Until you learn to accept it, it is painful for many fundamentally driven investors to accept trends that are short-term rational, but long-term irrational. (And, much as it hurts my fingers to type this, technicians don’t have that problem… they have other problems though.)

Tonight’s topic is private equity. There has been a cascade of bits and bytes splattered across the web on this topic, so I thought I would try to give a well-rounded picture, together with my views on the topic. Let’s start with the bull case:

Who better to start with than my colleague Jim Cramer? Two articles:

1. Fear Not the Private Equity ‘Bubble’, and
2. Five Reasons Private-Equity Deals Keep Going.

Let’s take the latter article. What were his five reasons?

Funny; it [DM: the private equity wave] will end. But not before many things happen, including these five:

1. Interest rates on the long end going to at least 6%-7%. At that point, I believe it will get too risky.
2. The equity market being closed to the IPOs of the companies that need to be flipped. It’s wide open right now.
3. Not one, not two, but maybe three or four, or even five deals going bust. Can’t we wait for even one to go belly-up before we get too nervous?
4. Valuations ramping up more. With the S&P 500 selling for about 17.5 times next year’s earnings, there is plenty of room to keep buying.
5. Private equity funds running out of money. Very unlikely.

He has made the case exceptionally well as to why Private Equity should continue to be a factor in the market in the short-to-intermediate run. Here are two other pieces that make a similar case, which can be summarized like this: if there is a positive spread between the forecast earnings yield of a company, and the interest rate at which we can finance the purchase of the company, then it is rational to take the company private.
It’s at times like this that my inner actuary comes out and says, “Hey, what about a provision for adverse deviation?” That is, how much can go wrong, and still make this deal work? My inner financial analyst asks a slightly different question, “Will you need additional financing later, even if it is selling off the company? What if financing or selling is not available on today’s advantageous terms?”

The private equity folks will say that the high debt levels force success; there is no room for error, so we will work like crazy to make it work. As for financing, there are always windows of opportunity within a reasonable time span. There is no reason to worry.

Now not all deals work out, despite the best efforts of the new private owners. Most are marginal with a few celebrated home runs. During mania times, buyers definitely overpay. As an example, you can see how badly Daimler Benz did in its purchase of Chrysler. Will Cerberus do as well? I am not as bullish as the BW article, but it is clear the Cerberus does not have as much at risk as Daimler. Where I differ is that it will be harder to shed liabilities and reduce costs than the article implies.

At present there aren’t a lot of hot problems in private equity deals. There are financing difficulties, like KKR finding it hard to get additional private equity investors. Institutional investors like to be diversified, which always makes it tough for the biggest players in any asset class to get financing. Aside from that, the risks from doing deals are in the future.

At present, there is a lot of cash to finance private equity for both debt and equity commitments. Today it is rare to find assets that cannot be refinanced. There are more vultures than carrion. There have also been many articles pointing out that amid the flood of financing, the leverage has been going up, and the interest coverage down.

These are not the problems of today, so bulls ignore it and bears get frustrated. These will be problems, just not yet. What if real interest rise? Well, that will affect the ability to re-IPO the company, but it won’t absolutely stop a deal today. What if interest rates rise simply due a bond bear market, whether due to inflation, or global competition for capital? That will affect new deals, making it harder for them to get done, and sale multiples will fall on companies that the private equity folks try to sell.

Perhaps the effects are reversed here. Maybe private equity troubles will be a harbinger of the next junk bond bear market. Could be; after all, one weakness of being private is that tapping the public equity markets is not an easy option, much as that can be valuable when times are about to get tight.

Here’s my verdict. In the short run, almost anything can work. When debts go bad, it typically occurs because the company chokes on paying the interest, not the principal. Private companies that can pay the interest will likely survive to make some money for their private equity sponsors. But many will over-borrow, and in a recession, or in an industry or company downturn, will find that they no longer have enough cash to make the interest payments, and possess limited options for refinancing. Multiple defaults will happen then; think 2009, give or take a year.

But maybe it takes until 2012. If so, perhaps this letter from the future will seem prescient in hindsight. Private equity is not a bubble today; history may judge it to be a mania. To my readers I say be careful, and stick with higher quality bonds and stocks.

