I am basically at breakeven, and above my tough rebalancing buy in August.?? I bought lower as well.? My view is that Deerfield returns to book value ($13) or above, because the market for prime and AAA whole-loan mortgage backed securities is improving.
It would not surprise me to hear that repo margins return to prior levels, which would benefit Deerfield Triarc.? The market for low risk mortgage collateral has returned.
There is disagreement over whether the merger with the asset manager is a good thing or not.? I favor the merger, because I think CDOs have a future.? That said, if it happens or not, I won’t be harmed much.
My view is this: at 73% of book, there is significant value to obtain here.? The company is not going broke.? I will only sell my full stake when the company trades over book.
The following things that I write are more risky than normal, and may be wrong.? If you decide to imitate what I have done, you are doing so at your own risk.? Please do your own due diligence.
I have bought more Deerfield Triarc [DFR] today @ $9.76.? A sharp-eyed reader noted (see the first comment) that DFR must have been past my rebalance point, and wondered why I hadn’t bought more.?? Truth is, I had been working on the issue for two weeks.? Whenever a security falls dramatically (it was close to a second rebalancing sell for me at one point), I do a review.? I don’t automatically do rebalancing buys when a company is under stress.
Okay, what gave me confidence to buy? DFR is levered; the main risk here is that they cannot continue to finance the positions that they hold.? Point one that gives me comfort is that the financing is likely secure.
Most of it is repo funding on prime mortgage collateral, most of which is floating rate.? Though there is a high degree of leverage there, the hedging inherent in managing such funding is a common skill.? You could contrast Deerfield and Annaly.? The collateral and leverage are similar; the main difference is that Deerfield uses swaps and floors to manage interest rate risk, and Annaly uses longer repo terms (1-3 years) than Deerfield (0-3 months).
The trust preferreds are not putable, and they lever up their alternative assets through CDO structures, which are not callable.? The risk there is that the equity and subordinate bonds that they hold could be worthless.? Unlikely, but a possible loss somewhere north of $50 million.? They also have warehouse lines, where assets are held prior to securitization.? I don’t know what might be in their warehouse lines now, but they did recently complete a securitization which freed up $230 million of those lines.? (Note: they couldn’t sell the BBB securities.)? The lines are capable of financing $375 million, and extend to April of 2008 at minimum.
Point two is that very little of the assets inside DFR’s CDOs are subprime.? The total risk to DFR is from the Pinetree CDO, which if they end up writing off the CDO equity, will reduce net worth by $12 million.? Not huge.
Point three is that they might not be able to consummate the merger with Deerfield? Capital Management [DCM], since DFR has to pony up $145 million.? I find it unlikely that they could not get the financing for what is a profitable asset where Debt/Operating Income is around 6.? But even if they can’t do the deal, that does not affect DFR, except that they don’t get to purchase an asset manager at a bargain price, which is even more of? bargain now, given that the stock price has fallen, and the deal terms (half stock, half cash) don’t adjust.
Point four is might the deal terms adjust?? Couldn’t DCM allege a material adverse change, and try to get the terms changed?? It’s a little late for that.? The DFR shareholders meeting is one week from today.? Besides, many of the same problems facing DFR are facing DCM.
Point five is that much of what DCM manages are ABS CDOs.? Much of the ABS collateral is subprime residential mortgages.? (For more details, here is an S&P report from last year.) Now, aside from about $20 million of investments in the CDOs that they manage, they don’t have any more risk exposure.? There is the outside possibility that they could be removed as manager on some of the deals that they manage, but that doesn’t happen often.? The current market environment could have a negative impact on their ability to issue more ABS CDOs and other CDOs, but once things clear up, those that? are still in the game of issuing CDOs will make much better interest spreads than they made in the last two years.
In summary, why did I buy more?
The losses look limited, if they occur at all
The financing seems secure
Exposure to subprime losses are small, and
I think the deal goes through.
Could I be wrong on some of these points and lose badly?? Yes.
