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.

If I did not use a mechanical method for ranking replacement candidate stocks against my portfolio, I would not let so many stocks go onto my potential replacement list. Today I updated my industry model, and here it is:

Industry Groups January 2008

(If you have any difficulty downloading that, let me know. I’ve been having trouble with that.)

From that, I ran a bunch of screens, adding in some technology industries that have been hit of late. Here are the additional tickers that will be added to my candidates list: AMIE ASYT BBBY BC BELM BGFV BIG BNHN BRLC BWS CAB CBR CHRS CHUX CMRG CRH CTR CWTR DBRN DECK DFS DSPG DSW ESEA EXM EXP FHN FINL FRPT FSS GASS HGG HLYS HTCH HZO IDTI IKN IM IMOS JAS JNS KSWS KWD LF LIZ LNY LSI MIPS MRT NSIT NSTC NTY ODP OPMR OVTI OXM PERY PLAB POOL RCRC RENT ROCK RSC RT RUTH SAIA SHOO SIG SMRT SNA SNX SONC SSI TJX TOPS TUES VLTR VOXX ZQK

Now, the mechanical ranking system is supposed to be a simple way of prioritizing value stocks, and typically it does pretty well in directing my attention to the stocks that I should analyze, not necessarily the ones I should buy. That’s true of any screening method, no matter how simple or complex. You always find some companies that look really good initially, but got there because of data errors, accounting mis-characterizations, or a business situation that was vastly different when the accounting snapshot was taken.

Now, after all of this work, I’m only trading 3-4 stocks into and out of my portfolio of roughly 35 stocks. But the idea is to end up with a portfolio with better offensive and defensive characteristics, such that the relative performance will be good, and should the market turn, I will be in the industries and companies with a lot of potential to outperform.

I will admit, I don’t feel much like doing my portfolio reshaping now, even though it is a part of my management discipline, because the portfolio has been kicked around.  Not much worse than the rest of the market, though, and there are some stocks that look interesting that could be worth considerably more three years out.  As you look through my tickers list for candidates for addition, you’ll see a few commonalities:

• Energy (still)
• Industrials (still)
• Retail (now, that’s new)
• Insurers (many still cheap, particularly some stronger operators, also title names)
• Technology (different for me)
•  A few odd real estate names (not likely, but there are some places where values are protected)

So, the process begins.  Within a few days, I’ll run my industry model, and do a few screens off of it, adding a few more tickers.  Beyond that, I invite you to send me ideas as well.  Last time, ideas suggested by readers made up two of the four new names that I bought.  So, send them in, and thanks as always for reading me.

The replacement candidate tickers:   AA ABK ACIW AEO AES AIG AIT ALL APA APL ARM ARO ARW ASGN ATU ATW AVCA AVZA AZ BAC BCS BER BGP BKE BKS BRO BRY CACC CAE CAKE CALL CAMD CBL CCRT CHS CNQ CNX COF COST CQP CRI CRK CRZO CSCO CSG CSGS CSL CTLM DDS DFG DITC DLB DNR DRI DTLK DVN EAT EEP EFII EMC ENWV ESST ESV EXAR EXTR FLEX FNF FNM FRE FSII GCA GLW GPC GS GSIT GSK GW HAS HCC HCSG HD HIG HILL HMC HOC HOG HOLX HPQ IDTC INAP INFN INSP INT INTC IRE ISSI JCG JCP JEC JRT JWN KEM KFT KSS LINE LM LOOK LRW LUV LYG MAN MAS MDC MHK MHP MHS MMC MNST MTSC MTW MU MUR MVC MW MWA NOV  NSH NSR OII OMX ORI OXY PCZ PDC PDE PDII PDS PHLY PNCL PNRA POL PROS PTEN PVSW RAMR RAVN RGA RIG RNIN RNWK SCMR SGP SIMG SKS SKSWS SKX SLXP SNY SPN SSTI SSW STC STI SU SWK T TECH TECUA TEX TGI TLGD TMTA TM TNB TOT TRID TRLG TSO TWB UFS UNP URBN USG VFC VMC VNR VPHM WAG WCG WDC WHQ WLL WSM WSTL WU WWW XL XTEX XTO

PS — Though I don’t feel like doing it, I didn’t feel like doing it in the Fall of 2002 either,and some of my best picks came then.  So, discipline before feelings.