The move in the bond market today was pretty violent. I briefly wondered how notable the move was relative to history, and I found that we have seen much worse moves in the past. Examples:

1. Early 2004, when the market realized that the FOMC was going to have to tighten.
2. Summer 2003, when we got a self-sustaining selloff in the market when we realized that fed funds would not be 1% forever, and mortgage hedgers forced an overshoot.
3. Spring 2003, when the FOMC hinted that it would cut to 1%, and actually did it.
4. 2002, when the FOMC was aggressively cutting the fed funds rate.
5. And more… I could go back a lot further, but moves of this level of violence occur about once a year on average. Since the start of the FOMC tightening cycle, things have been calm, and predictable, lulling investors into a false sense of security. That security has just gotten shaken.

Over at RealMoney, except for Tony Crescenzi, there aren’t many who know much about
bonds. A lot of the writers there are paying attention to bonds, but it is basically a black box, or a technical model to them. In this piece, I will try to explain the four factors playing tug of war with the long end of the bond market, and what the prevailing effect is likely to be over the short and intermediate terms.

Convexity

The largest component of the bond market is residential mortgage backed securities [RMBS]. Residential mortgages shorten when rates fall, because people refinance; when rates rise, fewer people than previously expected refinance, and people take longer to pay off their mortgages. A bunch of similar residential mortgages get gathered into a trust; participations in that RMBS trust are sold to institutional investors.RMBS is a complicated security to manage from an interest rate standpoint. Originators of the mortgages have to hedge them before they sell them off to investment banks who will turn them into RMBS. Many bond managers like to own RMBS for its high credit quality, liquidity, and attractive yields, but the problem is this: when interest rates move, the RMBS does what you don’t want to see happen. When rates fall, the bonds prepay, and you have to reinvest at lower rates. When rates rise the bonds pay slowly; you’d like to have more cash to reinvest at the higher rates, but the RMBS pays slowly.

This effect of shifting cash flows working against the owner of the mortgages or RMBS is called negative convexity. Basically, the owner has written a covered complicated bond call option. Anyone option writer receives a premium (extra yield), but must sell his investment if it goes into the money. If the investment stays out of the money he keeps the premium and the depreciated investment.
The mortgage originators and the RMBS holders want to limit the effect of the options that they have written, so they hedge. They can do that in three ways. I’ll use the example of hedging rising rates:

1. Sell or short long Treasuries to lower overall exposure to rising rates.
2. Sell RMBS that is lengthening, and replace it with RMBS that is less sensitive to rising rates.
3. Enter into a swap where you pay a fixed rate for a number of years, and receive (floating) three month LIBOR over the same period.

Now, when rates rise or fall by a lot, mortgage hedging tends to reinforce the move, making falls and rises sharper. The effect depends on the configuration of the rates that people are paying on mortgages across the US. Negative convexity is highest on mortgages the are near the current mortgage rate for new loans. (At the money) At present, most prime mortgages are now below the current mortgage rate. I estimate that 20% are above and 80% below. What that implies in the current situation, is though mortgage hedging has had a big impact in the move so far, its effect should diminish dramatically from here, and almost disappear if the ten year gets up into the 5.50-6.00% range. Compare this to an era like 1994, where at the start of the move 10% of mortgages were below the current mortgage rate, and 90% above; it’s no wonder that move was so devastating. From the convexity effect, it should not be that bad here.

The Fed

We finally reached the fifth stage of grieving on the expected FOMC rate cut. The market has accepted that no cut is coming in 2007. This makes me edgy because that had been my view since December, and when the crowd crashes my lonely party, I have to ask, “Okay, now what? When and what is the next FOMC move? What is the crowd missing?”
Honestly, I don’t know, at least not yet. The FOMC is happily balanced between a variety of concerns, and I think it leaves them in a state of noisy inaction. Right now I think they will stand pat for as long as they can justify it. The effect on the bond market been to de-invert the curve, with the long end rising significantly. From here, though, unless the probability significantly increases that the FOMC will tighten, the effect on long rates is done here and now.
Overseas Money Flows

