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Two Good Questions

Wednesday, November 27th, 2013

My last post, On Investment Ideas, Redux, received two good questions.  Here they are, with my answers:

When using your quantitative factors, do your normally compare an investment idea relative to its sector, industry, or a custom comp group? I have dabbled in quantitative factor models in the past, and normally I start with an index, group by sector, and then compare each company relative to its sector (I use valuation metrics, liquidity, technical factors such as relative strength and price relative to moving averages, earnings volatility, earnings estimates revisions, balance sheet metrics, beta, and a proprietary risk/reward metric). How do you go about making the data relevant?

I try to look at what is overplayed and underplayed among factors and industries, and adjust my weightings accordingly.  I look for companies that add to economic value relative to price  I look for companies that may benefit from an industry turnaround or a corporate turnaround.  I look for pricing power, and how that is changing.

My industry and factor models are not integrated.  I use industries as a screen, but I look for value via valuations and factors.  Consult my eight rules for more on this.

I make the data relevant by letting my scoring model highlight promising ideas, and then killing those that are qualitatively bad ideas.

The second question:

Do you think the insurance company meme, while historically profitable, has now been over-exposed by yourself, AIG, Berkshire, etc?

Seems like the barriers to entry throughout the financial industry have collapsed (dis-intermediation by whatever name), and the trade looks pretty crowded. Every industrial concern has a financial arm as widely reported.

I have noticed a lot of de-mutualization of insurance companies, a lot of M&A / consolidation activity, and obviously asset management (new competitors) has grown all over the place. The financial sector (as a percent of the S&P) is back near all time highs.

Is the insurance meme now a crowded trade?

There have been others talking about this idea long before me, notably Tom Gaynor of Markel, a few of the CEOs in Bermuda, Eddy Elfenbein, etc.  There are significant barriers to entry on this trade:

  1. Insurance is not a fast growth industry.  As such, many investors ignore it.
  2. Insurance is not sexy.  Few buy insurance companies as a result.
  3. Insurance is the most complex industry from an accounting standpoint, if you exclude investment banks.  Few follow it in detail.
  4. Insurance profits are volatile in the short-run, but consistent in the long-run, for conservatively run insurers.  People get scared out of insurance stocks from the volatility.

Demutualization is a plus for the publicly traded insurance industry, because it makes the more industry more economic.  That said, there are few large mutuals likely to demutualize anytime soon.  They know that they have got it good.  Good pay. Little oversight.  Why change a good thing?

I would look at it this way.  Since capital easily flows into insurers, be skeptical when insurers with short liabilities have price-to-book over 1.5x.  For life insurers, and those with long liabilities, get skeptical when the price-to-book is over 2.0x.

We’re not there yet, but we are getting closer.  My exposure to the insurance industry is still significant, but well below my peak, where buying discounted insurance shares was easy money, and with far less risk than buying banks.  Banks were the better choice in this scenario, but insurers would have made it through uglier scenarios.  Less leverage and credit risk.

I have not always been a fan of insurance stocks.  In the 90s, I never owned them, because many took too much risk in investing.  Today, those bad old days are gone, and underwriting is designed to make a profit, on average.  And in an environment where many stock valuations are stretched, the valuations of insurers are reasonable.  The only question is whether capital levels are so high that competition on premium levels will be brutal.

My view is this: it will be difficult for the general public, and even institutional investors to warm up to insurance stocks to the degree that they make relative valuations unreasonable.  But if they do, I will be gone.  Somebody give me a spank on the seat if we get another era like the mid-2000s where insurers trade well above their book value, some above 2.0x, and I don’t sell.

I failed to sell as much as I should in 2007.  This time, I will be more measured.  As for now, my overweight on insurers is still a reasonable and likely profitable trade.  But as valuations go up, I will lighten the boat.

On Investment Ideas, Redux

Tuesday, November 26th, 2013

Would I disclose proprietary ideas of mine?  I’ve done it before.  Why would I do it?  Because it would take a lot to make the ideas usable.  Remember my commentary from when I was a bond manager: I was far more open with my brokers than most managers, but I never gave them the critical bits.

So a reader asked me:

Any chance you could expand on what quantitative metrics you are using to compare potential investments? Could you also name a few of the 77 13fs you track? Thanks

I will go above and beyond here.  You will get the names of all 78 — here they are:

  • Abrams
  • Akre
  • Altai
  • Ancient Art
  • Appaloosa
  • Atlantic
  • Bares
  • Baupost
  • Blue Ridge
  • Brave Warrior
  • Bridgewater
  • BRK
  • Capital Growth
  • Centaur
  • Centerbridge
  • Chieftain
  • Chou
  • Coatue
  • Dodge & Cox
  • Dreman
  • Eagle Capital
  • Eagle Value
  • Edinburgh
  • Fairfax
  • Farallon
  • Fiduciary
  • Force
  • FPA
  • Gates
  • Glenview
  • Goldentree
  • Greenhaven
  • Greenlight
  • H Partners
  • Hawkshaw
  • Hayman
  • Hodges
  • Hound
  • Hovde
  • Icahn
  • Intl Value
  • Invesco
  • Jana
  • JAT
  • Jensen
  • Joho
  • Lane Five
  • Leucadia
  • Lone Pine
  • M3F
  • Markel
  • Matrix
  • Maverick
  • MHR
  • Montag
  • MSD
  • Pabrai
  • Parnassus
  • Passport
  • Pennant
  • Perry
  • Pershing Square
  • Pickens
  • Price
  • Sageview
  • Scout
  • Soros
  • Southeastern
  • SQ Advisors
  • Third Point
  • Tiger Global
  • Tweedy Browne
  • ValueAct
  • Viking Global
  • Weitz
  • West Coast
  • Wintergreen
  • Yacktman

What I won’t tell you is what I do with their data, because it is different from what most do.  But you can play with it.

Then you asked about factors.  Here are my factors:

  • Price change over the last year
  • Price change over the last three years
  • Insider buying
  • Price-to-earnings, both current and forward
  • Price-to-book
  • Price-to-sales
  • Price-to-free cash flow
  • Price-to-sales
  • Dividend yield
  • Neglect (Market cap / Trading volume)
  • Net Operating Assets
  • Stock price volatility over the last three years
  • Asset growth over the last three years
  • Sales growth over the last three years
  • Quality (gross margins / assets)

Now that I have “bared all,” I haven’t really bared all, because there is a lot that goes into the preparation and analysis of the data that can’t be grasped from what I have revealed here.  To go into that would take more time than I can spend.  That’s one reason why as a corporate bond manager, I would share more data with my brokers than most would do, because I knew that the last 20% that I reserved was the real gold.  That I would not share.

Beyond that, there are my industry rotation models, which I share 4-6x per year, and then my qualitative reasoning, which makes me reject a lot of ideas that pass my quantitative screens.

That’s what I do.  It’s not perfect, and my qualitative reasoning has its faults as well.  I encourage you to develop your own theories of value, as Ken Fisher encouraged me to do back in early 2000.  Develop your edge, with knowledge that you have that few others do.  I’ll give you an example.