This is the last article in this series… for now. ?The advantages of the modern era… I went back through my taxes over the last eleven years through a series of PDF files and pulled out all of the remaining companies where I lost more than half of the value of what I invested, 2004-2014. ?Here’s the list:
Avon Products [AVP]
Avnet [AVT]
Charlotte Russe [Formerly CHIC — Bought out by Advent International]
Cimarex Energy [XEC]
Devon Energy [DVN]
Deerfield Triarc?[formerly DFR, now merged with?Commercial Industrial Finance Corp]
Jones Apparel Group [formerly JNY — Bought out by Sycamore Partners]
Valero Enery [VLO]
Vishay Intertechnology [VSH]
YRC Worldwide [YRCW]
The Collapse of Leverage
Take a look of the last nine of those companies. ?My?losses?all happened during the financial crisis. ?Here I was, writing for RealMoney.com, starting this blog, focused on risk control, and talking often?about rising financial leverage and overvalued housing. ?Well, goes to show you that I needed to take more of my own medicine. ?Doctor David, heal yourself?
Sigh. ?My portfolios typically hold 30-40 stocks. ?You think you’ve screened out every weak balance sheet or too much operating leverage, but a few slip through… I mean, over the last 15 years running this strategy, I’ve owned over 200 stocks.
The really bad collapses happen when there is too much debt and operations fall apart — Deerfield Triarc?was the worst of the bunch. ?Too much debt and assets with poor quality and/or repayment terms that could be adjusted in a negative way. ?YRC Worldwide — collapsing freight rates into a slowing economy with too much debt. ?(An investment is not safe if it has already fallen 80%.)
Energy prices fell at the same time as the economy slowed, and as debt came under pressure — thus the problems with Cimarex, Devon, and to a lesser extent Valero. ?Apparel concepts are fickle for women. ?Charlotte Russe and Jones Apparel executed badly in a bad stock market environment. ?That leaves Avnet and Vishay — too much debt, and falling business prospect along with the rest of the tech sector. ?Double trouble.
Really messed up badly on each one of them, not realizing that a weak market environment reveals weaknesses in companies that would go unnoticed in good or moderate times. ?As such, if you are worried about a crushing market environment in the future, you will need to stress-test to a much higher degree than looking at financial leverage only. ?Look for companies where the pricing of the product or service can reprice down — commodity prices, things that people really don’t need in the short run, intermediate goods where purchases?can be delayed for a while, and anyplace where high fixed investment needs strong volumes to keep costs per unit low.
One final note — Avon calling! ?Ding-dong. ?This was a 2015 issue. ?Really felt that management would see the writing on the wall, and change its overall strategy. ?What seemed to have stopped falling had only caught its breath for the next dive. ?Again,?an investment is not safe if it has already fallen 80%.
There is something to remembering rule number 1 — Don’t Lose Money. ?And rule 2 reminds us — Don’t forget rule number 1. ?That said, I have some things to say on the positive side of all of this.
The Bright Side
A) I did have a diversified portfolio — I still do, and I had companies that did not do badly as well as the minority of big losers. ?I also had a decent amount of cash, no debt, and other investments that were not doing so badly.
B) I used the tax losses to allow a greater degree of flexibility in investing. ?I don’t pay too much attention to tax consequences, but all concerns over?taking gains went away until 2011.
C) I reinvested in better companies, and made the losses back in reasonably short order, once again getting to pay some taxes in the process by 2011. ?Important to note: losses did not make me give up. ?I came back with vigor.
D) I learned valuable lessons in the process, which you now get to absorb for free. ?We call it market tuition, but it is a lot cheaper to learn from the mistakes of others.
Thus in closing — don’t give up. ?There will be losses. ?You will make mistakes, and you might kick yourself. ?Kick yourself a little, but only a little — it drives the lessons home, and then get up and try again, doing better.
Full disclosure: long VLO — made those losses back and then some.
Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.
Rarely is a stock a better idea after it has risen 20%, thus, sell some off in case of mean reversion.? When a stock falls 20%, it is usually a better idea, but to make sure, a review should be done to make sure that nothing has been missed.? Since instituting this rule, I have only had two bad failures over the last 13 years.? One was a painful loss on a mortgage REIT, Deerfield Triarc, and the other was Scottish Re.