The current account deficit must be matched by a capital account surplus. The books have to balance! The only question is at what price (exchange rate) that the market clearing balancing will occur at. Partially due to the new view of FOMC policy, the dollar has strengthened over the last month, as foreign investors think that US rates will remain high for a while. But the varying currency policies of different countries will have an impact on the overall path of the dollar, and interest rates. Here are some bits of news affecting the question:

1. South Korea continues to let the won rise, depressing the economy, but limiting local inflation. Also, they don’t have to buy as many US dollar assets.
2. India has acted similarly with the rupee, which is having an effect on its competitiveness, but is reducing local inflation.
3. Thailand had to let its currency appreciate against the US dollar because of rampant speculation.
4. Other countries like Russia and some of the Gulf states are reducing exposure to the US dollar.
5. Not everyone is reducing exposure to the US dollar, though. Most of the Gulf states still recycle petrodollars at the same rate as before, and China still uses the dollar as its linchpin in its currency system (which is just a dirty crawling peg). Now, this is leading to inflation in China, and a potential crisis, but so far, nothing is imminent, and that should continue to have a depressing effect on US interest rates, and retard the fall of the dollar.
6. Growth is proceeding better outside of the US, which should put downward pressure on the dollar and upward pressure on rates.
7. The two main carry trade currencies, the Japanese Yen and the Swiss Franc, are still at low levels, with low but increasing interest rates. There is atill a lot of speculative borrowing going on in both currencies, both locally and abroad, which is depressing the exchange rates. Eventually this will end with the Yen and the Swaissie rallying, but that could take a while.

So long as enough foreign entities are comfortable providing goods and services to the US, which taking back financial promises, there will continue to be downward pressure on rates, and the dollar will muddle. Woe betide us when they tire of giving us such nice treatment.
Yields and Real Yields

Having been a bond manager at a major insurance company I have experienced being a yield buyer. A yield buyer is willing to buy more bonds at higher yields, all other things equal. A real yield buyer is willing to but more bonds as the inflation-adjusted yield rises. Well, we are at levels on the ten year Treasury yield that we have not seen in five years. Yield buyers should become increasingly interested, which should moderate any increase in yields. Similarly, certain types of bond issuance should slow, as some projects will no longer justify paying the higher yield to finance the deal.
Real yields are another matter. As real yields rise, defined benefit pension plans and endowments buy more. But how much is inflation rising? It’s hard to say; our trade with developing nations decreases our inflation rate; some suggest that that might be coming to an end as inflation rises in the developing countries. My suspicion is that inflation is higher than the government says it is, but is not increasing much at present.

My upshot here is that up 0.25-1.0% in yield from here, assuming modest increases in inflation, we would see a lot of incremental buyers for bonds. We would also see fewer issuers.
Summary

Of my four effects, convexity is a spent force soon. The FOMC is likely on hold, so that effect is largely over, unless I am wrong. If rates rise, I expect yield and real yield buyers to arrive. The wild card is the foreign investors; if more countries revalue their currencies upward versus the dollar, reducing exports to the US, and reducing the need to buy our debt, then interest rates could easily rise by another percent. I don’t think that will happen, but it is the major risk here.

Absent negative foreign developments, I will get more bullish on the long end around 5.50% on the ten-year Treasury. Until them, I with with my positions, and clip the coupons; I don’t expect the rise to be severe, but will invest more on weakness.

Full disclosure: long TLT, FXF, FXY, and the rest of my bond portfolio is over at Stockpickr.com.

PS — It is not obvious to me that the current correlation between the stock and bond markets will maintain. I expect stocks to do better, relative to bonds, in the short term.

Some housekeeping before I start. My post yesterday was meant to be a “when the credit/liquidity cycle turns” post, not a “the sky is falling” post. Picking up on point number 4 from what could go wrong, I would refer you to today’s Wall Street Journal for two articles on LBOs that are not going so well, and the sustainability of private equity in the current changing environment. Please put on your peril-sensitive sunglasses before reviewing the credit metrics.

In the early 90s, as 401(k)s came onto the scene, savings options were the hot sellers to an unsophisticated marketplace. Because of the accounting rules, insurance contracts could be valued at book, not market, and so Guaranteed Investment Contracts [GICs] were sold to 401(k) and other DC plans.

