I have often wondered about how to rank sports teams.  This goes way back to when I was 10 years old, when I ran across a magazine at summer camp that purported to do this for NFL football.  And so I wondered for many years, looking at similar problems and wondering how a ranking of teams could be generated from a win-loss history.  I finally came to a conclusion when I played the Mogul Game.

The Mogul Game has 148 rich people, and they vary from the super-rich (Gates, Buffett, Ellison) to the not-so-rich (I think they got a kick out of putting Donald Trump at/near the bottom of the list, much as he boasts to Forbes that he is much wealthier than they calculate).

After playing the game idly for a little while, I concluded that if I wanted to win, I would have to capture and analyze data from the game in order to win it.  And so I did, recording who was richer than whom.  I went through four phases:

• Doing qualitative comparisons when I wasn’t certain of who was richer.  Who had the two parties beaten and lost to?
• Comparing the trial ranks when the difference was greater than 10.
• Looking at the highest ranked persons that a given set of contestants had won against, and the lowest ranked that they had lost to.
• Looking at the average of the highest rank won against and the lowest rank lost to as the best proxy for a contestant’s own rank, unless it violated the results of an actual contest.  In hindsight, I should have adopted that rule much earlier.

It took three days of off-and-on playing to master the game.  Not all that important, but as I mentioned above, the method can be applied with some modifications for ranking sports teams in an unbiased way.  The same could be applied to any competitive activity where there is a win/loss result.  There are two changes for other activities, though.  Games are not necessarily transitive.  Rich person A is richer than B.  B is richer than C.  A will always be richer than C.  In competitions, Team A can beat team B one day, and lose the next.  Also, Team A can beat team B, which can beat Team C, but C can beat A.  So, if I were doing this for baseball teams, my ranks would drive probabilities of one team beating another.

Why would this be necessary when one can simply inspect the win-loss percentages?  Teams with good records may have weak schedules, and this takes account of the strength of the teams played in assessing the strength of a team.  I’m not sure what they do with ranking College Football or Basketball teams, but this would be a more bloodless way of making the comparison.  Granted, it takes a certain number of contests before there is enough density of information to create a ranking, but given a list of wins and losses from an entire season, this method should be capable of ranking an entire league.

I know this is an odd post for me, but I found it to be an interesting project, and it does have other applications.  Thoughts?

In the Fall of 2005, I was at the Annual Meeting of the Casualty Actuarial Society in exotic Baltimore, Maryland.  The Keynote address was by Roger Lowenstein who did a talk on two topics.  Warren Buffett the great investor, and the looming problems from the demographic crisis.

At the end of what was arguably a good talk, he asked for questions.  No one raised their hands.  After a pause, he asked for questions again, and I raised my hand.  I commented that he should have given his talk to the Life actuaries — they are the ones concerned about longevity and health costs, and if he really wanted to do a favor for casualty actuaries, don’t talk about Buffett the investor — talk about Buffett the P&C insurance CEO.

He commented that he was asked to speak about the topic by the CAS.  I like Lowenstein, so if you are reading this Roger, my apologies for making the comment.

Warren Buffett on Business is one step closer to the book I would like to see — I would like to see a book on Buffett as an insurance CEO.  Buffett is a great insurance CEO, and deserves a lot of credit in that capacity.  (Warren, I doubt you are reading this, but if you would like me to write that book, please e-mail me.)

But Berkshire Hathaway is an insurance/industrial hybrid, unique among companies.  Warren Buffett on Business ignores Buffett the investor to take up issues that are just as significant: Buffett the business owner and manager.

The words in the book are Buffett’s.  The man who organized the book took Buffett’s words over the last 25-30 years, and organized them into categories regarding management issues.  The topics include:

• Berky acts like a partnership even though it is a corporation.
• Corporate Culture and Governance
• Competent Managers and Honest Communication
• GEICO and Gen Re acquisitions (personally I think Buffett got hosed moving to terminate financial contracts  at Gen Re rapidly.  There is a rule of thumb that says negotiations on illiquid contracts should be undertaken slowly, unless the other side is panicking.)
• Assessing and Managing Risk
• Compensating Management
• Time Management
• Crisis Management
• Acquisitions — Buffett gets to own a wide number of unique corporations, because the one selling out wants the culture preserved, and if the price is right Buffett will do that.
• Ethics in Business
• And more…

Both in the chapters and in the appendices, the words of Buffett shine forth as a way to manage corporations for the best long term results, even if things don’t work so well in the short run.

