to the head boss, I would tell you to short it.”  Reply: “But it’s trading at half of book value.” Me: “Book value is misstates true economic value.  Can’t say for certain, but I think this one goes out at zero.”

As it was, we did nothing, and the stock, Penn Treaty, did go out at zero. (There was one small positive out of this, I did convince the private equity arm not to fund a competitor in long-term care.)

Back to the main point.  Have a sense as to the financial economy.  This will probably only happen once in your life, but that time is crucial.  If there is a financial mania going on, move to safety, and reduce exposure to credit-sensitive financials.  It’s that simple, but to most value investors who invest in seemingly cheap financials that is a hard move.  Remember, safe comes before cheap in value investing, and that means questioning asset accrual items.  Financial companies have that in spades.

If businesses anticipate a flow of financing, they will depend on it.  Then a diminution or increase in the flow of investable funds will affect markets, even if the flow of investable funds remains positive or negative.

Most of the sayings from the “rules” posts came from things I thought of while managing investment risk 1998-2004.  I think I wrote this one late in 2002, or early 2003.  I’ll apply this three ways — what I would apply this to now, then, and in-between.

Then: the Fed funds rate was below 2%, and the yield curve was steeply sloped.  The corporate bond market had gone through an incredible bust, but almost all the companies that would fail had already failed, and a big rally was just starting.  Banks were still in good shape, with plenty of lending capacity, which was being applied to residential and commercial lending.  The securitization markets functioned and financing was easily available for residential & commercial mortgages, and many types of consumer lending.

In-between (1): Now I’m talking about 2006-7.  Fed funds rate was rising to an eventual 5.5%.  The curve is flat to inverted, and corporate spreads are very tight.  Issuance of low grade paper is rampant, and covenant protections are declining.  Risk is chasing reward, and gaining.  Everything is overlevered.  Any attempts at prudence are financially punished.  That said, the securitization market slows; deal are harder to do.

In-between (2): Now I am talking about late 2008 to early 2009.  Fed Funds had shifted to its current near zero state, but the Fed had not begun playing with the asset side of its balance sheet.  The yield curve was relatively wide but bull flattening.  Nothing was getting done in lending, and credit spreads were as wide as wide can be.  Securitization drops to near zero. Bank lending is non-existent, aside from buying Treasuries on credit provided by the Fed.

Now: The Fed funds rate is still in the gutter, and the Fed dreams that QE will do a lot for the economy.  (It works in theory! Stupid economists.)  Corporate credit spreads are wide, covenant protections are low, and yields relative to intrinsic risk are low.  Securitization markets are functioning at a reduced level, while banks aren’t lending much to the private sector.  Most housing loans are backed by the US government.

So here is the graph:

The point of this piece is to tell you not to look at the level of risky interest rates, but to look at the rate of change in risky interest rates. It tells a lot regarding future prospects of the stock and bond markets.  The rate of change matters a great deal, not the absolute level of rates.

So, the implication is watch for a sustained rise in in high-yield bond yields.  When those yields cross their 10-month moving average, it is time to be gone from risk assets.

Mark Hulbert had a recent piece in the Wall Street Journal called How to Use Stock Splits to Build a Winning Portfolio.  I find it curious, because 31 years ago I wrote my Master’s Thesis called, “Predicting Stock Splits: An Exercise in Market Efficiency.”  As far as I know, aside from the unbound copy sitting next to me, the only other copy is in some obscure part of the Johns Hopkins Library System.  If a number of people are really curious about this, I could try OCR and see if that would adequately read the typewritten text.

But anyway, I find it amusing that some are still trying to use stock splits to try to make money.  Quoting from Hulbert’s piece:

But try telling that to Neil Macneale, editor of an investment-advisory service called “2 for 1,” whose model portfolio contains only those stocks that have recently split their shares, holding them for 30 months. Over the past decade, according to the Hulbert Financial Digest, that portfolio has produced a 14% annualized return, far outpacing the 8% gain of the Standard & Poor’s 500-stock index, including dividends.