The difficulty came when companies that issued contracts failed, like Executive Life, Mutual Benefit, Confederation, and The Equitable (well, almost). A market that treated all contracts equally was now exposed to the concept that there is such a thing as credit risk, and that the highest yielding contract is not necessarily the one that should be bought.

In the mid-90s, that was my first example of market maturation, and it was painful for me. I was running the Guaranteed Investment Contract desk at Provident Mutual, and making good money for the firm. We survived as other insurance companies went under or exited the business, but as more companies failed, the credit quality bar kept getting raised higher, until we were marginal to the market. Confederation’s failure was the last nail in my coffin. I asked my bosses whether I could synthetically enhance my GICs by giving a priority interest to the GIC-holders in an insolvency, but they turned me down, and I closed down an otherwise profitable line of business.
Failure brings maturity to markets, and market mechanisms. When a concept is new, the riskiness of it is not apparent until a series of defaults occurs, showing a difference between more risky and less risk ways of doing business. Let me give some more examples:

Stock Market Leverage: How much margin debt is too much, that it helps create systemic risk? In the 20s leverage could be 10x, and the volatility that that policy induced helped magnify the boom in the 20s, and the bust 1929-1932. Today the ability to lever up 2x (with some exceptions) is deemed reasonable. If it is not reasonable, another failure will teach us.

Dynamic Hedging: In the mid-80s, shorting stock futures to dynamically hedge stock portfolios was the rage. After all, wasn’t it a free way to replicate a costly put option?

When it was first thought up, it probably was cheap, but as it became more common the trading costs became visible. For small price changes, it worked well. Who could predict the magnitude of price changes it would be forced to try and unsuccessfully hedge? After Black Monday, the cost of a put option as an insurance policy was better appreciated.

Lending to Hedge Funds: I’m not convinced that this lesson has been learned, but if it has been learned, the crisis from LTCM started that process. After LTCM failed, counterparties insisted more closely on understanding the creditworthiness of those that they expected future payments from.

Negative Convexity: Through late 1993, structurers of residential mortgage securities were very creative, making tranches in mortgage securitizations that bore a disproportionate amount of risk, particularly compared to the yield received. In 1994 to early 1995, that illusion was destroyed as the bond market was dragged to higher yields by the Fed plus mortgage bond managers who tried to limit their interest rate risks individually, leading to a more general crisis. That created the worst bond market since 1926.
There are other examples, and if I had more time, I would list them all. What I want to finish with are a few areas today that have not experienced failure yet:

1. the credit default swap market.
2. the synthetic CDO market (related to #1, I know)
3. nonprime commercial paper
4. covenant-lite commercial loans, particularly to LBOs.

There is nothing new under the sun. Human behavior, including fear and greed, do not change. In order to stay safe in one’s investments, one must understand where undue risk is being taken, and avoid those investments. You will make more money in the long run avoiding foolish risks, than through cleverness in taking obscure risks ordinarily. Risk control triumphs over cleverness in the long run.

One of my readers, Steve Milos, asked me the following question:

Free cash flow is a metric that I like to use when judging investments in most types of companies. However, I’m not sure how to apply it to insurance companies, or even how to calculate it, given the uncertainty of claims. Do you use it? How do you calculate it? Currently, I’ve used P/E, P/Book, dividend yield, combined ratio as metrics for insurance companies instead.

Before I start, for those that have access to RealMoney, I would refer you to the following two articles:

Parsing the Financials of the Financials, and

Time to Get Personal with Insurers (free at TSCM).

Quoting from a recent article at RealMoney:

The free cash flow of a business is not the same as its earnings. Free cash flow is the amount of money that can be removed from a company at the end of an accounting period and still leave it as capable of generating profits as it was at the beginning of the accounting period. Sometimes this is approximated by cash flow from operations less maintenance capital expenditures, but maintenance capex is not a disclosed item, and changes in working capital can reflect a need to invest in inventories in order to grow the business, not merely maintain it.