Sorry for not posting yesterday, there were a number of personal and business issues that I had to deal with.

Sometimes I write a post like my recent one on Warren Buffett, and when I click the “publish” button, I wonder whether it will come back to bite me. Other times, I click the publish button, and I think, “No one will think that much about that one.” That’s kind of what I felt about, “If This Is Failure, I Like It.” So it attracts a lot of comments, and what I thought was a more controversial post on Buffett attracts zero.

As a retailer might say, “The customer is always right.”  Ergo, the commenters are always right, at least in terms of what they want to read about.  So, tonight I write about benchmarking.  (Note this timely article on the topic from Abnormal Returns.)

I’m not a big fan of benchmarking.  The idea behind a benchmark is one of three things:

1. A description of the non-controllable aspects of what a manager does.  It reflects the universe of securities that a manager might choose from, and the manager’s job is to choose the best securities in that universe.
2. A description of the non-controllable aspects of what an investor wants for a single asset class or style.  It reflects the universe of securities that describe expected performance if bought as an index, and the manager’s job is to choose the best securities that can beat that index.
3. A description of what an investor wants, in a total asset allocation framework.  It reflects the risk-return tradeoff of the investor.  The manager must find the best way to meet that need, using asset allocation and security selection.

When I was at Provident Mutual, we chose managers for our multiple manager products, and we would evaluate them against the benchmarks that we mutually felt comfortable with.  The trouble was when a manager would see a security that he found attractive that did not correlate well with the benchmark index.  Should he buy it?  Often they would not, for fear of “mistracking” versus the index.

Though many managers will say that the benchmark reflects their circle of competence, and they do well within those bounds, my view is that it is better to loosen the constraints on managers with good investment processes, and simply tell them that you are looking for good returns over a full cycle.  Good returns would be what the market as a whole delivers, plus a margin, over a longer period of time; that might be as much as 5-7 years.  (Pity Bill Miller, whose 5-year track record is now behind the S&P 500.  Watch the assets leave Legg Mason.)

My approach to choosing a manager relies more on analyzing qualitative processes, and then looking at returns to see that the reasons that they cited would lead to good performance actually did so in practice.

Benchmarking is kind of like Heisenberg’s Uncertainty Principle, in that the act of measurement changes the behavior of what is measured.  The greater the frequency of measurement, the more index-like performance becomes.  The less tolerance for underperformance, the more index-like performance becomes.

To the extent that a manager has genuine skill, you don’t want to constrain them.  Who would want to constrain Warren Buffett, Kenneth Heebner, Marty Whitman, Michael Price, John Templeton, John Neff, or Ron Muhlenkamp? I wouldn’t.  Give them the money, and check back in five years.  (The list is illustrative, I can think of more…)

What does that mean for me, though?  The first thing is that I am not for everybody.  I will underperform the broad market, whether measured by the S&P 500 or the Wilshire 5000, in many periods.  Over a long period of time, I believe that I will beat those benchmarks.  Since they are common benchmarks, and a lot of money is run against them, that is a good place to be if one is a manager.  I think I will beat those broad benchmarks for several reasons:

• Value tends to win in the long haul.
• By not limiting picks to a given size range, there is a better likelihood of finding cheap stocks.
• By not limiting picks to the US, I can find chedaper stocks that might outperform.
• By rebalancing, I pick up incremental returns.
• Industry analysis aids in finding companies that can outperform.
• Avoiding companies with accounting issues allows for fewer big losses.
• Disciplined buying and selling enhances the economic value of the portfolio, which will be realized over time.
• I think I can pick good companies as well.

I view the structural parts of my deviation versus the broad market as being factors that will help me over the long haul.  In the short-term, I live with underperformance.  Tactically, stock picking should help me do better in all environments.

That’s why I measure myself versus broad market benchmarks, even though I invest more like a midcap value manager.  Midcap value should beat the market over time, and clients that use me should be prepared for periods of adverse deviation, en route to better returns over the long haul.

Tickers mentioned: LM