Mr. Macneale’s track record isn’t a fluke. Several studies have found that the average stock undergoing a split outperforms the overall market by a significant margin over the three years following the company’s announcement of that split. Indeed, Mr. Macneale said in an interview, he got the idea for his advisory service in the 1990s from one of the first such studies, conducted by David Ikenberry, now dean of the Leeds School of Business at the University of Colorado, Boulder.

Research on stock splits goes back to the ’30s.  In the ’50s & ’60s before MPT got into full swing, a few researchers began trying analyze why there were abnormal rises in stock prices two months before a stock split.  Could it be that other factors affecting future value were somehow associated with stock splits?  Many factors pointed toward that, notably prior price increases, prior earnings increases, and increases in the dividend associated with the stock split.  Little did they know that they were anticipating momentum investing.

The consensus by the end of the ’70s was that there was no excess return after the stock split announcement, and few ways if any to capture the pre-announcement excess returns.  If in the present stock splits are providing excess returns for 2.5 years afterward, well, this is something new.

One of the leading stock-split theories—supported by the work of professors Alon Kalay of Columbia University and Mathias Kronlund of the University of Illinois, Urbana-Champaign—is that companies implicitly have a target range for where they would like their shares to trade.

If a firm’s shares are trading well above that range, and management believes that this high price is more than temporary, it is likely to initiate a split in order to bring its share price back to within that range.

This isn’t a new theory — it goes back to the ’50s, if not earlier.  One of the oldest theories was that it improved liquidity, but back in a time of fixed tick sizes, where everything traded in eighths, and higher commissions, that made little sense to a number of economists.  Splits made trading costs rise in aggregate for the same amount of dollar volume traded.

In the present though, there are many venues for execution of trades, commissions are much smaller, and negotiable.  Perhaps today more shares at lower prices does add liquidity, and the way to test might compare the bid-ask spread and sizes pre- and post-split.

The professors late last year completed a study of all U.S. stocks that split their shares by a factor of at least 1.25-to-1 between January 1988 and December 2007. They say the evidence their study uncovered suggests that splits are an “indication of sustained strong earnings going forward.” It therefore shouldn’t be a big surprise that split stocks outperform other high-price stocks that don’t undertake a split.

What this might mean is that stocks that split are examples of price and/or earnings momentum.  A management team splits the stock as a signal that corporate profit growth has been good, and will continue to be so.  If not, the management team runs the risk that if the stock price falls, it looks bad to a management to have a low stock price.  There are some investors who won’t buy stocks below $10, $5, etc.  Why run the risk of lowering your stock price if you think the odds are decent that the price will fall from there?  Low stock prices affect the confidence of many.

Investors looking to profit from the stock-split phenomenon should shun stocks that have undergone a reverse split and focus instead on those that have split their shares. You will have to invest in such stocks directly because there is no mutual fund or exchange-traded fund that bases its stock selection on stock splits.

Fortunately, constructing a portfolio of such stocks needn’t be particularly time-consuming.

For example, there is no need to guess in advance which companies are likely to split their shares—which in any case would be difficult, if not impossible, to do. There even appears to be no need to buy a company’s stock immediately after it announces a split, since research shows that it is likely to outperform the overall market for up to three years following that announcement.

Still, Mr. Macneale recommends that investors be choosy when deciding which post-split stocks to purchase. He cites several studies suggesting that the post-split stocks that perform the best tend to be those that, at the time of their splits, are trading at relatively low price/earnings or price/book ratios. Both are commonly used measures of a stock’s valuation, with lower readings indicating greater value.

I’m going to have to find the papers that say that post-split stocks outperform for the next 30 months.  Doesn’t sound right — a result like that would have been found from the research pre-1980, and no one suggested that; in fact, the evidence contradicted that consistently.