And quoting from the first article that I cited above: The cash-flow statement is of great use in gauging the health of industrials and utilities, but it tells us next to nothing about financials. One of the best values of cash-flow statements is that they enable one to attempt to derive estimates of free cash flow (the amount of cash that a business generates in a year that is left over after it has paid all of its expenses, including capital expenditures to maintain its existing business). Deducting maintenance capital expenditure from EBITDA often approximates free cash flow.

However, cash-flow statements for financials can’t in general be used to derive estimates of free cash flow, because when new business is written, it requires capital to be set aside against risks. Capital is released as business matures. In order to derive a free cash-flow number for a financial company, operating earnings would have to be adjusted by the change in required capital.Sadly, the change in required capital isn’t disclosed anywhere in a typical 10K. Even the concept of required capital can change depending on what market the financial institution is in and what entity most closely controls the amount of operating and financial leverage it is allowed to take on.

Federal or state regulators sometimes impose the biggest constraints on leverage — this is particularly true for institutions that interact closely with the public, i.e., depository institutions and life and personal-lines insurers. For companies that raise capital in the debt markets or do business that requires a strong claims-paying-ability rating, the ratings agencies may lay on the tightest constraints.

Finally, in rare instances of loose regulatory structures, the tightest constraint can be the company’s calculation of how far it can push its leverage before it blows up. Again, this is rare; many companies estimate the capital required for business, but regulatory or rating agency standards are usually tighter.

Actuaries have their own name for free cash flow. They call it distributable earnings. It is equal to earnings less the change in capital necessary to support the business. When sales are growing, typically distributable earnings are less than earnings. When sales are shrinking, typically distributable earnings are more than earnings.

As pointed out in the second quotation above, the hard part is knowing what entity requires the most capital to be held against the business. Is it the regulators, the rating agencies, or the company itself? The tightest constraint determines the capital that is required.

The second part of what makes it hard is that the capital standards for the rating agencies are dimly known to outsiders. Internal company capital standards are not known to outsiders either. Finally, the regulatory standards for capital are known but complex. The formula is known, but not all of the data that goes into the calculation is public. A further difficulty is that different companies run at different percentages above the minimum capital standards, and typically, that is not disclosed.

Aside from that, there is the problem of whether the reserves are fairly stated, but the nuances of that are beyond this discussion. What can an insurance analyst do to get something near free cash flow?

Ask questions on leverage policy. Ask the company how they decide what the maximium amount of business they could write next year is. Premiums-to-surplus? Statutory net income/loss limits? How much more could you borrow at the holding company at your current rating? Questions like this cut through the clutter of what you don’t know, and allow you to estimate how much capital they will have available to increase dividends, buy back stock, or buy other strategic assets. You can also read reports from the ratings agencies, since they focus on this.

In practice, I have a “back of the envelope” feel for how loose or tight capital is at firms that I analyze. I spend more time on pricing power, since it correlates better with stock price performance in normal situations. I look for the sustainability of underwriting margins. I also graph Price-to-Book versus Return on Equity, looking for companies that earn a lot on their net worth, and have a reasonable chance of sustaining those earnings.

I hope that helps explain how to analyze insurance companies, approximating some aspects of free cash flow. If you have a question, pose it below so others can benefit from your question and my answer.

This is post 100, as Wordpress counts. I am going to take a brief break from writing about the markets to write about the first two months of blogging.

First, this blog is not what I would like it to be yet. I have many more things to build out, but given my responsibilities as a husband and father, I can’t go overboard. I have to serve my employer as well, and for that matter, Realmoney.com.

Speaking of RealMoney.com for just a moment, this blog might not have come into existence were it not for the example of Barry Ritholtz, the encouragement of Cody Willard, the encouragement of various readers at RealMoney, and the neglectfulness of one of the editors there, who I made the offer to of a blog/newsletter, and after promising to get back to me, he did not get back to me. After three-plus years of writing there, I expected more. (Particularly since Jim Cramer was kind enough to recommend me to the editor in question. Anyone who thinks Cramer controls the editorial side of TSCM doesn’t know what he is talking about.)

Many, but not all of the things that I used to write in the Columnist Conversation are now getting written here as a result. I am internally debating as to where to put my comments. Here I might get some compensation for them, whereas at RealMoney I don’t get any compensation. I’m grateful to Cramer and RealMoney for the opportunity, but with work getting busier, it is easier for me to blog at night, rather than writing in the day.