I understand most areas in insurance.  I don’t get everything right, but it does give me an edge, because insurance accounting and competition is a “black box” to most investors.  Insurance has been one of the best performing industries over time, but many avoid it because of its complexity and stodginess.

Behind the hard to understand earnings volatility, there is sometimes a generally profitable franchise that will make decent money in the long run.  But few get that, and that is an “edge” of mine.  Develop your own edge.

That’s all for now.  Invest wisely, and be wary, because the market for risk assets is high, and what if the Fed stops supporting it?  Make sure your portfolio has a margin of safety.

Classic: Talking to Management, Part 3: The Competition

Wednesday, November 13th, 2013

This was originally published on RealMoney on April 17, 2007:

The Competition

What are you seeing that you think most of your competitors aren’t seeing? Or: What resource is valuable to your business that you think your competitors neglect?

This question is an open invitation to a management team to reach into its “brag bag” and pull out a few of its best differential competences for display. The answer had better be an impressive one, and it had better make sense as a critical aspect of the business. Good answers can include changes in products, demand, pricing and resources; they must reflect some critical aspect of business that will make a difference in future profitability.

Consider two examples from the insurance industry, both of which are future in nature:

I posed this question to the CEOs of several Bermuda reinsurers, and the answer was: “We don’t think that the profitability of casualty business is as profitable as the reserving of some of our competitors would indicate.” That might have been a bit of trash talk; perhaps it was a word to the wise. I favor the latter interpretation.

Then there was a CEO who suggested that many specialty casualty insurers he competed against had underinvested in claims control. That’s fine in the bull phase of the cycle, but it can spell trouble in the bear phase, when cash flow might go negative and skilled claims adjusters are hard to find.

If you could switch places with any of your competitors, who would it be and why? Alternatively, if you think you are the best positioned, who is next best, in your opinion?

This question usually won’t get an answer in large forums. It’s best saved for more intimate gatherings, because to the wider investing public, most companies portray themselves as the best. Also, in diversified corporations, it’s useful to ask this question of divisional heads rather than the CEO. They have a closer feel for the competition they face on a day-to-day basis.

When answered, this query can yield new research vistas. Who knows company quality better than an industry insider? The response can bring out the unique reasons a competitor is succeeding — and, potentially, what this company’s current management team is doing to challenge the competitor.

Note: The opposite question, “Which companies are not run properly?” will not get answered, except perhaps in one-on-one meetings. Few managements will publicly trash-talk the competition. The few that will do so deserve a red flag for hubris.

As an example, I had an interesting experience while at a financial conference. I was at a breakout meeting where J. Hyatt Brown, of Brown & Brown, was taking questions. Of the insurance brokers, Brown & Brown is no doubt the best managed, and Hyatt Brown has strong opinions and is almost never at a loss for an answer. When my turn to ask a question came up, I said, “OK, you’re the best-run company in your space. Who is No. 2?”

Hyatt Brown looked reflective, paused for 20 seconds and answered that it is was tough to say, but he thought that Hub International (HBG) was No. 2. And now Hub has gone private in a much better deal than Goldman Sachs’ (GS) buy of USI Holdings (USIH), from a quality standpoint. To my chagrin, I didn’t buy Hub off of Hyatt Brown’s comments. I missed a cool 59% in 10 months, but you can’t kiss them all.

What would your competitors have to do in order to reverse-engineer your competitive position? Or, why do you suppose other companies don’t adopt your methods?

This question gets at what management views as its critical differences for business success. The answer had better be a good one; it should be something important, and hard to duplicate. As Warren Buffett might put it, we are trying to determine the size and depth of the “moat” that exists around the business franchise.

If the answer doesn’t deliver an idea that is weighty and makes sense from a competitive standpoint, you can assume that the business doesn’t have a lot of franchise value and doesn’t deserve a premium multiple.

Valero Energy (VLO) is the leading oil refiner in the U.S. It also has the leading position in refining both heavy (high-density) and sour (high-sulfur) crudes, which cost less, leading to higher profit margins. It would cost a lot of money for a competitor to create or purchase the same capacity, assuming it could get all of the regulatory permits to do so.

On a competitive basis, who has the most to lose in the present environment?

Some executives won’t name names, but they might be able to point out what characteristics the worst-positioned competitors don’t have. In commodity businesses, the executive could point at those with bad cost structures. In businesses where value comes from customization, the executive could say, “To be a real player, you can’t just sell product, you must be able to assess the needs of the client, advise him, sell the product, install it and provide continuing service, leading to ancillary product sales.”

As commodity prices move down, the recent acquirers and developers of high-cost capacity fare the worst. With life insurance today, scale is becoming more and more of an advantage. Smaller players without a clear niche focus are likely to be the losers; that’s one reason I don’t get tempted to buy most of the smaller life insurance companies that trade below book value. Given their fixed expenses and lack of profitability, they deserve to trade at a discount to book.

Full Disclosure: long VLO

Ten Years of Investment Writing

Tuesday, November 12th, 2013

I’m late on this.  My first foray into public writing on investing was when I started writing at RealMoney on October 17th, 2003.  But how did I get there?

Sadly, almost all of the works of RealMoney prior to 2008 are not accessible.  My first effort was writing Jim Cramer the day after General American Life Insurance failed on August 10, 1999.  He wrote a short piece asking why no one was paying attention to the failure of a major life insurer.  He wanted to know what happened.  I had heard about the failure, and so I searched for more data on it, and I saw Cramer’s article, only one hour old, so I sent him an e-mail as “your friendly neighborhood investment actuary.”

I explained the situation to him in about three hundred words, and lo and behold, my e-mail was featured in a post by Cramer that very day saying how amazing it was that he could get such a cogent explanation that was not available elsewhere on the web.

Not wanting to wear out my welcome with Cramer, I e-mailed him maybe eighty times over the next four years, with occasional e-mails to Herb Greenberg and Howard Simons.  I e-mailed mostly bond market and insurance information.  But in the period from 2000-2003, information on the bond market from an active institutional participant was interesting.  At least, I thought so, and Cramer usually returned my e-mails, as did Herb Greenberg.

In August 2003, after I had taken a job as an insurance equity analyst at a financial services only hedge fund, Cramer e-mailed me, asking me to write for RealMoney.  I don’t have the actual e-mail, but he said something to the effect of “You write better than most of our contributors.  Please come write for us.”

I went to my boss to ask permission, and he refused.  After some pleading on my part, he eventually relented.  That said, when Cramer wanted me to appear on “Mad Money,” he refused, and did not give in.  He did not want the name of his firm associated with Cramer.  I was disappointed, but I understood.

At RealMoney, I wrote about a wide variety of topics as I do at Aleph Blog.  My editor one day called me and after we chatted for a while she said to me, “Did you know that you are our most profitable columnist after Cramer?”  I expressed surprise, and asked how it could be.  She said that I wrote more comments in the columnist conversation than most, and my comments were substantial.  Also, readers would read and re-read my posts, which was rare at RealMoney.

My objective was to teach investors how to think.  I did not want to get into the “buy this, sell that” game.  My most unpleasant memories revolve around bad calls that I made on a few stocks.  I think it was fewer than five stocks, but when you get it badly wrong, passions are heightened.

