When I wrote my last piece, “The Financings of Last Resort,” I did meant to add that this will be a common phenomenon for a year or so. Pretend you are part of a senior management team of a credit-sensitive financial institution, and your worst nightmare is slowly unfolding in front of you. You’re looking looking at delinquency and loss statistics stratified by year of issuance (”vintage”) and time since issuance. Every vintage since 2003 looks worse than the prior year, and the loss seasoning curves are all pointed upward — in the early vintages, mildly, and in the 2006-2007 vintages, wildly.

You are seeing current losses come through, and they are erasing much of current profits, or, creating crushing losses if you try to get ahead of the loss curve and put in sufficient reserves to handle likely future losses. Any loan loss estimate toward the beginning of a “bust” phase is a wild guess, and management teams are often behind the curve as they hope that the most recent data point was a statistical fluke.

But management teams often think along two tracks. The first is the “best current estimate,” which they give to the market through GAAP accounting. The second is “What if things get bad, and we run short of capital? Better to get financing now, while our stock price is relatively high, and bond and preferred spreads low.”

That reasoning drives two types of capital raising — financings of last resort, and protective financing. That second class of financing was what I commented on at Felix Salmon’s blog regarding JP Morgan.  Borrow when you can, not when you have to.  Get in front of the loss curve, not behind it.

But, for those that are behind the curve, the financings of last resort are protective, at least for a little while, of management teams and bondholders.  Consider the actions at:

• Citigroup
• CIT Group
• National City

But who loses? Current stockholders get diluted.  I can imagine the management consoling their consciences with the thought, “Yes, the stockholders lose, but what would they get in bankruptcy if things got worse, and we didn’t raise capital?”

So, even if credit-sensitive financial companies avoid going broke, they may not be good equity investments because of the dilution.  I said that early on with the financial guarantors.  The big guys are still alive, but their stock prices are down significantly.  (Oh, and note that the regulators like this approach.  No public funds get used.  No embarrassing front page insolvency news.  “What was the regulator doing?”)

How long will this continue?  Financings of last resort can go on until the stockholders rebel and throw out management (hard to do), or the estimated net present value of the profit stream of the company is negative; no one will finance that.  (Think of ACA Capital Holdings, maybe.)  The nature of a financing of last resort is that the financier hands over cash in exchange for cheap equity that can be recycled into the market.  It’s a coercive way of doing an equity or debt offering, and requires a significant discount to current financing valuations.

So, how long will the bailouts go on?  I think for quite some time, which I why I am avoiding that area of the market.  Avoid the equity “fire sales” if you can.  Remember, management teams usually know more than the average analyst when it comes to knowing the true value of cash that can be generated from illiquid assets.  So when you see financial firms pursuing liquidity during a time of debt deflation, don’t be a hero — avoid those companies.

For this quarter, I sold two my two placeholder assets, the Industrial and Technology SPDRs, and Arkansas Best, which had richened enough for me to trade out of it.

I had two rebalancing buys, Charlotte Russe and Avnet.  On Charlotte Russe, the rebalancing buy occurred because I tendered all my stock @ $18 in the Dutch Tender, and 45% of it got bought.  On Avnet, things aren’t as bad as the market thought on 4/15, in my opinion.  I had one rebalancing sell, Helmerich and Payne.  Just taking some off the table for risk reduction purposes.

Here is my final comparison file that was based off of data at the close of business on Monday.  To comply with the Bloomberg data license, all numeric fields remaining are ones that I calculated.  The columns of the file rank the 290 stocks on the following metrics (lower better unless noted):

• 52-week RSI
• Trailing P/E
• P/Book (2)
• P/Sales (2)
• P/2008E
• P/2009E
• Dividend Yield (higher better)
• Net Operating Accruals (2)
• Implied Volatility
• Neglect (higher better)

The grand rank sums up the ranks giving double weights to P/B, P/S, and NOA.  My current stocks are highlighted in yellow, except for the two middle ones, which are in orange.  Candidates for sale come from the lower half (high grand ranks), candidates to buy from the upper half.