Note that the investment manager in question uses cheap valuation to filter opportunities.  That the stock has split usually indicates strong price momentum.  Value plus momentum is usually a winner, so why should we be surprised that stock splits often do well?

But I know of three papers that focused on predicting stock splits — two in 1973, and mine in 1982.  It’s not that hard.  Most of it is price momentum, and with a balanced set of stocks that would and would not split, the models predict 70% of the companies that would split.

What’s better, is that the formulas to predict stock splits pick good stocks in their own right — they end up being value and momentum, and maybe a few other factors.  I remember my thesis adviser being surprised at how good my models were at picking stocks.

This brings me to my conclusion: stock splits are a momentum effect, but it is larger when companies are still have a cheap valuation.  Perhaps splits have no effect on stock performance — it is all momentum and valuation.  To me, that is the most likely conclusion, and my thesis anticipated quantitative money management by 10+ years.

In one sense it is a pity I didn’t do anything with it, but if I hadn’t become an actuary, I would never have gained many other insights into the ways that the market works.  I’m happy with the way things worked out.

Unions create inefficiency.  This creates an opportunity for new technologies that perform the same function, but aren’t as labor-intensive.  (E.g. integrated steel vs. mini-mills)

Unions were a useful force in the US in their early days.  They helped get safe working conditions, and helped workers get the Sabbath off, so that they could go to church.  Those were admirable goals, but after that, unions outlived their usefulness.

Unions restricted my father and uncle on whom they could hire, yet required them to be a part of the union, but gave them no vote because they were owners (they hired one worker at most).  My mother was particularly annoyed at the union, but today she draws a pension from it.

The main inefficiency of unions comes from work rules.  In most other ways, unionized workers are not inefficient.  But the inefficiency of unions attracts efforts from employers to substitute capital for labor.  One of the best examples is listed above — unionized steel gets its market share eroded by mini-mills, using a lot more science, fewer people, and producing steel a lot cheaper.

There are other examples of this, but if in the private sector attempts to raise wages above levels justified by productivity, or limit flexibility of work processes, there will be the tendency for non-union firms to come in and take market share.  Example: non-union auto parts companies now provide most of the parts to auto manufacturers.

This is one reason why I think non-union technology has been more harmful to unions than foreign competition.  Creativity is not union, by and large, though I know there are exceptions.  In an era of technological improvement, non-union firms have more quickly embraced change.  This is what has hollowed out the unions, leaving them largely to serve governments, where technological improvement plays little role, because there is no possibility of competition in government, mostly.

Yes, there may be modest changes here and there, but when was the last time you heard of a municipality breaking a police, fireman, or teachers’  union?  Until pensions break the states and municipalities, that will not happen.

Thus I expect unions to continue to decrease in power for the near term, aside from government employment.  Unions will always occupy the most backward parts of the economy.

Companies

  • Delta Sees S&P 500 in Reach as Credit Ratings Rise http://stks.co/rEBE  I would b cautious here, airlines have destroyed a lot of capital $$
  • Berkshire’s Weschler Holds Almost $150 Million of DaVita http://stks.co/pEIf  FD: + $BRK.B | The slow takeover of Davita continues $$
  • The real Apple tax scandal http://stks.co/gWz1  Scrap the corporate income tax & raise taxes on realized capital gains & dividends $$
  • Berkshire Hathaway Seeks Release of ResCap, Ally Financial Report http://stks.co/dVOD  Wants 2c if there was any fraudulent conveyance $$
  • Oil Revolt Generates $35 Billion as Icahn-Singer Agitate http://stks.co/jWnd  Many activist investors trawling in energy stocks $$
  • Inside Google’s Secret Lab http://stks.co/qE31  “Since its creation in 2010, Google has kept X largely hidden from view.” Long but good $$
  • Explaining Apple’s Irish Tax Dodge http://stks.co/hXHa  A good transfer pricing accountant is worth his weight in gold $$
  • Deal of the Week: Penney Holds Real Value http://stks.co/rDoO  $JCP needs to turn around its retailing much more than managing property $$
  • After all, that’s how BK conservation is done in the insurance industry, taxpayer never gets on the hook (please ignore $AIG) $$
  • Customer Service Is Next Job for IBM’s Watson http://stks.co/tDcy  Could Watson replace the grunts that take care of customer service? $$
  • “…insurance giants such as ACE Ltd and Endurance Specialty Holdings Ltd” http://stks.co/qDeA  $ACE is a giant @ $31B , $ENH not @ $2B $$
  • $VOD to Keep $VZ Payout Amid Europe Struggles http://stks.co/cV0K  Not surprising they stalemated on VZW, & no special div | FD: + $VOD $$
  • Regulators Scrutinize Firms’ Ties to Insurers http://stks.co/sDXn  How much unsafe assets are held by life companies of $APO $HRG $GS ? $$

