Around the Web, and then Some

Posted on 28 March 200731 March 2007 by David Merkel

There were two articles on reinsurers this morning suggesting that there should be a lot of consolidation via M&A. I’m not so sure. First, most players there want to acquire, not be acquired. Second, most of them don’t trust the underwriting and reserving of their competitors to the degree that they trust their own. To the extent that current players want to diversify, it is cheaper to do it organically than by acquisition. With the high degree of ease of entry into the market, the franchise value of a reinsurer is low. Now, maybe the property-centric reinsurers want to diversify (a smart idea, but they are stubborn), or the new reinsurers want to buy in a reverse merger one of the class of 2001 to eliminate the capital haircut from the ratings agencies (but they don’t have the cash for it). Those ideas make sense, but scale isn’t that much of a virtue here, and with P&C reinsurers the reserving is opaque as mud. I can see a deal or two getting done, but not a lot of them.
With all the hand-wringing in the Wall Street Journal this morning on free trade, just watch, we impose some series of tariffs or restrictions that reduce the current account deficit, only to see the capital account surplus shrink also, leading to higher interest rates and a lower dollar, breaking the current cycle giving the US cheap imported goods in exchange for dollar denominated bonds.
Throw a rock, hit a commentator who says that the Bank of China (or other major central bank with large dollar holdings) would never sell their positions because it would work against their interests, driving the value of the dollar down. That’s a half truth at best. Here’s why: the central bank will eventually focus on the future, realizing that sunk costs are sunk. Just because you have a big dollar position, does that mean you have to add to it to preserve its current value. Ignore the past, and let the dollar denominated securities mature. Use fresh cash and maturity proceeds to buy assets in the currencies that you like. It won’t cause a panic, but the dollar will still adjust down. Recognize from the start that the dollar assets are worth less than current exchange rates, and maximize value from there. (Large holders of any asset under pressure have to think this way to maximize value.)
Buyer Beware. Or maybe, it should be borrower beware. People are generally less competent at making rational choices when they are borrowing rather than paying cash. So it is no surprise that when Beazer finances homes that they sold, buyers might have gotten less than an optimal deal. This is true with many financial transactions. In general, the more moving parts in a transaction, the worse off the average person is in evaluating a deal. Better to line up your financing separate from the decision to purchase an asset, or you could end up up with a bop on your beezer, figuratively speaking.
So FASB might have a tighter leash on its neck from the SEC? Not sure whether that is good or bad. Neither organization gets high marks in my book. FASB desperately needs a more coherent overarching approach to accounting, rather than the piecemeal addjustments that they are doing. The SEC, if anything, is more beholden to political pressure, and the idiocy that that brings into accounting.
Then there’s Texas, basically invalidating the GASB on reporting the liability for long term government employee benefits. You might remember my piece at RealMoney, Pensions: Things Can Always Be Worse. Well, this is an example of that, and it is not limited to Texas. Though the Texas argument may have merits, governments all over the country are finding that they have to finally recognize the present value of the pension promises that they have made, and disclose it to the citizenry. It will be a mess, because a large amount of these promises are totally unfunded, much like Social Security, Medicare, and most other programs of our Federal Government.
It takes a week, but finally the market comes around to my view of the FOMC, though it takes Bernanke before Congress to correct the view of the markets. Inflation is not on hold, but the FOMC is, for now.

Bicycle Stability Versus Table Stability

Posted on 27 March 200728 March 2007 by David Merkel

A bicycle has to keep on moving to stay upright. A table does not have to move to stay upright, and only a severe event will upend a large table.

I developed this analogy back when I was a corporate bond manager, because there were some companies that would only stay afloat if they kept moving, i.e., if operating cash flow continued at its projected pace. That is bicycle stability; they have to keep pedaling. There were other companies that could survive a setback in earnings, and even lose money for a time, and the debt would still be good. That is table stability.

Need I mention that in a crisis, the equity of companies with table stability typically fall less than those with bicycle stability?

I think that it is incumbent on every portfolio manager to look over his portfolio, and ask what companies that they own would not be able to survive if they were not able to raise capital for two years.

My current main economic concern is that inflation in the developing world, particularly China and India, will lead to their central banks to overshoot on policy, and cause a drop in global aggregate demand. Inflation is accelerating, and money supply is not slowing. The excess liquidity is not finding its way into goods prices as much as into asset prices.

This portfolio review will not protect you from loss, but it will protect you in relative terms in a crisis. You won?t be hurt as much.