Here were my purchases (P/2008E):

• International Rectifier — 9.5x
• Group 1 Automotive — 7.1x
• OfficeMax — 9.3x
• Universal American Financial — 5.8x

Cheap names all (and could get cheaper?).  If you asked me what my concerns might be over this group of names, I would say that credit quality is adequate but not stellar.  I would also confess a little doubt on Universal American.  It looks cheap, and lines of business they are in are stable lines.  They lost money on mezzanine subprime mortgage ABS.  I looked at the writedowns, and they seem adequate.  If you send the security vintages 2006-2007 to zero, this stock is still cheap, in my opinion.   What I can’t evaluate is whether they could have operational problems in their senior health insurance business.  It’s a good business, if managed properly.

As for International Rectifier and Group 1, I have owned them before.  With IRF, I like industrial technology — stuff that is harder to obsolete.  On Group 1, I looked at all of the small cap auto retailers, and picked this one.  I liked its business mix, and what seemed to be a clean balance sheet, with few immediate needs for liquidity.  The group as a whole has been smashed, and is discounting very unfavorable conditions.  I don’t think things are that bad, and besides, a lot of the revenues come from repairs and sales of used cars.

With OfficeMax, I think prospects are less cyclical than the market seems to believe.  Office supplies get purchased during bad economic times as well, and the current price already discounts  a lot of pain.

Well, those are my purchases.  Let’s see how they fare over the coming years.

Full disclosure: long HP CHIC AVT GPI UAM OMX IRF

Okay, here are my industry ranks for April 2008. Please remember that my model can be used in value mode (the green zone) or in momentum mode (the red zone). I usually just stick to the green zone, but this time I included a few red zone ideas. So, this time I added in technology companies, insurance, industrial and healthcare companies. Yeah, I know that’s a lot, and my results reflected that — usually I have just 20 or so companies from the screen, but this time it is 80+.

Oh, my screen, aside from industry, has only two factors: market cap greater than $100 million, and Price-to-book times Price-to-forward earnings must be less than 10. Ben Graham had a similar criterion, except that he used trailing P/E, and his cutoff was 22.5. Here are the tickers:

ABG ACGL ACMR ACW ADPI AEL AFFM AGYS AHL AIG AMSF ARM AWH AXS BBW BC BRLC BRNC CBR CHUX CLS CMOS CNA CVGI DK EDS ENH ENSG FFG FL FLEX FMR FRPT GPI HMX HOTT HTRN IKN INDM IPCR IRF KEM KG LAD LNY LTR MENT MIG MRH MRT MWA MXGL NCS NNBR NSIT NSTC NYM OCR ODP PCCC PDFS PKOH PLAB PMACA PNX PRE PSS PTP RE RMIX RNR ROCK RTEC SAF SAH SANM SEAB SMP SNX TECUA THG TRS TRW TRX UAM UNM XL XRIT

Lots of insurers — what can I say, the group is cheap… cheaper than the lack of pricing power should make them. Add in two more tickers that crossed my desk today: MRO and AWI, and I think I am ready to put my spreadsheet together and start analyzing promising cheap companies. One nice thing about my methods is that it can accommodate a large number of tickers. When you add up the tickers from yesterday and today, and add in the 32 existing tickers, that’s almost 300 tickers altogether.

Fortunately, my ranking system helps my winnow down the list pretty quickly, as it scores cheapness on a wide number of variables at once, and throws in many of the anomalies that are mispriced in the markets. Then it is up to me to use business judgment to decide what makes sense, because most cheap stocks are cheap for a reason, while the gems are merely overlooked.

Feel free to pitch in more stock ideas. I should come to decisions within a week or so.

PS — Have you checked out Newsflashr.com yet? It looks like a promising way of aggregating financial news, as well as other news.

Late in the day, I looked at a table of valuations of the remaining major investment banks, and thought, “Huh, they’re priced like Bermuda Reinsurers.  Price-to-book near 1 or lower, and expected P/Es in the middle single digits.”  Well, that got me thinking… how are those two groups of companies alike?