But still I resist trends.? Human opinion is fickle, and most of the time, there is overreaction.? As a guard, on the downside, I review new purchases to make sure I am not catching a falling knife.
Much of it comes down to time horizons — my average holding period is three years.? If the asset has enough of a margin of safety, the management team will take action to fix the problems.? That is why I analyze management, their use of cash, and margin of safety.? A stock may seem like a lottery ticket in the short run, but in the long run it is a share in a business, so understanding that business better than most is an edge.? How big that edge is, is open to question, but it is an edge.
Another reason I resist trends is that industry pricing cycles tend to reverse every three years or so, offering opportunities to firms that possess a margin of safety in industries that are not in terminal decline, like most newspapers, bricks-and-mortar bookstores, record stores, video rental stores, etc.? (The internet changes almost everything.)
The second last reason why I resist trends is practical — experience.? Most of my best purchases have suffered some form of setback while holding them — were they bad stocks?? No, time and chance happen to all, but a good management team can bounce back.? It offers me an opportunity to add to my position.? I made a great deal of money buying fundamentally strong insurers and other companies during the crisis, sometimes with double weights.
The last reason is an odd one — the tax code.? Short-term gains are disfavored, and also cannot be used for charitable giving.
So why not take a longer view?? I can tell you what you would need to do:
Focus on margin of safety (debt, competitive boundaries, etc.)
Analyze how management uses free cash (acquisitions, dividends, capital investments, buybacks)
Analyze industry pricing trends, at least implicitly.
Look at the accounting to see if it is likely to be fair (there are a few tests)
Look for cheap valuations, which may have ugly charts.? People have to be at least a little scared.
That takes effort.? I am by no means the best at it, but I do reasonably well.? I avoid large losses without having any sort of automatic “sell trigger.”? Most of my initial losses bounce back, to a high degree.
With that, I wish you well.? Have a great Thanksgiving!
I remember looking at Eastman Kodak a number of times over the last decade.? Often a few metrics would look cheap, but when I would look at the bevy of factors in the financials and consider the effects of technology, I could never get myself to be a buyer.? To me, it seemed to be the ultimate value trap — a modern buggy whip company.
That’s why the behavior of Bill Miller, a so-called value investor, was so surprising to me.? He had a saying, “lowest average cost wins,” but that implies that the stock will rise at some point.? For stocks that keep falling, the average cost does not matter.? And lest I seem to be boasting, I made the same mistake on Deerfield Capital.
The core idea of value investing is NOT “buy cheap,” (lowest average cost) but margin of safety.? My greatest mistakes in investing came from not seeking enough margin of safety.? Same for Bill Miller, though the effect on his track record was far greater.
In hindsight, I’m not happy about what I wrote August-October 2007.? As the bubble built I criticized it in fainter ways than it deserved.? Given the implosion of money markets, I should have been more bearish.? Part of that faintness stemmed from the stigma that came to bears in that era.? But here are articles from that era:
Subprime was getting blamed, but there were many areas where markets were very speculative at the time.? I call them out here, and I was not often wrong.
I got a lot of publicity over this one.? I may do another one in 2011.? It is important to understand that those on the FOMC are not geniuses.? They are bright, but slaves to a view of the world that is not accurate.? The Fed drinks their own Kool-aid.
As the markets declined, there were a lot of signs of the oncoming trouble that were ignored.? Following market liquidity was an aid to avoiding some of the crisis that was to come.
I get some publicity for being a little ahead of the crowd in suggesting that Minsky was correct in the way he viewed economic cycles.? I also anticipate what will happen one year later.
In this article, I attempted to estimate what variable drove stock market performance in aggregate ten years out.? I discovered:
My Upshots
Note that it was a bullish period, and that stocks did not lose nominal money over a ten-year period to any appreciable extent.
Stocks almost always beat bonds over a ten-year period, except when inflation and real interest rates 10 years from now are high.
Investing in stocks during low interest rate environments can be hazardous to your wealth.