Quibbles

Much as I like the words of Buffett, I prefer a second voice adding analysis.  Let the words of Buffett star, but let someone else add color and history, because Buffett’s own words are not complete enough.

Also, an analysis of how Buffett managed the insurance lines of his enterprise would be welcome.  Even for those looking exclusively at investment issues, the insurance enterprises offered Buffett the balance sheet he needed to buy assets that could take a while to work out.

Who would benefit from this book: Any manager of any company would benefit from this book.  Buffett lovers, if you have read the last 25-30 years of annual reports from Buffett, and notable things he has said outside of that, you likely do not need this, unless you have specific questions on management that you want answered by Buffett, and you can’t remember what he said in the past.

For most of the rest of us, this will still be a valuable book.  If you want to buy this book, you can buy it here: Warren Buffett on Business: Principles from the Sage of Omaha

Full Disclosure:  I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.  Those that want to support me can enter Amazon through my site and buy stuff there.  Don’t buy what you don’t need for my sake.  I am doing fine.  But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.  Win-win.

This piece is one of my experiments where I try to straddle two different investment worlds in an effort to bring more understanding.  The two world are stable value funds and commodity ETFs.

Commodity ETFs have a hard job, in that they are supposed to replicate the returns on spot commodities.  Given the difficulty of storage, only a few commodities — gold and silver, can be physically stored — they don’t deteriorate.  Unlike government promises, they are uniquely suitable for being money.  (Sorry, had to say that.)

Other commodities require futures markets or off-exchange markets where swaps get traded.  The swaps introduce counterparty risk, which is a common risk in many currency and commodity-linked funds.  I’ve written about that before, along with criticisms of exchange-traded notes.

One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple.  “Buy the front month futures contract, and roll to the second month contract before the front month expires.”  Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy.

So, what do the other investors do?  They take the opposite side of the trade early, in order to make it more expensive to do the roll.  Buy the second month contract, and short the first.  As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract.  What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market.

Compounding Money Slowly

If you want to keep your money safe, and earn a little bit, what should you do?  Invest in a money market fund.  “Wait a minute,” some intrepid investor would say, “I can do better than that.  I don’t need all of my money for immediate liquidity.  I can ladder my funds out over a longer period.  I can invest surplus funds out to the end of my period, and earn a better yield, and over time, my funds will mature bit by bit.  I will have liquidity in a regular basis, and I will get a higher yield because yield curves slope up on average.”

Leaving aside the wrap agreements that a stable value fund buys, stable value funds build a bond ladder with and average maturity of 1.0 to 4.5 years.  Commonly, it averages around 2.0 years.

The funds could invest everything short and give up yield.  That would give them certainty, but lose yield.  That is what the commodity funds are doing.

What could go wrong?  There could be a large demand to withdraw funds when longer-dated contracts are priced below amortized cost, and the fund might not be able to meet all withdrawal requests.  So far that has not happened with stable value funds.

The Fusion Solution

Whether in war or in business, it is not wise to be too predictable; opponents will take advantage of you.  In this particular example, I would urge commodity funds to look at their liquidity needs over the next month, and leave an amount maturing in the next three months equal to 4-6x that amount.  Then spread the remainder of funds according to advantage, looking at the tradeoff of time into the future versus yield of the futures contracts versus spot.  Longer dated futures do not move as tightly with the spot markets, but they often offer more yield.

Ideally, a commodity fund ends up looking like a bond ladder, and as excess funds mature, they don’t get invested in the new front month contract, instead, they get invested in the longer dated contracts, near the end of the ladder, as a stable value fund would do.

This maximizes returns for the bond/stable value funds, and I believe it would work for commodity funds as well.  Please pass this on to those who might benefit from it.

A Closing Aside:

Back in the late 90s, I ran one of my interest rate models to try to determine what the best investment strategy would be.  I found that the humble bond ladder was almost always the second best strategy, regardless of the scenario, because it was always throwing off cash that could be reinvested out to the end of the ladder.