•  When losses come they can be severe.
• Both have strong underwriting cycles where a lot of money is made in the boom phase, and a lot gets lost in the bear phase.
• Earnings quality can be poor, unless management teams have a bias against meeting Street expectations, and allowing earnings to be ragged.
• The opacity of the investment banks’ swap books is matched by that of the reinsurers’ reserving.
• Both businesses are highly competitive, and global in scope.

Now, what’s different?

• The reinsurers typically don’t have asset problems, only reserving problems.
• The Bermuda reinsurers know that one day a change in their tax status may come (somehow forced to pay US tax rates — ask Bill Berkley), and that would lower earnings.
• The financial leverage of the reinsurers is a lot lower.
• The financing of reinsurers is a lot more secure.

The risk-reward seems balanced to me across the two groups.  The reinsurers are lower-risk/lower-reward, and the investment banks are higher on both scores.  Choose in accordance with your risk tolerance — as for me, I’ll look at the reinsurers.

1) I typically don’t comment on whether we are in a recession or not, because I don’t think that it is relevant. I would rather look at industry performance separate from the performance of the US economy, because the world is more integrated than it used to be. Energy, Basic Materials, and Industrials are hot. Financials are in trouble, excluding life and P&C insurers. Retail and Consumer Discretionary are soft. What is levered to US demand is not doing so well, but what is demanded globally is doing well. Much of the developed world has over-leverage problems. Isn’t that a richer view than trying to analyze whether the US will have two consecutive quarters of negative real GDP growth?

2) So Moody’s is moving Munis to the same scale as corporates? Well, good, but don’t expect yields to change much. The muni market is dominated by buyers that knew that the muni ratings were overly tough, and they priced for it accordingly. The same is true of the structured product markets, where the ratings were too liberal… sophisticated investors knew about the liberality, which is why spreads were wider there than for corporates.

3) Back to the voting machine versus the weighing machine a la Ben Graham. It is much easier to short credit via CDS, than to borrow bonds and sell them. There is a cost, though. The CDS often trade at considerably wider spreads than the cash bonds. It’s not as if the cash bond owners are dumb; they are probably a better reflection of the true expectation of default losses, because they cannot be traded as easily. Once the notional amount of CDS trading versus cash bonds gets up to a certain multiple, the technicals of the CDS trading decouple from the underlying economics of the bond, whether the bond stays current or defaults. In a default, often the need to buy a bond to deliver pushes the price of a defaulted bond above its intrinsic value. Since so many purchased insurance versus the true need for insurance, this is no surprise.. it’s not much different than overcapacity in the insurance industry.

4) If you want a quick summary of the troubles in the residential mortgage market, look no further than the The Lehman Brothers Short Swaption Volatility Index. The panic level for short term options on swaps is above where it was for LTCM, and the credit troubles of 2002. What a take-off in seven months, huh?

5) Found a bunch of neat charts on the mortgage mess over at the WSJ website.

6) I have always disliked the concept of core inflation. Now that food and fuel are the main drivers of inflation, can we quietly bury the concept? As I have pointed out before, it doesn’t do well at predicting the unadjusted CPI. Oh, and here’s a fresh post from Naked Capitalism on the topic of understating inflation. Makes my article at RealMoney on understating inflation look positively tame.

7) The rating agencies play games, but so do the companies that are rated. MBIA doesn’t want to be downgraded by Fitch, so they ask that their rating be withdrawn. Well, tough. Fitch won’t give up that easily. Personally, I like it when the rating agencies fight back.

8 ) Jim Cramer asks if Bank of America will abandon Countrywide, and concludes that they will abandon the bid. Personally, I think it would be wise to abandon the bid, but large companies like Bank of America sometimes don’t move rapidly enough. At this point, it would be cheaper to buy another smaller mortgage company, and then grow it rapidly when the housing market bounces back in 2010.