Around the Web

Posted on 26 March 200722 June 2017 by David Merkel

There was an article in Forbes interviewing Jeremy Grantham that made me think. He suggests that value investing might be heading for a period where it will underperform. I.e., value stocks are not as relatively undervalued as they normally are. If he is correct, what should I do? I could shut off the value discipline, and run my industry models in GARP [growth at a reasonable price] or even momentum mode. That cuts against my grain; perhaps what I would do is give a little more weight to the industry models as I make my selections. That would tilt me away from hard value measures. My methods are eclectic, so I have to adapt to what the market is likely to reward 2-4 years from now.
“Minsky moment.” Ah, cute phrase. Well, I loved Edward Chancellor’s, “Devil Take the Hindmost,” and he has an interesting article at Institutional Investor. The themes he talks about are dear to me. My only quibble is that we aren’t yet there for a collapse. There is enough cash available to mop up problems at present. Whether that will continue to be true is another question.
My biggest concern is the dollar, and the carry trade. If the dollar dips below 112 yen, I suspect that there will be a self-reinforcing panic as short yen positions get covered. The Economist had a piece on this recently that made a lot of sense. Eventually we will have an unwind here, but it will come with a lot of kicking and screaming in Asia.
For wonks only, First American Corelogic posted a report called Mortgage Payment Reset 2007: The Issue and the Impact. Very informative on the effects of the loan reset features on hybrid loans, and what might happen to the real estate markets.

Bond Market Notes

Posted on 24 March 200724 March 2007 by David Merkel

What a week. The yield curve disinverted with ten-year Treasury yields moving above two year yields. 30-year bonds traded off 11 basis points, 10-years 7 bp, 5 years 5 bp. The short end of the curve was largely unchanged.

But now look at Treasury Inflation Protected Securities. TIPS 10 years and longer fell a mere 3 bp. TIPS 5 years and shorter were flat. Now, I have a large allocation of my balanced mandates in TIPS and short-term debt, so my downside was protected this week.

So why did the bond market move that way? The FOMC shifted its monetary policy language this week in a way that said that they no longer have a bias to tighten policy, but they do have have a bias to worry about inflation. The Fed’s announcement this week says that they are willing to tolerate a little more inflation. The bond market reacted accordingly, and required more yield on bonds with no inflation protection.

What else happened? The equity markets rallied, both before and after the FOMC announcement. Credit spreads largely tightened, and the dollar fell on the FOMC announcement, before rallying back to flat the rest of the week. In general, the carry trade currencies, the yen and the swiss franc, underperformed, and higher yielding currencies did better.

What can I say, then? The willingness to take risk is alive and well, and the carry trade is re-emerging. M&A isn’t suffering; note the possible deals on Tribune, ABN AMRO, Chrysler and Volkswagen. And, at least according to Bloomberg, there are a scad of CDO deals in the pipeline waiting to be done. So, let the party continue; let others ignore the rising inflation (at your peril), and enjoy the punch that the Fed is serving. As for me, I’ll just enjoy my mug of tea, slowly reduce risk, and watch the spectacle.

Seventeen Days Later

Posted on 21 March 200723 March 2007 by David Merkel

We’ve had seventeen market sessions since the blowup in Shanghai and we are closing in on the level prior to the blowup. My broad market portfolio is down 40 basis points, versus the S&P being down 90 basis points.

This doesn’t mean that everything is back to normal. There are still significant imbalances in the financial system. The carry trade, CDOs, and private equity will yet have their comeuppance. The only question is when it will happen.

Final Step and My Portfolio Decisions

Posted on 19 March 200720 June 2017 by David Merkel

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

What I Am Not Selling

St. Joe ? This doesn?t score well. The idea here is the land is considerably more valuable than the share price would indicate.

SPX Corp, Sara Lee ? These are still in turnaround mode. Metrics don?t look good now, but should improve.

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

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

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

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

What I Am Selling

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

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

What I am not Buying

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

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

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

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

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

Encore Wire ? A bit of a cult stock. I just don?t like the business that they are in.

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

Foot Locker ? Too many earnings disappointments.

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

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

National Coal ? Too small.

Home Solutions of America ? I don?t like their business, given my view of the housing market.

What I am Buying

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

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

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

There Is Always Enough Time To Panic

Posted on 17 March 2007 by David Merkel

I always get a little amused when the permabears emerge from their dens and parade around for the media to observe.? I myself am often bearish, but I have an investment policy that keeps me from expressing too much confidence in it.? I have no doubt that the permabears will eventually be right on much of what they are claiming will happen? but permabears by their nature are too early, and miss more gains from the ?boom? than they typically make in the ?bust.?