Cramer and I often disagreed with each other at RealMoney.  I felt I had friends with Cody Willard and Howard Simons, and a few others like Aaron Task, Roger Nussbaum, Peter Eavis, etc.  If I didn’t mention you, please don’t take that as a slight, I just can’t remember everything now.  I thought highly of most of the cast at RealMoney, including the news staff, who would occasionally call me for advice on bonds, insurance, or investing theory issues.

I resisted the idea of starting a blog.  I said to my editors at RealMoney, “The Columnist Conversation is my blog.”  But in early 2007, while trolling the comment streams on Jim Cramer’s blog, and making comments defending him, a number of readers told me that I was one of the best writers on the site, so why didn’t I emerge from Cramer’s shadow?

I thought about this hard for about a month, and then I did it, after doing my research.  I created Aleph Blog, with the first post coming on 2/17/2007, and the first real post on 2/20/2007.  That first real post was prescient, and laid out a lot of what would happen in the bust.

But as I started, the Shanghai Market crashed, and Seeking Alpha pushed one of my posts to the top of their front page.  Cody Willard pushed another post of mine to his media contacts.

I was off and running without doing that much to advertise my blog.  I appreciated that because I think the best way of advertising my blog is to write good content.  I don’t generally like to quote large amounts of the writing of others, and add a few comments from me.  To me, that seems lazy.  I would far rather spend some time, and give you my thoughts.  I’m not always right, but I am always trying to give you my best.

After ten months of blogging, I stopped contributing to RealMoney because I liked the editorial freedom that bloggng offered.  I was never writing for RealMoney in order to get paid, so not getting paid at Aleph Blog was not a problem.

At Aleph Blog, I write about what resonates within me.  That usually produces the best results, though because I write about a wide variety of topics, some people don’t know what to expect of me, and aren’t interested in what I write.  I understand that, and I am not unhappy with a smaller audience.

What I did not expect when I started blogging was that I would do:

  • Book Reviews
  • The Education of a Corporate Bond Manager
  • The Education of a Mortgage Bond Manager
  • The Education of an Investment Risk Manager
  • The Rules

and other series at my blog.  I did not consider that I might be a conference blogger for notable institutions like Bloomberg and the Cato Institute.

I also did not realize that I would take aggressive stances against a wide number of semi-fraudulent financial practices like penny stocks, structured notes, private REITs, and a wide variety of other bad investments.

It’s been a lot of fun, and I did it to give something back.  With great power comes great responsibility, and that is why I blog.  Nothing more, nothing less.

May the Lord Jesus Christ bless you.

Thanks for reading me.

David

Sorted Weekly Tweets

Friday, November 1st, 2013

Market Impact

 

  • Keep the Economists off the Trading Desk http://t.co/3E3OoDJLrS As Howard Simons said, “Stocks are not GDP futures.” Ignore the economy $$ Nov 01, 2013
  • ‘Skew’ Measure Points to Excessive Market Optimism http://t.co/sT8aVfJ2MI Calls priced high, puts priced low & we r not so bad u know? $$ Oct 30, 2013
  • Bear hunting http://t.co/nvnCpNfl1G Bear shortage has a few wondering who is left to buy from existing stockholders $$ Oct 30, 2013
  • Amazing fact #1: Market has been unexpectedly strong since May 1 | Amazing fact #2: Market’s YTD 2013 returns have never been negative $$ Oct 30, 2013
  • 3 ‘amazing’ facts about the stock market http://t.co/SKog36iBgE Amazing fact #3: The stock market’s Sept and Oct have both been positive $$ Oct 30, 2013
  • Wall Street is way too bullish http://t.co/dBNe8oaeho Collapsing time horizons may presage a bearish turn for the risky asset markets $$ Oct 30, 2013
  • BlackRock’s Fink Says There Are ‘Bubble-Like Markets Again’ http://t.co/cgj8MI5vls “Fed policy is contributing to ‘bubble-like markets.’” $$ Oct 30, 2013
  • Five Bad Ways to Pick a Mutual Fund http://t.co/9ZXV7y0lWv Good as far as it goes. Important: don’t chase performance or ratings $$ Oct 30, 2013
  • How Our Brains Betray Us http://t.co/ZFzTZT4t1t We tend 2b 2 optimistic about the future,& not realistic enough about the present $$ Oct 30, 2013
  • JP Morgan’s Subprime Troubles Ran Deep http://t.co/df0Ok7fQG4 The originators r all dead, so they go after one of the last standing $JPM $$ Oct 30, 2013
  • Bond-fund charts of the day, rising-rates edition http://t.co/q7DDAectXI Where @felixsalmon finds the speed of rates rising matters a lot $$ Oct 30, 2013
  • Six Ways to Ensure Qualified Borrowers Can Get Mortgages http://t.co/S7XBegLn4k Unrealistic article, though the part on servicing is good $$ Oct 30, 2013
  • Is Your Pension Courting Catastrophe? http://t.co/0kMj4FdCpO Good summary & resources, but few pensions invest 2much in CAT bonds $$ Oct 30, 2013
  • Are CAT Bonds The Answer to Today’s Retirement Planning Woes? 2 Early 2 Tell…More Transparency Needed! http://t.co/M7taq4X2XE Not4retail $$ Oct 28, 2013

 

Companies & Industries

 

  • Phillips 66 to Build Texas Terminal to Export Propane, Butane Overseas http://t.co/XIUbREChpH Exporting nonstandard fuels from fracking $$ Oct 31, 2013
  • PwC Agrees to Purchase Booz to Expand Advisory Services http://t.co/TW21OqwH5Q Conflict of interests: auditing firms 4 which they consult $$ Oct 31, 2013
  • Now Amazon Is Just Giving Money Away http://t.co/mdtioUbM4K $AMZN -> great nonprofit that eats businesses continues like Galactus $$ #nomnom Oct 31, 2013
  • Stop Subsidizing Colleges’ 100-Year Debt Binge http://t.co/76w7ngChue Colleges r more fragile than 2 last 100 years; don’t lend 2 them $$ Oct 31, 2013
  • Dell’s Mitzvah Rescued Buyout as JPMorgan’s Lee Warned of Perils http://t.co/hKyGu1VCnj Da dirt, da whole dirt & nuttin but da dirt $$ Oct 30, 2013
  • Who’s Right About Apple’s Cash Pile: Cook or Icahn? http://t.co/ZJNFMpVtXu Simple: Cook. Most of the $$ is overseas & can’t easily return Oct 30, 2013
  • How Mobile Technology is Changing the Way We Dine Out http://t.co/Su0Po5ezxx Social media affects how people choose restaurants $$ Oct 30, 2013
  • Why Consol is Diving Into Natural Gas While Others Jump Out http://t.co/m3nIsWFv8a Oil > Natgas > Coal | Simple, huh? $CNX $$ Oct 30, 2013

 

Insurance News

 