9) Writing for RealMoney 2004-2006, I wasted a certain amount of space talking about home equity loans, and how they would be another big problem for the banking system. Well, we are there now. No surprise; shouldn’t we have expected second liens to have come under stress, when first liens are so stressed?

10) In crises, hedge funds and mortgage REITs financed by short-term repo financing are unstable. No surprise that we are seeing an uptick in failures.

11) As I have stated before, I am not surprised that there is more talk of abandoning currency pegs to the US dollar. That said, it is a getting dragged kicking and screaming type of phenomenon. Countries get used to pegs, because it makes life easy for policymakers. But when inflation or deflation gets to be odious, eventually they make the move. Much of the world pegged to the US dollar is importing our inflationary monetary policy.

12) Finally, something that leaves me a little sad, people using their 401(k)s to stay current on their mortgages. You can see that they love their homes, as they are giving up an asset that is protected in bankruptcy, to fund an asset that is not protected (in most states). Personally, I would give up the home, and go rent, and save my pension money, but to each his own here.

In investing, it is important to understand what industries the companies in which you invest are in.  There are several reasons for this:

• Companies within an industry tend to face the same cost pressures.
• Companies within an industry tend to face the same revenue drivers.
• Companies within an industry tend to face the same regulators and political pressures.
• Companies within an industry tend to face the same behavior from debt-financers and equity investors.

Now, some companies have competitive advantages that are difficult to replicate, but those are not plentiful.  It is no surprise then that equity performance within industries tends to be tightly correlated.

Now consider ETF activity.  The largest ETFs cover whole stock markets, or sectors containing many industries.  The trading can drive the prices of many stocks regardless of the fundamentals in the short run.  The ETFs allow for simple decisions to be made.  “Financials stink; sell the XLF.”  “Technology stinks; sell the XLK.”  “Energy and materials will do well here, buy the XLE and XLB.”

The thing is, in each of those sectors, there is a lot of variation.  Is there a reason to worry about financial companies that focus on mortgages?  Yes.  Does that have anything to do with insurers?  Aside from mortgage, financial and title insurers, no, it doesn’t.  What do chemicals have to do with base metals?  Not much.  Do refiners and E&P companies benefit similarly from a rise in the price of oil?  No, it is the opposite; one buys oil, the other sells.

ETF trading activity can be a benefit to the fundamental investor.  When your companies come under pressure from ETFs because ETF holders sell indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the selling, it is time to buy a little more.  When your companies rise because ETF buyers buy indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the buying, it is time to sell a little.

ETFs simplify decision-making for many investors.  Sophisticated investors will avoid the simplification and drill down the economics and the industries and companies that they own, leading to greater profits in the long run.

One month down, eleven to go?  Can we stick our heads out of the foxhole yet?

Personally, I was off just a little in January.  Comparing myself against a bunch of value indexes, which did better than growth indexes in January, I did better than all of them.  We’ll see what the future brings, though, these things can turn on a dime.

So what worked for me?  Arkansas Best, National Atlantic (not out of the woods yet), Charlotte Russe, Gehl, YRC Worldwide, Alliance Data Systems, Reinsurance Group of America, and Honda.

What hurt?  Nam Tai, Gruma, Valero, Deutsche Bank, Royal Bank of Scotland, and Anadarko Petroleum.

Common factors:

• Financials with complexity got hurt
• Energy was lackluster at best
• Industrials, Retail, and Trucking did well
• Value took less pain
• What got whacked before went up

One final note here.  Look at this graph from Bespoke.  The “sea change” there mirrors my own turn in performance.  What does that tell me?  Perhaps it tells me that in late 2007 there were a lot of hedge funds liquidating positions that value managers liked to own.  After the end of the year, the selling pressure ebbed, and value seekers came in.  At RealMoney today, both Cramer and Marcin were commenting on they could find stuff to buy when the market was down in the morning.  I agreed; I haven’t seen this many good values since 2002.  I’m not counting on anything here, but I think my portfolio has attractive valuations and prospects.  Much as I am not crazy about the macro environment in many ways, I have some confidence that my portfolio should do better than the S&P 500 in 2008.