 

Market Dynamics

  • Murray International’s Stout Says Stocks Too Expensive http://stks.co/aVhD  This means invest in cash, long Tsys or gold if correct $$
  • Bargain-Hunting Buoys Treasurys [sic] http://stks.co/rEBC  Strength Returns as Bargain-Hunters Appear, but Prices Still Fall 4 the Week $$
  • EVERGREEN VIRTUAL ADVISOR http://stks.co/eVjh  A very good publication this week. If u beg, u can get on the distribution list. $$
  • Richard Band notes that the S&P 500’s prices-to-sales ratio is 1.5 to 1, almost 60% above its average since 1955 http://stks.co/gX6Z  $$
  • Paul Tudor Jones: Macro trading, babies r a ‘killer’ 2a woman’s focus http://stks.co/gX54  Any significant outside activity harms focus $$
  • Is This the Best Time for Investors? Don’t Bet On It http://stks.co/cVSF  Long term valuation measures r flashing red, play defense $$
  • 3 articles on gold http://stks.co/pE4K  & http://stks.co/sDwa  & http://stks.co/rDwK  New hedging, record shorting, paper gold $$ $GLD
  • Follow the Leader @mktanthropology http://stks.co/jWlB  Global economy feeling deflationary; stock markets poised to follow down $$
  • Goldman raises S&P 500 targets through 2015 http://stks.co/gWYI  Not impossible historically, but not likely, profit margins would b2hi $$
  • James Surowiecki: Is There a Stock-Market Bubble? http://stks.co/sDac  Argues profit margins sustainable: lower taxes, globalization $$
  • Looking for Investments With Higher Yields in a Low Interest-Rate World http://stks.co/pDgr  Grab hi yields now= walk tightrope; no net $$
  • Gold in Yen and SP500 and Bitcoin : Back to the Future http://stks.co/fWYb  Gold almost back to peak in yen terms & much more $$
  • Gold Bear Bets Reach Record as Soros Cuts Holdings http://stks.co/jWKK  Market delivers pain to the gold longs: bears now overextended? $$
  • Gold Rebounded After Moody’s Says U.S. May Face Downgrade http://stks.co/qDZq  People want certainty somewhere, whether in Govt or gold $$
  • Junk Stocks Spur Broadest Equity Advance Since 1995 http://stks.co/qDZm  Highly indebted firms take the lead in the equity market $$