  • Harbinger Insurer Switches to Iowa Watchdog From Maryland http://stks.co/hsV7 Decamping 4 a more friendly & sophisticated regulator $$ $HRG Nov 02, 2013
  • Berkshire Hathaway defends asbestos claim-paying record vs stories by Mark Greenblatt of Scripps News http://t.co/lYcEQH13Ea FD: + $BRK.B $$ Nov 01, 2013
  • Buffett’s $40B Cash Pile Provides Acquisition Fuel http://t.co/WYZ5AWsBaj Would view largest private companies look4 transitional probs $$ Nov 01, 2013
  • Lincoln National Wins $4 Billion Annuity Reinsurance Deal http://t.co/E3v9AwvDb4 I find this dubious, but $WFC is the likely loser $$ Oct 31, 2013
  • Crop Insurance Hazards Shown in Lost Pheasants in Grasslands http://t.co/s96GcQn8jw W/Ag doing so well, we need to end the Ins subsidies $$ Oct 30, 2013

 

Other

 

  • No Bones About It: Day of the Dead Is Finding New Life http://t.co/AGzU8olA1b Life is for the living; let the dead bury their own dead $$ Nov 01, 2013
  • Little Sign of Housing Bubble in Land Prices http://t.co/P8LyXzvyZu Overinvested for a long time; we shouldn’t subsidize home ownership $$ Oct 31, 2013
  • The 50 Greatest Breakthroughs Since the Wheel http://t.co/Hy0ePPNa9W Ambitious article that explains why innovation benefits us all $$ Oct 30, 2013
  • Drones Delivering Pizza? Venture Capitalists Wager on It http://t.co/njvc3uysge Sadly, the pizza was cold when it arrived. $$ Oct 30, 2013
  • If New York Freezes in January Blame Siberian Snow Now http://t.co/7oMGUa8poK These tendencies r weak, like most things on global warming $$ Oct 30, 2013
  • Cheaper Laser Sensors for Self-Driving Cars Are on the Way http://t.co/Nx09HA3zEW If sensors r that expensive, driverless cars r far-off $$ Oct 30, 2013

 

NSA / Privacy

 

  • Furious Tech Giants Fight Back Against NSA Surveillance http://t.co/KSNmBfE2v4 Ripple effect from Snowden’s revelations get bigger weekly $$ Nov 01, 2013
  • Edward Snowden Has Japan Copying China’s Playbook http://t.co/iZ1sKibSSd Excessive secrecy creates environment for government wrongdoing $$ Nov 01, 2013
  • How anti-NSA backlash could fracture the Internet along national borders http://t.co/gswU55LYiS Democratic nations hate being NSA snooped $$ Nov 01, 2013
  • NSA infiltrates links to Yahoo, Google data centers worldwide, Snowden documents say http://t.co/Sr5YZD4u74 $$ shot: http://t.co/fTFufojKwz Nov 01, 2013
  • Tax delinquents by the thousands have security clearances, GAO finds http://t.co/8VnAziQSVN Easier 2 suborn someone who is in debt $$ Nov 01, 2013
  • Obama Unaware as US Spied on World Leaders: Officials http://t.co/DTz36LPrPE The surveillance state takes on a life of its own $$ Oct 30, 2013
  • The NSA’s Rent Is Too High http://t.co/xSGkk8GZvy Even if what they do were legitimate, they cost Americans far too much $$ Oct 30, 2013

 

PPACA / Obamacare

 

  • Health Policies Canceled in Latest Hurdle for Obamacare http://t.co/eT3EkcotYp I’m grandfathered for now, but how long will that last? $$ Nov 01, 2013
  • Obamacare’s Biggest Threat Isn’t the Website http://t.co/az9Imf0qBK burdensome complexity subsidy-based plan; failure universal coverage $$ Oct 31, 2013
  • You Can Keep Your Health Plan* http://t.co/Wi5xqZvdrB *Except if it not a health plan that the Obama Administration does not like $$ #lies Oct 31, 2013
  • Obama Tempers Insurance Pledge as Health Fight Rages http://t.co/fpZPH27KML An arrogant man who doesn’t understand economics and lies $$ Oct 31, 2013
  • Yes, People Are Losing Their Insurance Under Obamacare http://t.co/8aqWoASQfl Affects some people who buy their health plans on their own $$ Oct 31, 2013
  • The ObamaCare Awakening http://t.co/P01zM98SNZ Americans are losing their coverage by political design. That’s a feature, not a bug $$ #lose Oct 30, 2013
  • Insurers Oppose Obamacare Extension as Danger to Profits http://t.co/nsIz2wSoyT Clever Obama got the insurance companies2carry water4him $$ Oct 30, 2013
  • Americans lose coverage, Democrats say Obama too rosy about health care law http://t.co/jGg1lWtJA7 My plan was canceled; i had no choice $$ Oct 30, 2013
  • How Jon Stewart became President Obama’s biggest problem http://t.co/YAJ8fOnFJZ Lousy efforts from the govt deserve 2b exposed $$ Oct 30, 2013
  • Desperately Needed: More Geriatricians http://t.co/THkwfgtFqn We cannot create more Geriatricians via fiat in the sort run $$ Oct 30, 2013
  • The First Cracks http://t.co/UAnrYjlzXQ Some Democrats begin to question PPACA/Obamacare $$ Oct 30, 2013

 

Rest of the World

 

  • Will Toilet Rules Prove EU’s Waterloo? http://t.co/0jLUpeIA1a Standardizing toilet specifications across different cultures is futile $$ Nov 02, 2013
  • Japan Stocks Sink to Monthly Worst in Developed Markets http://t.co/XHJewfR5NZ Really difficult 2c how Japan normalizes econ policy $$ Nov 01, 2013
  • Ignore Greek Elections: Stocks Might Be the Best Buy in over 60 Years http://t.co/7tKWQ365RW Good call from @valuewalk timely/contrarian $$ Oct 31, 2013
  • Greek Recovery Makes Stocks World’s Best as Paulson Buys http://t.co/m25XYjWQsE Buy on the rumor, sell on the news, stick a fork in it $$ Oct 31, 2013
  • Eike Batista’s Empire Soared, Then Melted Into Bankruptcy http://t.co/3lh9catSFf At best, a huckster. At worst, a robber. A cheater $$ Oct 31, 2013
  • Japan Salaries Extend Fall as Abe Urges Companies 2 Raise Wages http://t.co/jOprQhpTsk Abe has quite an imagination; markets will dictate $$ Oct 31, 2013
  • OGX Bankruptcy Filing Caps Batista’s $30 Billion Demise http://t.co/MkIdlrCKNv He seemed incredible to me at first, he is credible now $$ Oct 31, 2013
  • Political Gridlock, Beijing Style http://t.co/xCrcTd2htZ Entrenched economic interests fight Party leadership seeking economic reform $$ Oct 30, 2013
  • Rebuilding Reserves Means U-Turn on Treasuries http://t.co/5EH3t378gb The $$ is not the only game in town, better liquidity than others $$ Oct 30, 2013
  • India Breast Cancer Surge Hinders Private Exams for Women http://t.co/Fumyl2WHTO Big problem, few resources; makes me feel sorry for them $$ Oct 30, 2013
  • Study Sheds Light on the Dark Side of China’s Urbanization http://t.co/GZFyxNKEHn Communism alienates from the means of production $$ #China Oct 30, 2013
  • The Lust Beneath Japan’s Sex Drought  http://t.co/APyIFrlth7 Japan’s sex culture is perverse, & their society shrinks as a result $$ Oct 30, 2013
  • The China Americans Don’t See http://t.co/E8FwXk1H6W China is weaker than it looks b/c it can’t handle dissent against the Party $$ Oct 30, 2013
  • Greek Government Bonds Pay Off Big for Fund Managers http://t.co/9LiFTr8BED Every dog has its day, & this bond mgr rates a healthy “arf” $$ Oct 30, 2013
  • Man Making Ireland Tax Avoidance Hub Proves Local Hero http://t.co/Iy2CVenb3f Controversial fellow who is not universally admired $$ Oct 30, 2013