In general, and over the long run, prudent risk taking is the best strategy.? The only exceptions are when there is war on your home soil, and aggressive socialism.? That said, in this post, I want to detail reasons to be concerned, and reasons to not be concerned.? Here we go:

Concerns

Earnings growth is slowing year-over-year to about a 4% rate, and actually fell from the third to fourth quarters of 2006.
Loan covenants for loans to private equity have almost disappeared.? Bullish in the very short run, but what are the banks thinking?!
Anytime the bond market maxes out in a given sector, tht is usually a bad sign for that sector.? 42% or so of the whole Investment Grade corporate bond market is financials.? (Contrast that with its weight of 21% in the S&P 500.)? I would be very careful with financial companies as a result.? Were I running a corporate bond portfolio, I would deliberately tilt against financials, and give up income in the process.
Have you noticed the small stocks have begun to underperform?? Not bullish.
The balance sheets of US consumers are in poor shape.? The further down the income spectrum you go, the worse things are.
Abandoned housing is becoming a problem in many parts of the urban US.? (Hey, I?m in the suburbs, and I have two abandoned homes on my block!)
According to ISI Group, corporate capital expenditures exceeds free cash flow by $70 billion.? (That?s what?s driving corporate bonds!)
In 1998, one of the causes of the volatility was a rise in the Japanese yen, which blew out the ?carry trade? at that time.? That may be happening now.
Chinese and Indian inflation is accelerating.
In general, central banks of the world are tightening monetary policy.? The US is an exception, which helps to explain the weak dollar.? Even China is tightening monetary policy.
I don?t worry about the budget deficit; it is part of the overall current account deficit, which I do worry about ? particularly the fact that investment income we receive from abroad is exceeded by that which we pay out.? This shift occurred in 2006, and is unprecedented for at least 50 years.
Inflation is above the FOMC?s comfort zone, even with the bad way that the government measures it.
Private equity is overlevering otherwise stable assets.? That is bullish for the public markets in the short run, but unsustainable in the intermediate term.
Merrill had to withdraw a CPDO in February; to me, this means that corporate default spreads had reached their absolute minimum.
According to Bloomberg, Moody?s says that $82 billion in corporate bonds will mature between now and 2009, and 61% is rated B1 or less.
Actual volatility of stock prices has risen relative to implied volatility.? Further the average holding period of stocks has declined markedly over the last four years, to around seven months, according to the WSJ citing Bernstein.
Margin debt is at its highest level since the 1920s, though as a percentage of market capitalization, it is lower than it was in 2000.
Troubles in subprime and Alt-A lending are leading to declines in US residential real estate prices.
Mortgage equity withdrawal is declining significantly in 2007.? The higher quality the loan, the lower the equity extraction generally.? A reduction in subprime and Alt-A affects this considerably.

Not to Worry

In general, stocks are better buys than bonds at present.? The earnings yield exceeds the 5-year Treasury yield by 120 basis points.? Note though, if profit margins mean-revert, bonds will be the better asset class.
At present, there is no lack of financing for CDOs and private equity, and corporations are still buying stock back aggressively. ?Investment grade corporate bond issuance is robust, surpassing the amount issued in 2006 YTD. On the other hand, high yield has slowed down considerably.? (CDO mezzanine and subordinated debt spreads have widened though, particularly for asset-backed deals.? The arb spread has not been so wide in years.)
Many new BBB bonds are coming with change in control covenants.
The VIX hasn?t closed above 20 yet.
Investment grade corporate balance sheets are in relatively good shape.
The relationship of earnings yields to corporate bonds is a fuzzy one. From the seventies to the nineties, P/Es moved inversely to bond yields.? Not so, so far, this decade, or in the 1960s.? If bond yields rise due to growth expectations, P/Es may follow along.
Money supply growth is robust in the US and globally.? In the short run it is difficult to have a bad market when money supply growth is strong, and measured inflation is low.
There is a still a desire to purchase US assets on the part of foreigners; the recent fall in the dollar has not affected that.
My view is that we won?t have a recession in 2007, and that we might have one in 2008.
ECRI forecasts inflation falling in the US, together with decent growth in 2007.
Proxies for systemic risk have been receding, though they are considerably higher than one month ago.
Export sectors are finally showing some decent growth, partly due to the weak dollar.
IPOs are outweighed by LBOs and buybacks.? With a few exceptions, IPO quality doesn?t seem too bad.
Global demographics favor net saving because of the various baby booms after WWII.? Excess money growth is going into the asset markets for now.
Most M&A deals are for cash, which is usually a bullish sign.? M&A waves typically crest with a bevy of stock deals.? Deal premiums are not out of hand at present.
According to the ISI Group survey state tax receipts are quite robust, indicating a strong economy.
Also according to ISI Group, China is now a net coal importer.
Commodity indexes, scrap steel pricing, and Baltic freight rates are still robust.
Foreigners are buying some of the excess US homes as second homes.? Having a residence in the US offers flexibility.

I did not aim for nineteen of each, I just went through my research pile, and summarized everything that was there.? To me, this is a fair rendering of the confusing situation that we are in today.