Watch for inflation pressures to protect your portfolio. Stocks get hurt worse than bonds from rising inflation.
Inflation and real rate cycles tend to persist, so when you see a change, be willing to act. Buy stocks when inflation is cresting, and buy short-term bonds when inflation is rising
I argued that if many hedge funds had mismarked assets, then many investment banks would as well.? Definitely worked out that way, but bigger than I expected.
This was a forty minute talk that I gave to the Society of Actuaries at their Annual Meeting.? Very big picture, and very prescient.? Worth a look if you have 15 minutes sometime.? I put a lot of work into this one.
Every now and then, some crank like Bill Clinton comes up with the idea that “all we gotta do is invest the Social Security trust funds in the stock market, and the funding problem will go away.”? This is the antidote to that malarkey.
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But, as the markets approached their recent highs during this period, I was skeptical, but insufficiently skeptical.? Further, I blew it on Deerfield, National Atlantic, and my view of how FOMC policy would evolve.? So for this era of my blogging, I have my regrets — I should have done better, even though I got some interesting things right.
We’re coming up on the fourth blogoversary for the Aleph Blog next month, so I wanted to do something a number of readers asked me to do — create a list of my best posts, with a little commentary.? I’m going to do it in segments of three months each, so that should be 16 posts by the time I am done.
Our first period goes from February-April 2007.? I wrote a lot on the panic after the Chinese market fell dramatically.? I also got Cemex and Deerfield Capital dreadfully wrong.? But here are the high points of that quarter:
Liquidity is not a simple concept.? Depending on the situation, it can mean different things.
Helpfully, Martin Barnes, of BCA Research, an economic research firm, has laid out three ways of looking at liquidity. The first has to do with overall monetary conditions: money supply, official interest rates and the price of credit. The second is the state of balance sheets?the share of money, or things that can be exchanged for it in a hurry, in the assets of firms, households and financial institutions. The third, financial-market liquidity, is close to the textbook definition: the ability to buy and sell securities without triggering big changes in prices.
Pretty good, but it could be better. These are correlated phenomena. Times of high liquidity exist when parties are willing to take on fixed commitments for seemingly low rewards. Credit spreads are tight. Credit is growing more rapidly than the monetary base. Banks are willing to lend at relatively low spreads over Treasuries. Same for corporate bond investors. And, if you are trying to generate income by selling options, it almost doesn?t matter what market you are trading. Implied volatilities are low, so you realize less premium, while giving up flexibility (or, liquidity).
A bicycle has to keep on moving to stay upright. A table does not have to move to stay upright, and only a severe event will upend a large table.
The main point there was to ask yourself what happens to your investments if the finance markets ever shut for a while.? Not that that scenario was likely to happen.
When I wrote What Stories Aren?t Being Told?, I did not expect a big response.? But I got 53 responses, more than double the responses of my next-most-responded-to article.? Many bloggers linked to it, and responses continued on for almost four days.
But after Dr. Jeff’s comment, I decided to write a second piece, What is Going Right? Now, part of that also sprang from an e-mail that Rolfe Winkler sent asking what is going right, but I did it as a kind of test to see if asking for optimism would yield a response.
Alas, but only eleven responses came and a few were negative in nature.? I only received one link.? What should that tell me?? The most obvious answer to me is that people by nature are more inclined to complain than to praise.? Though I could resort to the Bible for proof here, instead I will cite two researchers I first bumped into 28 years ago (before they were cool), Daniel Kahneman and Amos Tversky.? They found that losses delivered roughly three times the pain, when compared to pleasures of an equal-sized gain.? (Side note: this has many applications, and in our day and age, most of them are politically incorrect.? As investors, though, we know it — avoiding losses is a better motivator than seeking gains.? At least, those that avoid losses stay in the game.)
Look, I see it in myself.? I tend toward the negative in this era, because I think it is under-told.? Would it surprise you if you knew that I was one of the more bullish guys in my last three firms (1998-2007)?? But even if under-told, there is something that always makes the bear case sound smarter.? Skeptics almost always seem smarter than optimists.? But, the optimists usually win, except when there is war on your home soil, famine, plague, or extreme socialism.