 

Monetary Policy

 

  • Fed’s Bubble Alarm Stuck on Snooze http://t.co/Wwx4fARLH4 Not in Fed’s interest 2 go bubble hunting, do bad enough w/inflation & unempmt $$ Nov 01, 2013
  • JP Morgan sees ‘most extreme excess’ of global liquidity ever http://t.co/WurN40hJfP Global QE leads to a surfeit of spendable funds $$ Nov 01, 2013
  • Yalies Yellen, Hamada Put Tobin Twist Theory to Work in QE http://t.co/Okj2CGXZfo Op Twist might work at low debt levels, not at high $$ Oct 31, 2013
  • Sen. Paul Ties His Fed Bill to Vote on Yellen Nomination http://t.co/5hBSNbsOCg Auditing Fed’s monetary policy decisions is a good idea $$ Oct 30, 2013
  • http://t.co/SrNx6yfP2T Negative interest rates are a way for the government to steal from those that want to keep their risk profile low $$ Oct 28, 2013

 

Politics & Policy

 

  • Prosecutor Pleasantly Surprised to Find There’s a Law Against Fraud http://t.co/nqneLdc6JP Regulators use FIRREA to prosecute finl fraud $$ Nov 01, 2013
  • Wife Poisoning Husband’s Lover Tests Weapons Law at High Court http://t.co/0p7Otz5hyD Upheld, would federalize all crimes using chemicals $$ Nov 01, 2013
  • Speedy Lunches Urged at SEC as Union Decries Time-Clock Watching http://t.co/RpXErNaSct Never knew SEC workers had a union $$ #huh Nov 01, 2013
  • Policymakers think of investment like magic; just because u invest does not mean everyone will be better off; investment can b a waste $$ Oct 31, 2013
  • 12 Steps toward a Simpler, Pro-Growth Tax Code http://t.co/vQWaVnHUw8 Problem is 2Much deferral of income tax & favoring investment $$ Oct 31, 2013
  • Gross Says America’s Privileged 1% Should Pay Higher Taxes http://t.co/c9i5W8i9R2 Real problem is definition of income; 2much deferral $$ Oct 31, 2013
  • Counties Made for Horse and Buggy Reject Savings http://t.co/oZshDLJGA6 Ppl value tangible/local govt & don’t begrudge its costs so much $$ Oct 31, 2013
  • Budget Deficit in US Narrows to 5-Year Low on Record Revenue http://t.co/9puVuXTbNm But it needs 2 shrink further, it is 2 big $$ Oct 31, 2013
  • Obama’s Broken Promise of Better Government Through Technology http://t.co/bWn3F3Pphy Bigness of govt tends to sabotage tech development $$ Oct 31, 2013
  • Christie Confounded as Padded Services Send New Jersey Taxes Soaring http://t.co/HTRKeQwchD NJ & corruption? We r supposed 2b surprised? $$ Oct 31, 2013
  • The expected future payments from defined benefit plans is the acid test for municipal finances; that includes social security & medicare $$ Oct 30, 2013
  • Pension Pinch Busts City Budgets http://t.co/dUid8OAyuI W/underfunded plans, watch the cash cost curve: what u expect to pay going fwd $$ Oct 30, 2013
  • The Great Pension-Bonus Giveaway Fiasco http://t.co/JWiO616X5e One of the stupidest things in pensions, allowing ppl 2spike benefits $$ Oct 30, 2013
  • Evangelical Pastors, Marriott CEO United on Immigration http://t.co/1AG0STUpK2 So long as we do not give them benefits, immigrants r good $$ Oct 30, 2013
  • Armed agents seize records of reporter, Washington Times prepares legal action http://t.co/NCJ33BSDjG State & Military abuse reporter $$ Oct 30, 2013
  • Software Helps GOP House Majority Leader Isolate ‘Astroturf’ Emails http://t.co/eDPLGwo1a7 Easy 2c lazy ppl who only have time 2 copy $$ Oct 30, 2013
  • Mystery of the ‘Missing’ Global Warming http://t.co/3xkNAd50JA Argues that rising water temperatures r more indicative of the problems $$ Oct 30, 2013
  • Colorado Secessionists Struggle as Trend Lifts Democratic Votes http://t.co/BJ9g0CbS6K Secessionists r unrealistic; Congress won’t do it $$ Oct 30, 2013
  • Reagan Revolution Misses Tax Fiefdoms Flourishing in US http://t.co/feUsHyGL5B Many local municipalities levy taxes; some do little $$ #IL Oct 30, 2013
  • Obamacare and the Death of Liberalism http://t.co/VLVk1GiJrT Liberalism ends when entitlement promises fail; I say give it 10-15 years $$ Oct 30, 2013

 

Wrong

  • Wrong: Germany Hits Back at US Over Economic Criticism http://t.co/hsoeuvvtLd Neomercantistic Germany’s surpluses will not get paid back $$ Oct 31, 2013
  • Wrong: Startup Defeats the Captcha, Wins One for the Machines http://t.co/vVAMnaBdJG Captchas have evolved beyond what has been cracked $$ Oct 30, 2013
  • Wrong: The political middle is dying. But it’s not redistricting’s fault. http://t.co/zRplttRK5w We need to force the middle to govern $$ Oct 30, 2013
  • An interview with Alan Greenspan http://t.co/eLgAExy6bQ One constant w/Greenspan is he will not accept blame for the mistakes he made $$ Oct 30, 2013
  • Wrong: PPP and Japanese Inflation Expectations (Extremely Wonkish) http://t.co/1G5MpBSnhw As usual, Krugman says inflation won’t hurt $$ Oct 30, 2013

 

Replies, Retweets, & Comments

  • $$ @ritholtz It is a plan if you prefund the deductible, which many medical service providers r requiring w/PPACA plans b4 service granted Oct 31, 2013
  • @viccan1 I don’t believe in conspiracy theories Oct 31, 2013
  • First, this isn’t new. I had professors talking about this in the early 1980s. Second, what may work when… http://t.co/MDJSt6EHaQ Oct 30, 2013
  • I do not want to spend my days, writing out the i’s & j’s. But i’s & j’s are an enigma, when squashed between a double sigma $$ #mathpoetry Oct 30, 2013
  • If you too should choose to skew sir, with the skew-goose, please sir, do sir — w/apologies to Dr. Suess $$ Oct 30, 2013
  • http://t.co/prav9FGJ2h “Now Fink tells us. He was more of a cheerleader for QE at its start.” — David_Merkel http://t.co/MNHiiBTfnp $$ Oct 30, 2013
  • “The difficulty w/prosecution is apportioning blame. Easier to go after the corporation.” — David_Merkel http://t.co/qOh82vAqvU $$ Oct 30, 2013
  • RT @RCdeWinter: This seems truer and truer every day. http://t.co/cKGi6IBdJH Oct 30, 2013
  • RT @TFMkts: Exactly how has QE helped jobs? NFP pattern no looks no different before and after QE http://t.co/Y0IUuDxT3B Oct 30, 2013
  • RT @mccarthyryanj: Amazing hire of @MattGoldstein26 by @DealBook. A really big loss for Reuters Oct 30, 2013
  • “Consider Stocktwits. They created cashtags. To refer to Google, you would type $GOOG. Twitter…” — David_Merkel http://t.co/ZxWfSQjwze $$ Oct 28, 2013