US Politics & Economic Policy

  • Obama Bully Pulpit Bullied With Congress Probes Obscuring Agenda http://stks.co/jWz8  Maybe we should limit Presidents to one 4-yr term $$
  • Fannie Mae Profiting as Market Middleman Angers Lenders http://stks.co/sEB4  If we really want 2wind down F&F, we should end purchases $$
  • Goldman Sachs Research Disputes TBTF Subsidy http://stks.co/aVW5  In quiet times, advantage difficult to detect, easy during crisis $$
  • Unaccountable Executive http://stks.co/rDwj  If President doesn’t run government, who does? Can delegate authority, not responsibility $$
  • The Prisoner’s Dilemma of Central Banks [pdf] http://stks.co/rDwg  Everyone has an incentive 2 inflate, which leaves everyone worse off $$
  • The Fed Is Squeezing the Shadow-Banking System http://stks.co/tDy5  As they should: repo market was a big part of the financial crisis $$
  • The FED & F-35: Still no Rules of Engagement http://stks.co/pDwg  The Fed doesn’t know what they are doing; making it up, smiling a lot $$
  • Sheila Bair: Dodd-Frank really did end taxpayer bailouts http://stks.co/jWPv  Will follow BK pecking order, after that charge industry $$
  • Naming Names in the Dodd Frank Mess http://stks.co/jWPr  Mark Wetjen manages to stymie Dodd-Frank reforms; some of it is good, some bad $$
  • What Strong Dollar? US Boom Provides Oil Hedge http://stks.co/tDcb  W/more energy produced in the US, $$ has less impact on oil prices
  • White House urges Senate to cut crop insurance in farm bill http://stks.co/cV18  Difficult to beat the Ag lobby on crop insurance $$
  • Health Law Costs: Employers Eye Bare-Bones Plans http://stks.co/tDXo  Obamacare messes up the health system; avg person less well-off $$
  • Puerto Rico Statehood Bid Gets New Push http://stks.co/pDdM  Sensing future bankruptcy, Puerto Rico reconsiders a permanent liege-lord $$
  • Does Rand Paul’s Rise Signal A Broader Libertarian Moment? http://stks.co/aV62  Somehow I think this one will end in disappointment too $$
  • US Immigration Plan Encounters Business-Labor Rift http://stks.co/hWgM  Fascinating how seeming certainty of immigration bill has gone $$
  • The end of QE? http://stks.co/rDKW  @izakaminska tells us why more QE won’t help, & why the process will have to end soon. $$ #becareful

Rest of the World

  • Turkey Moves 2Curb Alcohol Sales http://stks.co/hXJT  This will b an interesting test of govt power; vodka is delivered quietly in Iran $$
  • Foreign Fighters Enter Syria to Defend Shiites and Al-Assad Regime http://stks.co/tEAp  “Islam is a religion of peace” “Islam is a…” $$
  • The Great Chinese Property Bubble: a Wall of Worry? http://stks.co/pEH3  2 much 2 occupy; prices 2 high; enough debt 2b troublesome $$
  • BRICS risk ‘sudden stop’ as dollar rally builds http://stks.co/cVY1  EM blowups often preceded by rise in $$ | Good 4 EM exporters though
  • Wrong:Avoid These 3 Stocks on Japan, Says Expert http://stks.co/dVX1  An expert that doesn’t understand insurance trashes $AFL | FD:+ $AFL
  • Asia Goes on a Debt Binge as Much of World Sobers Up http://stks.co/sE8v  Over-indebted economies don’t grow rapidly; complexity chokes $$
  • 2 articles on Japan http://stks.co/fWuS  & http://stks.co/hX67  Rising bond yields & trade deficit, monetary policy drives both $$
  • Two articles on the Tokyo market rout http://stks.co/qE7K  & http://stks.co/rE2d  Abenomics is stretching the limits of the possible $$
  • Nobel Laureate Phelps Warns Against EU as Iceland Abandons Talks http://stks.co/fWui  Iceland gets smart, doesn’t join the Eurozone $$
  • Death in Parched Farm Field Reveals Growing India Water Tragedy http://stks.co/cVN6  Water shortages r big factor 4 India’s development $$
  • The Abenomics Experiment: Major Risks for Banks http://stks.co/gWlx  If interest rates rise 2much, banks in Japan go to neg net worth $$
  • Experts call for urgent measures to tackle debt http://stks.co/qDtR  One advantage of US over China; we resolve troubled debts better $$
  • Stockholm Riots Continue for Third Night http://stks.co/gWlk  If this can happen in Stockholm, it can happen in a lot of other places 2 $$
  • Hollande Bonds Without AAA Shine Brighter Than Gold http://stks.co/dUzy  Similar things worked 4 Japan 4a while, but now may b shifting $$
  • World’s Biggest Volatility Jump Spurs Fund Outflow http://stks.co/gWTm  Investors invest outside Japan 2 escape perpetually falling yen $$
  • China April housing inflation quickens to two year high http://stks.co/fWM5  Chinese inflation is the endgame for many globally $$ #theend