Where does that leave me?? It leaves me with rules.? I have trading rules.? I have asset allocation rules.? I can lean against something that I think is wrong, but I can’t put all of my weight on it.? I listen to the Sirens, but I tie myself to the mast.? Discipline trumps conviction.
So, to close, I offer an old CC post to illustrate:
I Listen to the Sirens, but Like Ulysses, my Hands Are Tied to the Mast
12/27/2006 2:31 PM EST
When I had dinner with Cody two weeks ago, he asked me (something to the effect of): “If we have so many problems, why are you so net long?”
I told him about a hedge fund friend of mine who let his bearishness drive his macro bets over the last four years. The only thing that has bailed him out is that his analysts are really good stock-pickers… their fund has been in the plus column despite being an average of 25% net short, but not positive by much.
I tie my hands when it comes to asset allocation policy. After determining what I think the neutral policy should be for someone that I advise, I allow myself to tweak it by no more than 10% to reflect my overall levels of bullishness or bearishness. This keeps my emotions from taking over, and protects me and those that I manage for.
Besides, absent a major war on home soil, or a Communist takeover, markets have a tendency to eventually bounce back. (even if the bounce takes 25-odd years, as in the Great Depression). The question is whether one’s asset allocation is conservative enough to be around for the “bounce back.” So, it generally pays to play along with the optimists in the long run. Or, as Cramer has said, the bear case always sounds more intelligent. That can trap bright people who let legitimate fears of something that may happen a ways out get treated as a clear and present danger.
At present I am slightly bullish on the US markets and think that 2007 will produce moderate gains, 5-10%. There are things to worry about, but don’t let it blind you to opportunities that will emerge if disaster doesn’t happen. Instead, diversify. Stocks and high quality bonds. (Maybe even some municipal bonds.) Domestic stocks and foreign. There are ways to reduce risk that don’t cost that much in terms of performance. Use them, and don’t worry about the big, bad event. That event will happen, but it will usually be further out, and less bad than expected.
I am always reminded when I see the myriad negative articles about macro issues that you must be like Ulysses — you have to tie yourself to the mast and plug your ears — if you are really going to make money. The parade of horrible worries is so loud and so seductive that the toughest thing to do is to stay the course. And the toughest thing to do is almost always the most lucrative.
I asked him via e-mail whether he had read my piece, and he said he had not. Quite a coincidence. Before I asked him, though, I wrote this response:
I am always reminded when I see the myriad negative articles about macro issues that you must be like Ulysses — you have to tie yourself to the mast and plug your ears — if you are really going to make money. The parade of horrible worries is so loud and so seductive that the toughest thing to do is to stay the course. And the toughest thing to do is almost always the most lucrative.
At my last firm, we conflated two maxims into: “Great minds think alike, but fools seldom differ.” Jim and I disagree on housing. In this case, though I still have many reasons to be bearish on housing, I don’t let it affect my investing to any great degree. For my broad market portfolio, I still own Cemex, Lafarge, and St. Joe. I even own a mortgage REIT, Deerfield Triarc. I’m not bullish on the consumer, but I still own Sonic Automotive and Lithia Motors.
The point is, it’s too easy to say “I’m too worried about the macro environment,” or, “I can’t find anything cheap enough to buy.” Will there be down years? Yes. Might the first decade of the 2000s have a negative total return? Possible, but unlikely. Like the farmer in Ecclesiastes 11, we have to cast the seed into the muddy spring soil, and not worry about the bad weather that might come. Diversification reduces risk, but not taking risk is possibly the biggest risk of all. The advantage belongs to those who take prudent risks.
Now, after all this, if you still want to worry, the biggest risks among the somewhat likely risks out there a breakdown in global trade and an error in Fed policy. I watch these things, but I’m not losing sleep over them.
PS — regarding Ulysses, he put wax in the ears of his sailors, but he tied himself up so that he could listen to the Sirens, but not do anything… it’s a tough discipline to maintain, but it helps me do better in the markets.