 

On Liabilities in Asset Allocation

Thursday, October 17th, 2013

From an e-mail from one of my readers:

I’m not sure if you have the time to respond to this, but figured I’d send to you and just see!…

(Just FYI, I’m not an investment professional of any sort, so I don’t have any “skin in the game” as they say, just a geek who follows the markets and DIY financial-planning issues and long-time reader of the Aleph blog)

I recently read an FP article by a guy I’ve read a lot (Alan Roth).  He suggested that, when your analyzing an investment portfolio and making asset-allocation decisions, you need to treat mortgage debt as an “inverse-bond” or an “anti-bond”…such that any mortgage debt held would dollar-for-dollar negate or reduce your actual bond investment holdingsAnd the result is that this made the investor’s actual portfolio risker than they realized, since their “true” bond allocation was smaller than they had considered.

I thought it was a novel concept, but I found some problems with that approach, within the context of asset-allocation.  My main point was that the primary purpose of analyzing a portfolio’s asset allocation is to manage risk through diversification of assets (generalizing here in interests of being concise).   The pinnacle of diversification is non-correlation: generally in economic environments where equities soar, bonds will underperform, and vice versa.  However, classifying a debt as an “anti-bond” doesn’t actually provide any portfolio diversification, or introduce any non-correlation.  It won’t actually negate the amount that your bonds would rise, and it won’t actually offset the amount your bonds would fall, in those respective market environments.  And even if you consider that the real value of the debt is decreased if inflation rises (as the NPV calculation would be using a greater discount rate), that doesn’t have any real-world effect on the portfolio and it’s risk and return behavior.  Since borrowers aren’t allowed to “mark-to-market” their mortgages, that debt holding value does not fluctuate–it is fixed, and amortized from its historical cost, regardless of any market conditions or any theoretical NPV/DCF changes.  Therefore, the inverse- or anti- bond holding in the portfolio has zero impact on the portfolio’s actual risk/return behavior, and so it seems to me it doesn’t add any functional value to frame debt as an “anti” portfolio holding of some sort.

Also, if you were going to do that, to be fair and complete, you must apply that same principle to every single debt the client has (otherwise, it would be rather arbitrary just selecting the mortgage debt).  This adds unnecessary complexity in the asset allocation analysis.

Instead, the appropriate (and only) way to analyze debt is, separate from investable portfolio assets, on the cash-flow side of things.  Simply asking what is the “optimal” use of the available capital; i.e. what net “return” do you earn by using capital to eliminate debt, versus what net return could you earn if you kept the debt and employed the capital elsewhere (this will be different for each investor and their unique situations).  This is the way to analyze and evaluate debt, not to mingle it in with your invested assets and classify it as an “anti-bond” holding within your portfolio.

I was just curious your take on this, and if I am misunderstanding or missing something.  Do you ever consider client’s debt as “inverse-“ or “anti-“ bonds in the context of asset allocation?

Thanks!

When you manage money financial firms, if you do it right, you consider the promises that your firm needs to fulfill.  When will cash be needed to pay obligations?  That helps drive asset allocation, because assets should broadly match liabilities.

Now, I am not a financial planner.  That said, the same principles apply to personal asset allocation.  If someone has a large mortgage or other debts, and he can’t invest his fixed income assets at levels that exceed the yields on those debts with reasonable risk, he should not invest in bonds — he should pay down his debt.  In the case of 401(k)s or IRAs, where there might be matches or tax advantages, the calculation becomes more complicated.  You have to weigh the match and tax deferral vs the negative arb on bond yields vs the mortgage and personal debts.

There is another factor here — how stable is your job?  If stable, it is bond-like, and you can take more equity risk with investments.  If your job has payoffs that vary a great deal with the market — commissions, bonuses, etc., it is stock-like, and you should take less risk in your investing — take excess earnings and pay down the mortgage.  I did that when I went from being a bond manager inside an insurance company, to being an equity analyst inside a hedge fund.  I paid off my mortgage in full, so that I would be free to take risks for my new employer.

As for the article, the concept is not novel.  It is well-known and practiced by institutional asset managers who manage money to the horizons needed by their clients.  As an example, the cash flows of a pension plan are relatively determinate, and the discount rate calculates the value of the liability.  The portfolio should throw off cash when needed in order to minimize risk.

In some cases, where bonds don’t offer enough yield, and equity prices are depressed, it might make sense to tactically mismatch, betting that equities will offer better returns versus the liabilities than bonds would on a risk-adjusted basis.

This argument has made its rounds for the last 20 years in insurance and pension management?  Do we match asset and liability cash flows, or do we trust in the equity premium, and invest in risk assets?  The correct answer is hybrid.  In general, match assets and liabilities, but if there is a significant tactical advantage to not match, then do that.  Think of buying junk bonds in late 1998.  Time to throw matching out the window.  And then in mid-1999, buy equities.

Now, not all clients will allow for that much risk-taking.  Many institutional investors will not let the asset manager take advantage of temporary dislocations.

In general, I think Mr. Roth is correct, but with an adjustment.

  • In extraordinary times, where bonds yield more than the earnings yields of stocks (think 1987 & 2000), buy bonds heavily, even if you have mortgage and other debts.
  • In extraordinary times, where stocks earnings yields are much higher than bonds, mismatch and own more stocks relative to bonds.  Just beware deflation, with falling future earnings.
  • In normal times, an indebted investor should not add to his leverage, but should invest in bonds, or better, pay down his debt.  Being debt-free is an excellent thing, and allows the investor to take more risks when the market is offering bargains.

Debt is either something to be funded by bond assets, or funds a margin account where you outperform the yield, or die.  All of this depends on where the market is in its risk cycle.  Only take risk where it is rewarded.

 

The Rules, Part LVI

Wednesday, October 16th, 2013

Leverage and risk eventually transfer to the least regulated

I’m coming near the end of this series.  It will either end at LX or LXI.  To refresh, I started a file in 1999 of insights before I started writing at RealMoney or Aleph Blog.  I ended it in 2003, near the time I started writing for RealMoney.  I threw a few of the insights away, but not many — there may have been near 70 when I was done.  These ideas stemmed for all of the new ideas I ran into as I transitioned from being an investment actuary to being a portfolio manager.  Onto tonight’s idea!