Full disclosure: long NTE GMK VLO DB APC RBS ABFS NAHC CHIC GEHL YRCW ADS RGA HMC

I’ve worked for years to take the emotions out of my investment processes, with some success.  Where it gets tough is when I am in an absolute and relative drawdown, as I was for most of the second half of 2007.  Nonetheless, I stuck with my disciplines.  This week, a lot of things went right:

• Retail
• Insurance
• Trucking
• Energy
• Small cap value was the best style

Will this persist?  Who can tell…  I was ahead of the Russell 2000 Value index this week, even though my portfolio is more midcap value in nature.  I’m still wrestling with where to deploy incremental funds.  I’m 2-3 positions light at present, and I know I am already insurance-heavy, with many of my best candidates being insurers, and the rest Irish Banks.  I don’t want to get too heavy in financials… I’m overweight there now.  Ideas are welcome.  Oh, at the end of the day I did make a small purchase:

		David Merkel
		Rebalancing Buy
		1/25/2008 4:02 PM EST

Bought some Gruma, SA into the close. Tortillas and other Mexican foods are not going out of style, even if the Mexican stock markets are having difficulty of late. I’ve had a good week. Hope you did too.

Position: long GMK

The market always has a new way to make a fool out of you, so I am not relying on a change in the financial weather here.  I just keep doing what I do best.

Full disclosure: long GMK

I didn’t feel well today, but my broad market portfolio did better than me. I probably could not have picked a worse day to do my reshaping, but here are the results:

Sales:

• Aspen Holdings
• Flagstone Reinsurance
• Redwood Trust
• Mylan Labs
• Lafarge SA

Purchases:

• Reinsurance Group of America (old friend, cheap price)
• Honda Motors

Rebalancing Buys:

• Valero
• ConocoPhillips
• Vishay Intertechnology

Rebalancing Sale:

• Deerfield Capital

I’m not done. My moves today raised cash from 5% to 10%, and trimmed positions from 36 to 33. I have room for two more ideas, and am working on where to place cash. My timing of buys and sells today was good — not that that is a key competency of mine by any means.

Aside from the sale of the reinsurers, which were just cheap placeholders, the other positions were not as relatively cheap as they once were. RGA and Honda are quality companies selling at bargain prices. If I had more names like those, I would buy them all day long.

Away from my broad market portfolio, I raised my equity exposure in my mutual funds fractionally today. Time to rebalance.

PS — I can’t remember another day quite like this, where the late negative to positive move was so pronounced.

Full disclosure: long DFR RGA HMC VLO COP VSH

For my readers, particularly my Canadian readers, you can read an article that I wrote on risk control in portfolio management for MoneySense magazine.  In the process of writing the piece for MoneySense, I got to read a number of back issues, and found it to be a good quality publication, of most use to Canadians.  Having passed the Life Actuarial exams, I know enough about Canadian tax law and financial services to be a danger to myself, and those who listen to me.  Fortunately, the piece I wrote was generic, and can benefit investors anywhere.

Notes on Stocks and the Fed

On a side note, why didn’t the stock market fall more today? For me, it boils down to two things: the FOMC surprise move, which ratcheted up total rate cut expectations for January, and seller exhaustion.  It’s hard for the market to fall hard when you have already had a high level of down volume net of up volume, and huge amounts of 52-week lows net of 52-week highs.  This wasn’t just true of the US, but of most global equity markets.

So, if we are going down further, the market will have to rest a while.  That said, valuations are more compelling than they were, especially compared to Treasuries.  Compared to BBB corporate yields, they are still attractive.  I think I would need to see 10-year BBB corporates at yields of 7% or so before I would begin edging in there.

One other note, the forward TIPS curve is showing some life again; perhaps that will be another fake-out, as in August, but there is certainly more oomph in the inflationary effort now than when the stimulus effort was grudging and fitful as it was back then.