Friends help in blogging. I particularly want to thank James Altucher, Roger Nusbaum, Jeffrey A. Miller, Bill Luby, and Abnormal Returns for the help in getting noticed. I also want to thank the editors at RealMoney who put up with me mentioning my blog several times in the first week of its existence.Business opportunities come as you blog. Newstex is indexing the content of my blog for its readers, and I get a percentage of the revenues. A fellow trying to start an individual health insurance company wants me to be his chief investment officer; first let him get assets to manage, and we can discuss it (It is a very interesting opportunity). Insurance Journal is using some of my insurance posts. I signed up early with Seeking Alpha and Technorati to increase my visibility. I’ve talked with some value investing blog aggregators, but nothing has come of it really.What I would love to be able to do would be to work from home. My commute is horrible, and I would like to spend more time with my family. I have about 20 takers if I started a newsletter, but that’s not enough to get off the ground. I would need at least 100 before I would start doing a newsletter.

Ability to reference free articles that RealMoney has syndicated to Yahoo!, etc., has been another source of exposure. All in all, I’m happy with the first two months, and am looking forward to yet more fun with my readers and collaborators. Do you have feedback for me on what I have been doing here? E-mail me, or just post a comment to this article. Above all, thanks for reading!

PS — If you like what I write, recommend me to other well-known bloggers. If you like how I invest, and you have a wealthy friend who might like to seed a low risk equity manager, recommend me to him. Thanks again.

The Wall Street Journal had two bits on international diversification: a poll, and an article. Both were good as far as they went, but the past outperformance of international over domestic stocks doesn’t help us analyze which will be better in the future. That macro question is hard, particularly because once a streak gets long, it gets more touchy to be long. But let’s look at a “micro” angle on foreign investing.

One of the reasons to invest abroad is to diversify currency risk. Let’s pretend for a moment that we know the dollar is going down over the next few years. What stocks would I buy? I would buy foreign companies that import US goods (costs are getting cheaper), foreign companies that are purely local (earnings stream rising in dollar terms), and US companies that export (sales should rise as the dollar falls).

Now let’s pretend for a moment that we know the dollar is going up over the next few years. What stocks would I buy? I would buy foreign companies that export goods to the US (sales should rise as the dollar rises), US companies that are purely local (earnings stream rising in foreign currency terms), and US companies that import (costs are getting cheaper).

All that said, foreign investing is more complex because of:

• Expropriation risk
• Different accounting standards
• Often less disclosure
• Poor corporate governance (US investors don’t know how good they have it, or on the negative side, SOX chases foreign firms away from US listings.)
• Inability to get fair redress in the courts
• Language issues
• Foreign trading costs if not listed in the US.
• War
• Exchange controls

As for me, I am mainly country-indifferent in investing. I agree with John Templeton, who said something to the effect of: “Buy the cheapest companies in a given industry.” I do look for the “rule of law,” though. Just as when we buy shares in a company, we check to see how they treat outside passive minority shareholders, with foreign firms, we have to go a step further, and ask how the country treats foreign outside passive minority shareholders.

With bonds the issue is simpler, because it boils down to yield, currency and repayment issues. The challenge there is to understand what will drive the relative forward interest rate policy between countries. In the intermediate term, it is better to invest in currencies where the central bank is tightening, particularly if there are any “surprise” tightenings.

I believe in international diversification; in general it is a good thing. But it should not be done blindly; investors should consider the factors that I have mentioned above, if not more factors.

Well, my RealMoney column from April 9th got republished on the free site, and got syndicated out to Yahoo! as well. When I write a piece where I mention a company, like Assurant, it’s fun to see the piece appear on the Yahoo! news. But when I don’t mention a ticker, I know that if they put it on the free site, I know they also syndicate it out to Yahoo!, and a number of other places as well. I get amazed at times where my stuff ends up. Well, I hope it makes money for them, and most of all, I hope it benefits those who read it.

That’s particularly true for this piece, because it focuses on risk control in a very direct way. Too many market players don’t realize that risk control is a way to make more money on average over the long term. How does that work?