After the recent crisis, tonight’s insight may seem rather banal, but I saw it as an actuary many times as onshore insurers would shed reserves using reinsurance treaties to Bermuda companies and other domiciles with weak reserving, capital or tax rules.  It was reinforced to me when I blew it badly regarding Scottish Re.  It was only in the midst of their crisis, that I finally saw a full diagram of their corporate structure.  It was a hodgepodge of all of the weak insurance domiciles, with many lines going this way and that.

A picture is worth a thousand words, and as I have often said, complexity within financial companies is rarely rewarded.  That diagram focused my research, and changed my view of what was going on.  After having bought into the decline, we sold into an incredible one day rally when some positive news was released, while my view had shifted that cash could not make it to the holding company, and the common would go out at zero.

What a mess, and the best thing I can say was that selling into the rally was the right thing to do, as the common did go out at zero.

But in the recent crisis:

  • How many weakly capitalized investment banks died or were acquired?
  • How many REITs, particularly mortgage REITs died or were acquired?
  • How much of the mortgage insurance industry died?
  • How much of the financial guaranty industry died?
  • How many significant GSEs died?
  • And with all of these, how many barely survived?

These all had weak financial models, taking on too much credit risk, with weak, backward-looking models for risk.  It is no surprise that the bad credit risks found the fools that assumed that housing prices could only go up, and incurred considerable leverage to make their bets.

All of these were weakly regulated.  There was more than a bit of the “this is free money” attitude to many of these businesses — it was an era that rewarded yield hogs for a time.

Thus, when you see financial firms with weak balance sheets taking on significant credit risks, be wary, it is often a sign that the credit cycle is about to turn.

Letters from Readers

Saturday, October 12th, 2013

I’ve been reading your blog for quite sometime and I’ve always been astounded by your vast knowledge of just about everything in investments. I’m new to this game and I hope to learn from you, which brings me to the following:

I know we have to calculate “float”, “cost of float” and find the “combined ratio” for an insurance company to value it more accurately. However, I’ve spent hours googling around and I still can’t find what exactly in the balance sheet/P&L/CF statement (or even in the footnotes!) that constitutes as:

loss adjustment expense, unearned premiums, other policyholder liabilities, premium balance receivable, loss recoverable from reinsurance ceded, deferred policy acquisition costs, deferred charges on reinsurance, related deferred income tax, etc. 

In most insurance companies’ balance sheets, all I see are the usual suspects “cash & cash equivalents”, “goodwill”, “intangible assets”, “derivative financial instruments”, “PPE” and the likes. I’ve never seen any of those above-mentioned terms, are there substitute words for them? I’m obviously missing something out. Thank you for your time!

Let’s clear something up here — there is no GAAP financial statement item called float.  What is float?  Let me teach you something deeper.  How does a property & casualty insurer invest?

There is some wiggle room around this, but typically, the premium reserves are invested in high quality short-term debt.  Premium reserves represent the premiums paid in advance that have not yet been taken into income, because some insureds don’t pay month-by-month, but they have paid for many months in advance.  They are often called unearned premiums.

Claim reserves are typically invested in longer-term debt, where the term of the debt will approximately match the period over which the claim will be paid.  Much of the claim reserves fall into the category “Incurred but not Reported [IBNR].  Insurance claims are not always filed immediately.

Finally, the surplus of the insurance company is usually invested in risk assets — equities, private equity, real estate — whatever area the insurance company thinks they have expertise to make money.

The first two categories, premium and claim reserves, comprise float.  You can try to measure them by looking at the statutory statements of the insurer, where those are real line items on the liabilities page, or you can approximate it by looking at the current liabilities, and adding in the claim reserve, which is usually in one of the footnotes.

Reinsurance can mess this up a little, so try to work with numbers net of reinsurance.

Property & Casualty Insurers do not have to credit interest as they delay paying claims, or receive premiums in advance.  Thus the concept of float.  Few insurers use float to be as aggressive as Buffett.  They invest more conservatively, especially among insurers where claims get paid quickly (home & auto).  With long-tailed claims, like asbestos & environmental, the claims may take so long to emerge that the insurer can be investing in stocks, and that will be the optimal investing decision.

The so-called “cost of float” is net underwriting losses.  If there are no net underwriting losses, float is free, or more often, is a source of profit.

But float isn’t worth much unless you have a clever investor investing the cash that stems from the delay of paying claims.  Even with Buffett, that advantage is uncertain.

Tell you what, I never analyze float in insurance.  I analyze management teams.  Insurance is uncertain enough, that I want a margin of safety, and the best way that I can do that is find management teams that are conservative.  Do they consistently make money on underwriting?  Do they occasionally/frequently deliver negative surprises?

I wouldn’t spend time on float.  Any insurer can generate float.  Look at how they make money.  How do they underwrite?  How do they invest?  Are they conservative in their accounting?  That is what you should look for.

Next letter:

I hope you are doing well.  I have been reading your blog for the last few years and have found myself thoroughly educated and entertained.  My favorite series of posts has been your explanation on the holders’ hands, which is a unique and more useful way of classifying market participants, rather than just using timeframe.

A little bit about myself: I am currently a student at zzzzzzzzz studying Economics and before that I was in the Marine Corps Reserves where I served a tour in Iraq. 

I managed to save some money from that time and began investing, which dovetailed nicely with my burgeoning interest in macroeconomics (particularly through the Austrian and Post-Keynesian lens).

As I learned from my mistakes and improved, I recently felt confident enough to form my own LLC in the hopes of bringing on close family and friends as part owners (essentially limited partners) and manage our savings in a more productive and less expensive manner than the current meta of mutual funds or indexing.

This brings me to the the reason I am emailing you: suppose I would like to expand this type of business…How would I go about this? Am I reliant on word of mouth via friends and family?  I also plan to talk to the Small Business Administration for investors, but I don’t think anybody will even give me a chance until at least after a few years. 

Would it be feasible to talk to pension/asset management firms for interest in investing?  I would love to hear your opinion on the matter and please let me know if there is someone more appropriate for me to send this email to.

If I have this straight, you have started a firm that invests in other firms, not all that much different from Buffett in his days after ending his limited partnership.  In this case, you are limited by the number of people that can invest in your private firm, which in these days, I believe is 1000 people.  I could be wrong here, so consult competent legal counsel to guide you.  Not sure how the SBA would fit in here, though I know they aid funding small firms together with venture capitalists.

What you are doing is too small for pension and asset managers.  Given the JOBS Act, your best option is to recruit medium-sized investors, and invest wisely.  Given that you run a private firm, you might not want to limit yourself to public companies.  You might be able to compound capital faster by buying whole small companies, or large portions of medium-sized companies.

Of course, this all presumes that you have a real talent here.  If you’re not sure, give it up now, and give the capital back to your shareholders.

I wish you well, but if you are doing public assets, far better that you do what I do and manage separate accounts for investors.  It’s a lot cleaner.

On Tower Group

Wednesday, October 9th, 2013

Lo, how the mighty have fallen.

Let’s take a step back and see the full stock chart.

My, but Tower Group [TWGP] was a juggernaut in its time, but I never bought it or sold it.  Let me explain:

In 2005 my boss at the hedge fund came to me and said, “Why don’t we own Tower Group?  One of my friends owns it and says it is the greatest company in insurance.”