Again, please pass this along, and commodity fund managers that don’t get this, please e-mail me.  I will help you.

Since the first time I read him, I have been a fan of James Grant.  He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.  Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.  When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”  For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.  This book followed the same format, reprinting the best of old columns, with modest commentary.  In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?  Isn’t that a waste of time? That depends.  Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?  Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

• How does monetary policy affect the financial economy?
• Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
• Why do value (and other) investors need to be extra careful when investing in leveraged firms?
• What is risk?  Variation of total return or likelihood of loss and its severity?
• Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
• Why great technologies may make lousy investments.
• Why does neoclassical economics fail us when trying to understand the financial economy?
• How does one recognize a speculative mania?
• And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.  Being too early means you eventually get disregarded.  The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.  That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.  You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

• Those that have assumed that neoclassical economics adequately explains the way our economy works.
• Those that want to understand how monetary policy really works, or doesn’t.
• Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
• Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,  but your costs don’t go up.   Also, thanks to Axios Press for the free review copy.  I read the whole thing, and enjoyed it all.

When I was an actuary interacting with the investment department inside a life insurance company, one of the things that I learned early was that there was an inpenetrable jargon on the part of the bond investors that neophytes had to learn.  My boss, the best actuarial businessman that I have ever known, insisted that we have a weekly meeting with the investment department, and in their offices.  Being on their own turf made them freer to talk their own lingo, and that helped us learn it.

When I went to work in an investment department years later, the shoe was on the other foot.  I was still learning investment lingo, but when the actuaries showed up, I was there to translate.  Not surprisingly, there is jargon on both sides, often with the same term having two different names, because it is used two different ways.

It was true until the day I left the firm, where I heard a bond term I had never heard before.  We have a lot of jargon in investing, whether it is fixed income or equities.  There is additional jargon in insurance.

Here’s my offer: I try to define what I write about, but if I fail to define something adequately, let me know in the comments, and I will add an entry to the new Jargon page.  Let me know; I live to serve.

An article in the New York Times quoted by Barry Ritholtz on risk management tells some very salutary lessons.  Value-at-Risk, and other systems that rely on liquid tradable markets fail when bid-ask spreads widen.

One of my main lessons on risk comes from the concept of “bicycle stability versus table stability.” As I said at RealMoney: “This emphasis on the size of monthly payments to the consumer reminds me of the 1920s. We have traded table stability for bicycle stability. A bicycle is stable if it continues to move forward; a table is stable regardless. In an effort to ‘lock in’ housing prices in markets that are rising rapidly, many people are doing things that are rational in the short run, but not necessarily in the long run.”

I’ve talked about the the difference between bicycle and table stability before at this blog, notably:

• Bicycle Stability Versus Table Stability
• Update on Indicators (Bearish point #1)
• On Information Cascades and Lemmings

If your risk control methods require liquidity, then they won’t work when you need reduction of risk the most.  There are no free lunches in risk management.  In order to get “table stability” leverage has to be reduced, and in some cases, cash balances carried in order to assure that an enterprise can survive in all circumstances.  It implies a lower ROE in good times, in order to be sustainable in the worst times.

Bloomberg wrote a piece over the puzzlement that many in the Chicago School of Economics feel at the present time with all of the distress in the markets.  After all, don’t markets self-correct?  Sadly, no, not all the time, or, at least not with high speed during credit crunches.  (All of the econometric studies I have done note a weak tendency to mean reversion in financial markets, even excluding periods where there are credit difficulties.)

For markets to self-correct, it requires that economic agents have enough access to capital in order to make the investments necessary to arbitrage the differences between the markets that are in disarray.  It should be no surprise that during a time where credit is hard to come by, that there are potentially profitable arbitrages that are going begging.

Barry did a post today off of the Bloomberg piece, suggesting the death of the Chicago School.  I think that prediction is too early.

I am not a Chicago School economist.  I don’t like the neoclassical synthesis.  It posits human rationality in ways that make us robots, both individually and collectively.  I have been a critic of their methods through both behavioral economics and nonlinear dynamics, a la the Santa Fe Institute.  We need a new paradigm to replace the neoclassical synthesis.  It does not adequately describe how mankind behaves (and we have known that for 25 years — the models don’t predict well, either in micro or macro).