1. It keeps you in the game. Absent war on your home soil and aggressive socialism, being an owner in society is a winning strategy over the long haul.
2. Rebalancing allows you to pick up an incremental 2-3% annually on average. It forces you to buy low and sell high.
3. There will be drawdowns. You will get drawn down less, and if you stay with strong companies in industries that have previously underperformed, when the bottom arrives, you will outperform the market.

I view risk differently than most market players, and than almost all academics. Risk means trying to avoid loss on every name in my portfolio, not avoiding loss on the portfolio as a whole, and certainly not standard deviation of returns, or even worse, beta.

“Don’t keep all your eggs in one basket.” True enough. “Keep all your eggs in one basket, and watch that basket carefully.” Also true. “Watch every egg.” That’s what I try to do. I’m a singles hitter, not a home-run hitter with attendant strikeouts. I try to make money on every company, by following my eight rules. That doesn’t guarantee success, but my losers over the last 6.5 years have been less than 10% of the names that I invested in. And, in each case where I lost, the error of judgment came from neglecting one of the eight rules.

All that said, I encourage you to focus on risk control. It’s a lot easier to make money if you don’t lose it.

Full disclosure: long AIZ

An article in Friday’s Wall Street Journal described the creation of new closed-end funds dedicated to the production of yield. I am simultaneously horrified at the concept, and yet wondering whether I couldn’t create one with multiple strategies to smooth out the difficulties of single strategy yield creation. I could buy:

• unusual bonds with high yields.
• certain fixed income closed end funds at a discount.
• dividend paying stocks, and occasionally (ugh) preferred stocks.
• non- or low dividend paying stocks that fit my eight rules, and sell out-of-the-money calls against them.
• lever the fund by borrowing at LIBOR.
• Use my mean reverting REIT, utility, LP strategy. Backtests have it generating a 20% return annually, and I haven’t tweaked it.

The thing is, though, yield is a conceit. People like to think that they are merely scraping the income off of the portfolio, when in many cases, they are truly consuming capital, but the accounting doesn’t make it look that way. Think of a high yield fund with a single-B average credit quality. During good times, the full yield, and maybe a tiny amount of capital gains comes into income. During bad times, the yield shrinks, and capital losses get passed through. Over a full cycle, the NAV of a high yield fund shrinks.

Logical people would not invest in income vehicles like that, but invest they do. Two parting bits of advice. One, there is no reason to ever invest in a closed-end fund IPO. Closed-end funds should trade at a discount equal to the annual fee times five (or so). Two, be conservative in yield investing. It is little known that lower yielding REITs tend to outperform higher yielding REITs. The only time to stretch for yield is when everyone is scared. Even then be careful; make sure the yield that you are getting is secure.

Here’s the final list that I worked with in making my trades. Working up from the bottom of my list, I decide on what to sell. If I’m not selling something that rates low on my quantitative screen, I have to have an explanation as to why I am keeping it.

What I Am Not Selling

St. Joe – This doesn’t score well. The idea here is the land is considerably more valuable than the share price would indicate.

SPX Corp, Sara Lee – These are still in turnaround mode. Metrics don’t look good now, but should improve.

Sappi – Value of underlying assets not reflected in the metrics. South Africa is also out of favor.

Dow Chemical – it’s still cheap, and there are probably transactions that can unlock value.

DTE Energy – My one US utility. Would benefit from a sell-off of their energy production arm. I might be close to selling, but am not there yet.

Premium Standard – The merger with Smithfield will go through, and Smithfield will be able to take out costs. They might also gain a wee bit of pricing power. I think cost pressures have reached their maximum here, and profits will improve more than street estimates.

What I Am Selling

ABN AMRO – Barclays may do the deal or not. ABN Amro is fully valued here, and then some.

Devon Energy and Apache – I like them both, but their valuations have risen, and I have other places to deploy money.

What I am not Buying

After this, I look from the top down, and look for replacement candidates from the list. If I reject a highly rated name, I have to have a reason:

Group 1 Automotive – I already have Lithia Motors and Sonic Automotive. It’s in less desirable areas of the country, so I will pass on it for now, but will revisit it at a later date.

Georgia Gulf – It’s cheap, but I worry about the balance sheet, and I already own Dow and Lyondell.