Me: “They are a new company underwriting in tough lines, with a weird reinsurance agreement from a small Bermuda company.  They are growing too fast, and I doubt they are as profitable as they claim.”

Boss: “Well, should we short them then?”

Me: “I don’t think shorting into strength is smart, so no.  We should do nothing here.” (After a little more, boss leaves, probably annoyed at me because I recommended no action.  He was a man of action!  I am a prudent risk-taker, and very selective about when I short.)

As an analyst of insurance stocks, I was always skeptical of Tower Group for three reasons:

  1. The acquisitive nature of Tower Group.
  2. The rapid growth in premiums, 52% per year over the last 10 years — no insurance company can successfully grow that rapidly in a mature market.
  3. Odd reinsurance agreements that made me wonder.

But by the time I ceased being a buy side analyst for a hedge fund in 2007, there was nothing to make me short Tower Group, much as I did not like it.  And so, I stopped following the company, because it is much easier to look only for companies to be long.  (TWGP remained on my “consider shorting” list till the end of 2007.)

I stopped following it.  Had I been following it, I would have noted the unusual strengthening of reserves for losses from prior year business (Page F-32, worth $69 Million) from the 10-K filed on 3/4/2013.  Someone selling on that day or soon after would have received something in the $18s/share vs. $4s/share now.  Large reserve strengthenings are often a harbinger of greater reserve strengthenings to come.

After their writedown, Tower Group was downgraded by the rating agencies to the degree that few will buy new insurance or reinsurance from them.  Further, they are seeking a buyer, and the buyers are skittish.

Thus, the company is probably in runoff. Runoff means there are no more new premiums, and the company aims to pay all legitimate claims until it closes its doors, hopefully leaving the equity investors a little.  Unless you are an expert, I would avoid taking any action here.  It is quite possible that reserves were set fraudulently, and that we have been given as much as the market can absorb in losses.  It’s also possible that the third-party actuaries have given a conservative view of reserves, and things get better from here.

I feature this company tonight to indicate how fraught with uncertainty it is to invest in insurance stocks, particularly those that grow premiums fast — that is usually a negative sign.

I have no idea where Tower Group goes from here, but they are a poster child for past fast growth and weak reserving.

The Education of an Investment Risk Manager, Part IX (The End)

Thursday, October 3rd, 2013

I’m bringing this series to a close with some odds and ends — a few links, a few stories, etc.  Here goes:

1) One day, out of the blue, the Chief Investment Officer walked into my office, which was odd, because he rarely left the executive suite, and asked something like: “We own stocks in the General Account, but not as much as we used to.  How much implicit equity exposure do we get from our variable annuities?”  The idea was this: as the equity markets go up, so does our fee stream.  If the equity market goes up or down 1%, how much does the present value of fees change?  I told him I would get back to him, but the answer was an easy one, taking only a few hours to calculate & check — the answer was a nickel, and the next day I walked up to the executive suite and told him: “If we have 20% of our liabilities in variable annuities it is the equivalent to having 1% of assets invested in the stock market.

2) This post, Why are we the Lucky Ones? could have been a post in this series.  At a small broker-dealer, all sorts of charlatans bring their ideas for financing.  The correct answer is usually no, but that conflicts with hope.  Sadly, Finacorp did not consult me on the last deal, which is part of the reason why they don’t exist now.

3) The first half of the post, The Education of a Mortgage Bond Manager, Part IX, would also fit into this series — the amount of math that went into the analysis was considerable, but the regulatory change that drove it led us to stop investing in most RMBS.

4) While working for a hedge fund, I had the opportunity to sit in on asset-liability management meetings for a bank affiliated with our firm.  I was floored by the low level of rigor in the analyses — it made me think that every bank should have at least one actuary to do analyses with the level of rigor in the insurance industry.

Now, this doesn’t apply to the big banks and investment banks because of their complexity, but even they could do well to borrow ideas from the insurance industry, and do stress testing.  Go variable by variable, on a long term basis, and ask:

  • At what level does this bring line profits to zero?
  • At what level does this bring company profits to zero?
  • At what level does this imperil the solvency of the company?

5) This story is a little weird.  One day my boss called me in and said, “There’s a meeting of corporate actuaries at the ACLI in DC.  You are our representative.  They will be discussing setting up an industry fund to cover losses from failures of Guaranteed Investment Contracts.  Your job is to make sure the fund is not created.”

His concern in 1996 was that it would become a black hole, and would encourage overly aggressive writing of GICs.  He didn’t want to get stuck with losses.  I told him the persuasion was not my forte, but I would do my best.  I said that my position was weak, because we were the smallest company at the table, but he said to me, “You have a voice at the table.  Use it.”

A few days later, I was on the Metroliner down to DC.  I tried to understand both sides of the argument.   I even prayed about it.  Finally it struck me: what might be the unintended consequences from the regulators from setting up a private guaranty fund?  What might be the moral hazard implications?

At the meeting, I found one friend in the room from AIG.  We had worked together, and AIG didn’t like the idea either.  In the the early parts of the meeting it seemed like there were 10 for the industry fund, and 3 against, AIG, Principal, and us.  Not promising.  We talked through various aspects of the proposal, the three representatives taking the opposite side — it seemed like no one was changing their minds, but some opinions were weaker on the other side.

By 3PM the moderator asked for any final comments before the vote.  I raised my hand and said something like, “You have to think of the law of unintended consequences here.  What will be the impact on competition here?  What if one us, a large company decides to be more aggressive as a result of this?  What if regulators look at this as a template, and use it to ask for similar funds more broadly in life insurance?   The state guaranty funds would certainly like the industry to put even more skin into the game.”

The room went silent for a few seconds, and the vote was taken.

4-9 against creating the guaranty fund.

The moderator looked shocked.

The meeting adjourned and I went home.  The next day I told my boss we had won against hard odds.  He was in a grumpy mood so he said, “Yeah, great,” barely acknowledging me.  This is the thanks I get for trying something very hard?

6) In early 2000, I had an e-mail dialogue with Ken Fisher.  I wanted to discuss value investing with him, but he challenged me to develop my own proprietary sources of value.  Throw away the CFA syllabus, and all of the classics — look for what is not known.

So I sat down with my past trading and looked for what I did best.  What I found was that I did best buying strong companies in damaged industries.  That was the key idea that led to my eight portfolio rules. Value investing with industry rotation may be a little unusual, but it fit my new view of the world. I couldn’t always analyze changes in pricing power directly, but I could look at industries where prices had crashed, and pick through the rubble.

In Closing

My career has been odd and varied, which has led to some of the differential insights that I write about here.  In some ways, we are still beginning to understand investment risks — for example, how many saw the financial crisis coming — where a self-reinforcing boom would give way to a self-reinforcing bust?  Not many, and even I did not anticipate the intensity of the bust.  At least I didn’t own any banks, and only owned sound insurers.

Investment risk is elusive because it depends partly on the collective reactions of investors, and not on external shocks like wars, hurricanes, bad policy, etc.  We can create our own crises by moving together in packs, going from bust to boom and back again.

It is my hope after all these words that some will approach investing realizing that avoiding risks is as important as seeking returns, and sometimes, more important.  It is not what you earn, but what you keep that matters.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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