But the answer is not Keynesian policy, in my opinion.  Just because markets are unstable, that doesn’t mean that government action can stabilize them over the long run.  In the short-run, while credit is still easily available, yes, government action can work, whether through the Fed, subsidies, or tax incentives.  But Keynesian remedies don’t work when the government can’t easily tax or borrow in order to provide the stimulus.  We will face borrowing problems soon enough.

The answers are not to be found by asking the Chicago School or the Keynesians.  We need an economic theory that accepts the neccessity of moderate booms and busts, where the government does little to try to correct the imbalances.  Moderate imbalances are normal, and if we try to eliminate the moderate busts, wew get a series of small busts, followed by one humongous one.  We experienced easy money in the 20s, and in the 1990-2000s.  Easy money cured the moderate busts, but at a price.

A quick excursus: I agree that tight regulation of financial institutions is necessary if there is fiat money.  Controlling the money supply means controlling credit.  I don’t like fiat money, and would rather have a gold standard, but if we must have fiat money, then make life tough for the banks.  Restrict what they can invest in.  Regulate lending practices.

The present distress stems from both a lack of regulation and too much regulation.

Lack of regulation:

• Lack of enforcement on bad lending
• Leverage limits on commercial and investment banks were too loose.
• Modest limits on the banks dealings with the non-regulated financials.
• Regulatory arbitrage allowed depositary financial to choose weak regulators.
• Failure to disallow investment in areas the regulators did not fully understand.

Too much regulation:

• Lack of limits on Fed stimulus action (our “independent” central bank was/is compromised)
• Tax deductions for residential real estate, including the home sale capital gains exclusion.
• Limiting the number of rating agencies.

My view is that we eventually have to give our currency some backing and get the government out of the money business.  Until we get there the ride will be bumpy.  We need to transist back to an economy where credit is not easy, but not non-existent, and where total leverage declines.  Saving has to become a virtue again, which our present monetary policies will not encourage.

It is too early to declare the demise of the Chicago School, much as it should disappear.  But now we will get the test of the Keynesian School and I predict failure there; they will not solve our crisis.  The crisis will end when enough bad debts have been liquidated, and the financial system can begin lending normally again.  Call it unrealistic; call it the Austrian School if you like (I have not read and von Mises or Hayek), but it is what restores the financial sector, which cannot live with too much leverage once assets are deflating.

PS — The Bible says that the borrower is servant to the lender.  True enough, but if the lender is himself a borrower, like most of our banks, the proverb does not hold.  The only lenders that are truly soverign are those that control their own destinies, because they have no debt.

From 2003 to 2007, we went through a period where the balance sheets of financial entities went through a systemic downgrade.  They became:

• More leveraged
• Less transparent via derivatives
• More reliant of floating rate finance
• Reliant on debt structures with shorter maturities
• More sensitive to calls on cash via ratings-sensitive collateral agreements

That is what has set us up for the problems that we have today.  In the bond markets, those conditions have led to the failures of many large market makers, straining the remaining system.  The remaining market makers in bonds are offering little liquidity amid the panic.  It doesn’t matter what sub-segment of the bond market I point at, every part faces a lack of risk-bearing capacity as parties hoard cash.

Part of this is the fault of the Treasury and Fed, as they proffered their TARP and pullled it back.  The greater the uncertainty from large parties, the more that small parties run and hide.

Away from that, many parties with capital have decided (seemingly) as a group to seek safety all at once, leading to a general malaise in all things risky.  Part of that could be related to the original TARP, as many parties decided to wait on selling until the TARP came along.  With no TARP (as originally conceived), those inclined to sell made offers, and the markets balked.

What can I say? Compared to 2002, there are fewer entities willing to bear credit risk during the crisis, even for short amounts of time.  This allows for arbitrage situations that don’t immediately get resolved, because no one has the balance sheet necessary to do it.

Eventually we wil get to a point wher those with unencumbered cash will make an effort to close those arbitrage gaps, and lend to worthy businesses at exorbitant rates, but it may take some time.  UNtil then, the market will flounder in the volatile way that it does.

I have been of two minds on bailouts.  First, I would prefer we did not do them because bailouts beget more bailouts.  Free money brings out the worst in humanity.  Where is the logical end?  How do we choose what is critical, and what is not?