Wrong

Other

  • Soldiers Turn Entrepreneurs as One Million Exit Military http://stks.co/gX55  Military training has similarities w/entrepreneurship $$
  • The Exercise Equivalent of a Cheeseburger? http://stks.co/cVY6  Exercise is good; too much exercise is worse than little exercise $$
  • How Rail is Reshaping America’s Energy System http://stks.co/iWqJ  Summary piece on how tank cars r taking cheap fuel to the coasts $$
  • Wined, Dined, Canned http://stks.co/tDq6  Inside the insiders game that is the Cannes film festival $$ Movie about the business of movies
  •  Teen’s invention could charge cellphone in 20 seconds http://stks.co/eVD0  Wonder how stable supercapacitor will b? Might b an issue $$
  •  “I’m going to be setting the world on fire,” she said. http://stks.co/jWPq  Having seen overpowered capacitors burn, could b literal $$
  • The Tech Innovator Who Almost Killed Saddam Hussein http://stks.co/dV1x  Long interesting article; Sabra becomes rich computer maven $$
  • Getting Along With the Original Other Woman—Your Mother-in-Law http://stks.co/iWbp  Husbands, support your wives. Mothers, bow out $$
  • New Rival Emerging for Bloomberg Chat http://stks.co/bV4p  Bloomberg may learn the hard way: messaging security can’t be compromised $$

Comments, Replies, & Retweets

  • @Sir_Strangelove Had not caught that, thanks for correcting me
  • “There is one thing you neglected: Baa bond yields are 3% lower than in 1999. That roughly comports…” — D_Merkel http://disq.us/8d7ha9  $$
  • @joshuademasi It’s like long-tail reinsurers in the mid-’80s, most were technically insolvent, but book capital was +; losses eaten slowly
  • “Jeff Matthews is correct; Dealbook, though usually good, is wrong.” — David_Merkel http://disq.us/8d735b  $$
  • “This is a failure of the regulators, that they let this happen at all. They have the power to top it” — D_Merkel http://disq.us/8d730h 
  • @danielckoontz I know that dividend swaps exist, can imagine the possibility of leverage, don’t think it’s done much though, I hope
  • @danielckoontz So long as there isn’t any leverage on the person holding the dividend paying stocks, generally it should self-limit

FWIW

  • My week on twitter: 35 retweets received, 1 new listings, 66 new followers, 30 mentions. Via: http://20ft.net/p 

The trouble with VAR and other mathematical models of risk is that if it becomes the dominant paradigm, and everyone begins to use it, it creates distortions in the market, because institutions gravitate to asset classes that the model makes to appear artificially cheap.  Then after a self-reinforcing cycle that boosts that now favored asset class to an unsupportable level, the cashflows underlying the asset can no longer support it, the market goes into reverse, and the VAR models encourage an undershoot.  The same factors that lead to buying to an unfair level also cause selling to an unfair level.

Benchmarking and risk control through VAR only work when few market participants use them.  When most people use them, it becomes like the portfolio insurance debacle of 1987.  VAR becomes pro-cyclical at that point.

Sometimes I think the Society of Actuaries is really dumb.  The recent financial crisis demonstrated the superior power of long-term actuarial stress-testing versus short-term quant models for analyzing risk.  The actuarial profession has not taken advantage of this.  Now, maybe some investment bank could adopt an actuarial approach to risk, and they will be much safer.  But guess what?  They won’t do it because it will limit risk taking more than other investment banks.  Unless the short-term risk model is replaced industry-wide with a long-term risk model, in the short-run, the company with the short-term risk model will do better.