Thornburg Mortgage – Would give me conflicts of interest with my employer.

Optimal Group – This is the most interesting of the ones that I did not buy. They have some interesting payments technologies, but the earnings estimate momentum was negative, and I could not really discern what competitive advantages they had.

Encore Wire – A bit of a cult stock. I just don’t like the business that they are in.

Arkansas Best, P.A.M. Transportation – I own YRC Worldwide, and these are not appreciably cheaper.

Foot Locker – Too many earnings disappointments.

Spectrum Brands – Lousy set of brands, and a poor earnings history.

Stolt Neilsen – I own Tsakos, and I think it has better growth prospects.

National Coal – Too small.

Home Solutions of America – I don’t like their business, given my view of the housing market.

What I am Buying

Bronco Drilling – Seems to be a cheap land driller, and replaces some of the exposure I lost selling Apache and Devon.

Komag, Nam Tai Electronics, Vishay Intertechnology – Cheap technology stocks that are near the beginning of the technology food chain. The businesses are more stable than those who buy their products.

Full Disclosure: long VSH KOMG NTE BRNC BCS LAD SAH DOW LYO JOE SPP SPX SLE DTE PORK YRCW TNP

I was a little ahead of the market yesterday, say 10-15 basis points ahead of the S&P. Leading the charge were Fresh Del Monte (my current largest loser), and Grupo Casa Saba (what a great undiscovered stock). Fresh Del Monte was upgraded from underperform to neutral after their less bad earnings. Grupo Casa Saba reported excellent earnings. They run drugstores in Mexico, an excellent industry for a country with a growing middle class. For my balanced mandates, I kicked out the QQQQs that I bought yesterday. The rally wasn’t as big as the reduction in short term risk implied by the VIX.
At RealMoney.com, I had a post late in the day called, “What I Have Learned Over the Past 36 Hours.” It attempted to put forth a dozen things that have been revealed since the recent crisis hit. Here’s an explanation:

1. China sneezes; the world catches cold. If we needed any proof that America no longer solely dominates the global scene we saw it on Tuesday.

2. Systemic risk may or may not be a problem now, but a lot of people acted like it was a problem. Thus the rallies in the currencies used to finance the carry trades. The Yen and the Swiss Francs are good hedges here. I am more dubious about long Treasuries, though not long TIPS. (It was neat to see the rallies in the yen and swiss francs. Thne long bond fell more today than the carry trade currencies did.)

3. The current equity market infrastructure is marginal to handle the volume of the last two days. Given the nature of modern finance, major errors are not acceptable. I got off a couple of good trades as a result of the accident, but those trades were accidental as well.
4. The lack of human intermediaries with balance sheets leaves markets more volatile than before. It genuinely helps to have someone who can stop the market at certain volatile points, and then restart with an auction so that a fair level can be determined after news gets disseminated. Also, liquidity providers show their value in a crisis.

5. Algorithmic trading and quantitative money management is making stock price changes more correlated with one another than they used to be. Markets behave differently in normal times, and under stress. The methods that make money when the market is calm exacerbate volatility when market stress appears

6. Panic rarely pays.
7. Patience usually pays.
8. Diversification pays.
9. In a crisis, strong balance sheets and free cash flow are golden. During times of stress, these four bits of wisdom pay off. They protect an investor from his own worst temptations.
10. People want the Fed to loosen more than the FOMC itself does. The FOMC doesn’t care about weak GDP if labor employment is robust. The FOMC certainly doesnot care about te stok market unless i affects the banking system, which is unlikely.
11. The oscillator is not oversold, yet. Sad, but true. We have a decent number of days in the rear-view mirror that aren’t so bad. The intermediate-term panic level is not high.
12. What do you know? Cyclicals are cyclical. I’m just glad I didn’t get kicked worse yesterday. That’s the danger in playing cyclical names. I take my risk therethough, rather than in growth that might not materialize.

All this said, I feel well positioned for the next few trading sessions. I am working on my quarterly portfolio reshaping, which will take out a few companies, and replace them with cheaper companies in industries with more potential. Once I complete that analysis, you will hear about it on RealMoney and here.
Long SAB FDP