Second, if we’re going to do bailouts, they should be a last resort to the companies receiving them.  Unlike the relatively sweet terms of the capital offered to the banks, bailout capital should be something that a management says, “Ugh, time to fall on our swords, guys, but at least the business and much of the rank-and-file will survive.”

So, when I look at hopeless cases like the “big” 3 automakers, I think that we need a new chapter in the bankruptcy code for businesses that are “too big to fail.” [TBTF]  The rules would be a little different here:

• Failure of a TBTF institution usually occurs during a major economic crisis.  Other institutions would be stretched too thin, so the US Treasury (together with the Fed) would serve as the Debtor-in-Possession [DIP] lender.
• In addition to being senior to the existing debt, the Treasury would receive some stock in the reorganized entity.
• There would be a special court to deal with the competing claims, with a goal of speedy resolution.  Marginal claims would get thrown out early.  Claims without a lot of variability would get little attention.
• The Court would have the power to throw out contracts, including union and management contracts.
• The idea is to preserve the business while finding who really owns the new equity, and quickly, so that real life can resume with a balance sheet that has little debt.
• The court would choose who puts together the first restructuring plan, aiming for the party that has the most at stake, skipping the current nominal equity, in favor of the parties that practically are the equity.
• A Chapter 11 case could be moved into this chapter if no DIP lender is found, at the option of the Secretary of the Treasury.

A method like this tries to respect the taxpayer, making it unlikely that bailout funds would be tapped, while still allowing for situations where TBTF institutions could be reorganized in an emergency where the banks can’t lend, rather than a quick liquidation.  It’s a tough balancing act, but one that has to be done for the good of the nation as a whole.  Formalizing methods like this could have value for future crises, such that businesses end up saying that they don’t want to go down the TBTF Bankruptcy Chapter, which would be good for the nation.

That’s my reasoning.  I am open to other ideas, and improvements to the concept.

When is a stock safe enough to buy when it becomes difficult for corporations to find financing?  We can answer the question two ways: 1) Why should we buy stocks when the financial markets are choking?  Better to sit on cash.  2) We can’t tell when the turn is coming, so if we buy companies that are cheap with strong balance sheets and free cash flow, we should do okay over the intermediate-to-long run.

I’m going to illustrate this with a single stock tonight: General Electric.  Why GE?  Here’s something I haven’t mentioned recently about how I source stock ideas.  I read widely, and when some one tells me a stock is cheap, I write it down for later analysis.  My initial cursory analysis during this time of credit stress looks like this:

Let’s look at earnings estimates:

Yeah, is does look cheap.  How has it done recently relative to expectations?

Mmmm…. not so good.  Looks like they are still working off all of the bad accruals from the Jack Welch era.

Now, let’s look at the balance sheet:

Mmmm… there are a lot of intangibles on the balance sheet.  Taqngible book value is light.  Perhaps the intangibles have real economic value.  If so, I would expect to see additional earnings over operating cash flow, and the is not there. Let’s look at debt maturities, could there be a call on cash?

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That doesn’t look good.  What if we look at only the holding company?

Okay, not so bad.  Most of the debt is from the finance subsidiary that I have argued for years should spun off.  In a pinch, what are the odds that they would send GE Capital into insolvency?  Very low, so I worry about the refinance risk.  Will GE Capital get attractive financing terms over the next several years?

On to cash flows.  Here are the cash flow screens:

Okay, free cash flow is positive, and congruent with earnings over the last five years.  That’s a good sign.  What else is there to look at?

holding-company-only.gif

Okay, Price-to-sales indicates that GE could be cheap versus their long history, but it could get cheaper.

Let’s look at summary statistics:

From all of the above, as I look at GE, there is a refinancing problem.  Many debts come due over the next 5-10 years, probably matched by debt repaqyments over the same horizon.  The effect of default from these repayments could be significant.  I doubt that GE would be willing to send its finance subsidiary into insolvency.

In conclusion, even at the low levels that GE stock price has reached, I’m not comfortable with it.  GE will have to refinance a lot of its debt over the next five years, unless they sell or default on GE Capital.  The debt load outweighs the seeming cheapness.

Full disclosure: no position