Position: Long CX LR JOE DFR SAH LAD
A very different era, that, but I am now bearish, and Cramer is still bullish.? I try not to change my positions often, and even then, I limit my behavior.? Discipline triumphs over conviction.
I’ll write something more about Fannie and Freddie at a later time.? Things have worked out there largely as I expected.
What I did not expect is that the market would be up a lot on a day like today.? I did expect that Treasuries would be down.? After all, there are more claims on the Treasury now than before.
Why should the market be up?
The possibility of lower mortgage rates, which will help those that can put money down on a new home, and those that can refinance within conforming limits.
Risk is shifted off the balance sheets of lending institutions that held the senior debt of the GSEs.
A big uncertainty is resolved.? (And the next uncertainty has not arrived… yet.)
Now, as for me, I am probably having my best relative outperformance day ever, and it is due to one stock in my portfolio: Gehl.? As the AP says, “Construction and farm equipment maker Gehl Corp. said Monday it is being purchased by its largest shareholder Manitou BF SA for $450 million, or $30 per share.”? 120% premium to the Friday close.? I can live with that. 🙂
I don’t play for takeovers, particularly not in this environment where financing is scarce.? But in value investing, if you have reasonable financed assets trading at a discount to their value, takeovers will sometimes come, though rarely at premiums like this deal.? Wow.
There’s one more thing I would like to point out here.? I sometimes get a little criticism for not having an automatic sell rule.? My first purchase of GEHL was around $20.? I averaged down twice.? Each time I reviewed the position, and concluded financing was adequate, though short-term earnings did not look promising.? I concluded that over a 2-3 year timeframe, I would probably be rewarded, or not lose much.? If I had used a mechanical sell rule, I would not have gotten the good side of Gehl.? (And, for those that keep score, this gain almost pays for the loss in Deerfield.)
That’s how it goes.? I could not predict this incident, and I have enough bad things that happen that I also can’t predict.? But in a well-diversified portfolio of cheap, well-financed stocks, there can be room for good surprises.? I just happened to get a big one today.? (And, it puts me in the plus column for YTD performance.? What a tough year for the market.)
Full disclosure: Flat GEHL — my limit orders got lifted as I wrote this…
Of the 35 stocks in my portfolio, only 4 lost money for me in May: Magna International, Group 1 Automotive, Reinsurance Group of America, and Hartford Insurance.? My largest gainer, OfficeMax, paid for all of the losses and then some.
I am only market-weight in energy, so that was not what drove my month.? Almost everything worked in May: company selection, industry selection, etc.? My other big gainers were: Charlotte Russe, Helmerich & Payne, Japan Smaller Capitalization Fund, and Ensco International.? I have often said that I am a singles hitter in investing — this month is a perfect example of that.
Now, looking at the year to date, I am not in double digits yet, but I am getting close — I am only 3.6% below my peak unit value on 7/19/07.? My win/loss ratio is messier: 15 losses against 32 wins.? It takes the top 5 wins to wipe out all of the losses.? The top 5: National Atlantic, Cimarex, Helmerich & Payne, Arkansas Best, and Ensco International.? Energy, Trucking, and a lousy insurance company that undershot late in 2007.
The main losers: Deerfield Triarc (ouch), Valero, Royal Bank of Scotland, Avnet, and Deutsche Bank.
I much prefer talking about my portfolio than individual stock ideas, because I think people are easily misled if you offer a lot of single stock ideas.? I have usually refused to do that here; I am not in the business of touting stocks.? I do like my management methods, though, and I like writing about those ideas.? If I can make my readers to be erudite thinkers about investing; I have done my job.
So, with that, onto the rest of 2007.? I don’t believe in sitting on a lead — I am always trying to do better, so let’s see how I fail or succeed at that in the remainder of 2007.
PS — When I have audited figures, I will be more precise.? You can see my portfolio, for now, at Stockpickr.com.
Full disclosure: long VLO AVT NAHC XEC HP ESV MGA GPI RGA HIG OMX CHIC JOF