On Maintaining an Even Keel, Without Getting Wishy-Washy

Posted on 15 March 2007 by David Merkel

The Broad Market Portfolio was up a little less than 50 basis points today.? Leading the charge were Dow Chemical and Sappi.? Trailing the pack were? Grupo Casa Saba, Industrias Bachoco, and Deerfield Triarc Capital.

One of the things that I debate about as I write for RealMoney is how public to be when I disagree with Cramer.? I’ve had a very good call on the FOMC for the past four years, with very few mistakes, and Cramer, in his view that the FOMC will loosen because of the present weakness in the stock market, because of subprime lending, seems misguided to me.? I differentiate between what I would do if I were the Fed Chairman, and what I think the current Fed Chairman will do.? My use of a political pain avoidance model has worked well for me over the last six years.? I no longer assume that the FOMC will want to do the right thing; they do what leads to the least political risk.

Also, I want to avoid becoming so bullish or bearish that I don’t listen to reason.? This is a pit for those that write about the markets, particularly if one is sensitive about being wrong.? Well, I will be wrong, hopefully just every now and then.

The course of action that is the most intellectually lazy is becoming a perma-bull or perma-bear.? It makes life simple because you can dismiss a large amount of the data.? It’s easier to write when you can focus on the same likely future difficulties/successes again and again.

I choose the hard route, trying to be fair about likely outcomes, and not overstating the case.? It doesn’t make for good journalism, but it makes for good investing!

PS — I will post on the last phase of my portfolio reshaping tomorrow.

Full Disclosure: long DOW SPP SAB IBA DFR

A Weak Day to Begin the Week

Posted on 12 March 200714 March 2007 by David Merkel

The broad market portfolio was only up 10 basis points today, against greater moves for the major averages. Leading the charge on the downside was Fresh Del Monte. Nothing was materially up, aside from Griupo Casa Saba.

There’s a lot of “I told you so” going on in the pundit-sphere at present regarding subprime mortgages. Those that have read me at RealMoney know that I have been talking about the problems there for the past 2-3 years. I will say this, the shrillness of the Johnny-come-latelys on the issue almost make me want to reconsider my opinion.
I’ll have the results of my comparison of competitors to my portfolio available tomorrow. I’m still scrubbing the data.Full disclosure: Long FDP SAB

Life in Warren’s World is Still Expensive

Posted on 10 March 200710 March 2007 by David Merkel

Last year, I wrote and ill-timed piece at RealMoney entitled, ?Life in Warren’s World Is Expensive,” and a follow-up, ?Buffett the Businessman.” I claimed that Berkshire Hathaway was overvalued. It has since risen by 15-20%. I am eating my crow, and wish that I had more salt.

Trouble is, I think that my thesis is still correct. I view Berkshire Hathaway as an insurance company that uses its liability structure to fund its operating businesses. To me, the performance of the insurance enterprises is a critical aspect of whether Berkshire is a good or bad investment.

In 2006, Berky wrote some of the riskiest coverages that the rest of the insurance industry would not touch on the property side of the business. Then came a ?no catastrophe? year. Is it any surprise that the stock is higher? Give Buffett credit for the AAA balance sheet that allowed him to be the last man standing in writing risky property coverages. Even in this year?s letter, he says he is willing to lose $6 billion in a single event. Pricing is slipping, and I have no doubt the Berky won?t chase the pricing down below levels where they can?t make their profit on average. That may mean that Berky will have a lot of idle cash.

Warren has changed his tune regarding retrocessional coverages in the last few years. In the 2007 letter, he explains how it can be used to ameliorate the risks of other insurers. This is a good and proper use of retro. In years 2005 and prior, he would crow about his riskless deals, which no doubt passed accounting muster, even if they missed the spirit of the regulations.

Berky has $50-70 billion to put to work. I don?t see how they can do that easily. Berky?s acquisition pattern over the past few years is to scrape up a few distressed companies, and a few companies where the owner was willing to sacrifice on price to preserve the culture. Outside of bold moves like acquiring ConocoPhilips outright, I don?t see how they can deploy that much capital.

Give Buffett credit for staying in enough of his foreign currency trade to draw a profit from it. I agree with Buffett over the state of our national finances, and think the dollar is headed lower over the intermediate term. That said, I increased my size of the trade when he lightened up in 2006.

Finally, they are looking for a successor to Buffett. Whoever that man may be, he will have to reckon with a few realities. If the objective is to grow long term book value, what is he best way to do that? Hold onto cash and wait for a crisis? Buy reasonably priced operating businesses with a hope of growth? Wait for utilities to go on sale? Behave like Magellan, Contrafund, or any other large mutual fund? (Not Buffett?s way.)

In summary, I can?t see Berky doing that well over the next twelve months because of the weak pricing environment for insurance, and the difficulty the Buffett will have in deploying the free cash of Berky. It is a more competitive environment for investments, which means that Berky will not deploy much cash.

Full Disclosure: Long COP