The reason why VAR does not effectively control risk is simple.  VAR is a short-term measure in most of its implementations.  It is a short-term measure of risk for short- and long-term assets.  Just as long-term assets should be financed with long-term liabilities, so should risk analyses be long-term for long-term assets.

This mirrors financing as well, because bubbles tend to occur when long-term assets are financed by short-term liabilities.  Risk gets ignored when long-term assets are evaluated by short-term price movements.

And, as noted above, these effects are exacerbated when a lot parties use them; a monocultural view of short-run risk will lead to booms and busts, much as portfolio insurance caused the crash in 1987.  If a lot of people trade in such a way as to minimize losses at a given level, that sets up a “tipping point” where the market will fall harder than anyone expects, should the market get near that point.

The idea that one can use a short-term measure of risk to measure long-term assets assumes that markets are infinitely deep, and that there are no games being played.  You have the capacity to dump/acquire the whole position at once with no frictional costs.  Ugh.  Today I set up a new client portfolio, and I was amazed at how much jumpiness there was, even on some mid-cap stocks.  Liquidity is always limited for idiosyncratic investments.

The upshot here is simple: with long term assets like stocks, bonds, housing, the risk analysis must be long term in nature or you will not measure risk properly, and you will exacerbate booms and busts.  It would be good to press for regulations on banks to make sure that all risk analyses are done to the greater length of the assets or the liabilities (and with any derivatives, on the underlying, not contract term).

There is probably money to be made in analyzing the foibles of money managers, to create new strategies by taking on the opposite of what they are doing.

What errors do most money managers make today?

  • Chasing performance
  • Over-diversification
  • Benchmarking / Hugging the index
  • Over-trading
  • Relying too heavily on earnings growth
  • Analyzing the income statement only
  • Refusing to analyze industries
  • Buy newsy companies
  • Relying on the sell-side
  • Trusting management too much

 

Let me handle these one-by-one:

Chasing performance

In writing this, I am not against using momentum.  I am against regret.  Don’t buy something after you have missed most of the move, as if future stock price movement is magically up.  Unless you can identify why the stock is underappreciated after a strong move up, don’t touch it.

Over-diversification

Most managers hold too many stocks.  There is no way that a team of individuals can follow so many stocks.  Indeed, I am tested with 36 holdings in my portfolio, which is mirrored for clients.  Leaving aside tax reasons, it would be far better to manage fewer companies with more concentrated positions.  You will make sharper judgments, and earn better returns.

Benchmarking / Hugging the index

It is far better to ignore the indexes and invest in what you think will yield the best returns over the next 3-5 years.  Aim for a large active share, differing from the benchmark index.  Make some real nonconsensus investments.     Show real moxie; don’t be like the crowd.

Yes, it may bring in more assets if you are never in the fourth quartile, but is that doing your best for clients?  More volatility in search of better overall returns is what investors need.  If they can’t bear short-term volatility, they should not be invested in stocks.

Over-trading

We don’t make money when we trade.  We make money while we wait.  Ideas take time to work out, and there are frequently disappointments that will recover.  If you are turning over your portfolio at faster than a 50% rate, you are not giving your companies adequate time to grow, turn around, etc.  For me, I have rules in place to keep from over-trading.

Relying too heavily on earnings growth

Earnings growth is far less predictable than most imagine.  Companies with high profit margins tend to attract competitors, substitutes, etc.

When growth companies miss estimates, the reaction is severe.  For value companies, far less so.  Disappointments happen; your portfolio strategy should reflect that.

Analyzing the income statement only

Every earnings report comes four, not just one, major accounting statements, and a bevy of footnotes.  In many regulated industries, there are other financial statements and metrics filed with the government that further flesh out the business.  Often an earnings figure is less than the highest quality because accrual entries are overstated.

Also, a business may be more or less valuable than the earnings indicate because of the relative ability to convert the resources of the company to higher and better uses, or the relative amount to reinvest in capex to maintain the earnings stream.

Finally, companies that employ a lot of leverage to achieve their earnings will not do well when financing is not available on favorable terms during a recession.

Refusing to analyze industries

There are two ways to ignore industry effects.  One is to be totally top-down, and let your view of macroeconomics guide portfolio management decisions.  Macroeconomics rarely translates into useful portfolio decisions in the short run.  Even when you are right, it may take years for it to play out, as in the global financial crisis – the firm I was with at the time was five years early on when they thought the crisis would happen, which was almost as good as being wrong, though they were able to see it through to the end and profit.

Then there is being purely “bottoms up,” and not gaining the broader context of the industry.  As a young investor that was a fault of mine.  As a result, I fell into a wide variety of “value traps” where I didn’t see that the company was “cheap for a reason.”

Buying newsy companies

Often managers think they have to have an investable opinion on companies that are in the news frequently.  I think most of those companies are overanalyzed, and as such, don’t offer a lot of investment potential unless one thinks the news coverage is wrong.  I actually like owning companies that don’t attract a lot of attention.  Management teams do better when they are not distracted by the spotlight.

Relying on the sell-side for analysis

Analysts and portfolio managers need to build up their own industry knowledge to the point where they are able to independently articulate how an industry makes money.  What are the key drivers to watch?  What management teams seem to be building value the best?  This is too important to outsource.

Trusting management too much

I think there is a healthy balance to be had in talking with management.  Once you have a decent understanding of how an industry works, talking with management teams can help reveal who are at the top of the game, and who aren’t.  Who is honest, and who bluffs?  This very long set of articles of mine goes through the details.

You can do a document-driven approach, read the relevant SEC filings and industry periodicals, and not talk with management ever – you might lose some advantage doing that, but you won’t be tricked by a slick-talking management team.  Trusting management implicitly is the big problem to avoid.  They are paid to speak favorably regarding their own firm.

Summary

This isn’t an exhaustive list.  I’m sure my readers can think of more foibles.  I can think of more, but I have to end somewhere.  My view is that one does best in investing when you can think like a businessman, and exclude many of the distractions that large money managers fall into.

A little more than two years ago, I wrote Goes Down Double-Speed.  I wrote it after the market had doubled from its lows two years earlier.  I want to update the piece and explain we have learned over the past 2+ years, and maybe discuss what could happen over the next 2+ years.  Anyway, here is the modified table of bull and bear markets:

spx_31294_image002

Since the last piece, the gains have come slowly, validating my comment, “But it would be unprecedented for the market to continue to advance at a 3% [per month] pace from here.”  In long recoveries, gains first come quickly, then slowly, then near the end they often come quickly again.  Things are coming quickly again now, but who can tell how long it might persist.

Maybe Goldman Sachs can tell us.  After all they increased their price targets for the S&P 500 yesterday.  Now let me republish my updated bull market graphs from the prior piece:

spx_8180_image001

And now look at the cumulative gain:

spx_24509_image001

The predictions of Goldman Sachs are both believable and unbelievable.  Believable: it’s not historically impossible for a rally to last that long, or for it to be so large.  That said the probability historically has been low.

Unbelievable: Unless revenue growth kicks in, that means the profit margin, already at record highs, will soar to an astounding record.  But won’t revenue growth begin again?  That’s hard to say, but if revenue growth starts in earnest, the Fed will start removing policy accommodation, because bank lending will be perking up.  At that point, it is anyone’s guess as to what will happen.  Therefore, I rule out Goldman Sachs’ forecast as a possibility.

The rally continues to get longer in the tooth, and its has been aggressive this year.  I repeat how I ended the original piece: “Consider trimming some of your hottest positions.”